Operational Risk
The term “operational risk” refers to a business’s vulnerability to possible dangers and difficulties it might come up against while doing its everyday endeavors in its commercial or industrial sphere. Operational risk is a part of business risk in general, which covers a variety of different possible threats of income lowering or a failure, with operational risks particularly denoting only the hazards coming mostly from internal factors, like inner processes and systems, staff and customers.
Operational risk might be viewed in terms of distinguishing systematic and unsystematic risk. In case of operational risk, it’s possible to classify it as a subtype of unsystematic risk, as systematic one means risk typical for the market in general or for one of its spheres, while unsystematic risk refers to problems specific for a certain company and occurring because of its inner processes and not the processes of the entire market.
What is Operational Risk
As it is stated by European Solvency II Directive, operational risks might actually come from both internal and external events (including natural disasters, global pandemics, terrorism, international crime activities and legal issues), although for most part operational risk is connected with inherent problems and decisions made by people inside a company.
Such risk is generated by the following issues:
- Work-place and employee-related issues, including abuse, harassment and insiders’ fraudulent activities;
- Difficulties with executing procedures according to the company’s rules or inability to implement such rules;
- Inefficiently organized and implemented inner processes;
- Possible product flaws and imperfections;
- Personnel errors, either intended or occasional;
- System and utility failure (including software and hardware failure and data storage problems).
In general, as its main origins are human-made decisions and actions, operational risk might be roughly characterized as a risk caused by human factors. So, it’s possible to assume that operational risks are lower in the spheres that require less human involvement and communication.
Operational Risk instances
There is a correlation between a market segment in which a company operates and its main operational risks. So, for a retail company, in which there is a significant amount of interaction between customers and the company’s representatives, such risks would likely be connected with personnel, and the more educated and qualified the employees are, the lower are the risks. If, for some reason, the company’s management decides to reduce staff, or hires workers of lower qualification, operational risk increases.
If a company in question is a producer or a service provider, operational risks are generated by the managers controlling the processes of production and distribution. The managers’ decisions lead to increase or decrease in operational risk. For instance, if a company’s executive chooses a resource supplier, and picks up the one with lower prices but longer delivery, it might generate operational risks.
Operational Risk evaluating
It’s not actually necessary for operational risk to turn into real losses, as it reflects only a possibility of losses or failures to occur, and depending on the quality of management it might be high or low. When correctly evaluated, operating risk is a useful indicator for a company’s management, helping to control the situation and choose the paths for development and improvement.
When evaluating such risks, it’s important to not just indicate possible problems and weak spots, but also plan corrective and preventive actions beforehand. To measure operational risks, various types of data on the company’s activities are gathered and analyzed, and special metrics called KRIs (Key Risk Indicators) are also used. This process might be challenging for some companies, especially for large and complex entities, as it might be difficult to get and arrange all the required data. Nevertheless, it’s crucial for sufficient measurement of operational risk, and to ease the process, various specialized software has been developed, and it’s also possible to hire a professional risk manager.
For risk management, especially if it’s required for a large company, it’s important to monitor KRIs regularly and closely to notice emerging changes to act preventively in time. A list of KRIs important for a certain company depends on the sphere the company is working in.
Operational Risk and other types of risk
As operational risk is a composite of business risk in general, it’s important to distinguish it from other kinds of risks because their evaluation and use are done and used differently. Sometimes, operational risks are viewed as something similar to financial risks, but there’s a key difference between these concepts.
Operational risk, in general, represents the change of value happened because of the difference between expected losses and actual losses. At the same time, financial risks represent the possibility of the company’s revenue being less than its financial obligations (debt payments, salaries, charges and fees, and so on). While these two kinds of risks might be connected and the latter may be the result of the former, they aren’t necessary linked and should be assessed separately.
