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Operational risk is the risk of losses resulting from ineffective or failed processes, people, systems, or external events that can disrupt the flow of operations, and that can result in direct or indirect financial losses for a business.
It refers to both the risk of operating an organization and the process management uses when implementing, training, and enforcing policies.
Four types of operational risk
The four types of operational risks are:
- Technical Error
- Intentional Frauds
- Human Error
- Uncontrollable Events
Examples of operational risk
A few examples of operational risks are:
- Employee conduct and behaviour
- Breach of private data resulting from cybersecurity attacks
- Technology risks tied to automation, robotics, and artificial intelligence, 4. Business processes and controls
- Physical events that can disrupt a business, such as natural catastrophes, 6. Internal and external process fraud.
Operational risk management
Operational risk management is the process of understanding and managing the risks that the entity is inevitably subject to in attempting to achieve its corporate objectives.
For management purposes, risks are usually divided into categories such as operational, financial, legal compliance, information, and personnel.
Primary objectives of operational risk management
A key objective of operational risk management is to reduce risks associated with daily operations. Operational risk management focuses on operations and excludes strategic and financial risks. Operational risk management processes emphasize controlling and eliminating risk rather than optimizing risk appetites, as other risk disciplines emphasize.
In operational risk management processes, operational risks are categorized into people risks, technology risks, and regulatory risks.
Employee risk includes human error and intentional wrongdoing, such as fraud. This category includes employees, customers, vendors, and other stakeholders. There are numerous operational risks outside of the organization, such as breaches of policy, inadequate guidance, poor training, poor decision-making, or fraudulent behaviour. One of the most comprehensive areas of operational risk is monitoring and controlling people.
Hardware, software, privacy, and security are all technology risks from an operational perspective. Hardware limitations and lack of training in software can hinder and reduce productivity. Customers can also experience software effects. Leaks of customer information and data privacy concerns can occur as hackers attempt to steal information and hijack networks.
This is a risk of non-compliance with regulations in nearly every organization. Some industries are more heavily regulated than others, but all regulations require operationalizing internal controls. A growing number of rules and increasing complexity have increased penalties in the past decade.
Benefits of operational risk management
There are many benefits of operational risk management, a few critical benefits are:
- Better-informed business risk-taking
- Improved product performance and better brand recognition
- Stronger relationships with customers and stakeholders
- An improved view of C-suite
- More sustainable financial forecasting
- Greater investor confidence.
operational risk management process
There are five steps in the operational risk management process:
Step 1: Risk Identification
Identifying risks begins with understanding the organization’s objectives. Risks are anything that prevents the organization from achieving its goals.
Step 2: Risk Assessment
Risk assessment is a systematic method for rating risks based on likelihood and impact. The outcome is a prioritized list of known risks.
Step 3: Risk Mitigation
Risk mitigation involves transferring, avoiding, accepting, or controlling a particular risk in an operational risk management process.
Outsourcing and insurance are two common methods for transferring risks.
Risk avoidance strategy prevents an organization from getting into a situation where it will be exposed to risk.
Management accepts risk based on a comparison of the cost of control and the amount of risk, called risk-cost comparison.
Control is a set of processes followed by the organization to minimize the impact of risk on the organization when it occurs or to make it more likely that if the risk occurs, the organization will still be able to achieve its goals.
Step 4: Control Implementation
Risk mitigation is followed by the implementation of controls that are tailored to meet the specific risk. The controls implemented should emphasize preventive control activities. Control rationale, objective, and activity should be clearly documented in order to ensure that they are clearly communicated and implemented.
Step 5: Monitoring
It is important to monitor controls because they may be performed by people who can make mistakes or if the environment changes then error persists. Key Risk Indicators (KRIs) are used to monitor nearly any potential risk, and a notification can be sent when a risk is detected.