Operational risk is the risk of losses resulting from malfunctioning processes, policies, systems, or disruptive events affecting business operations. Factors such as employee mistakes, fraudulent activities, and physical incidents can trigger such risks.
A business is exposed to various risks that threaten to affect its procedures and profitability. Operational risk is one such broad category of potential challenges. Every business is exposed to some kind of operational risk that could affect its regular processes and systems. In this article, we examine the meaning of operational risk, how it is measured, its different categories and more.
What is operational risk?
Operational risk is the possibility of disruptions in the regular operations and processes that keep a business running. It can also be described as the possibility of losses arising from interruptions in the regular systems and operations of a business.
Since a business relies on various types of operations to remain functional, operational risk can manifest in several different ways. Any process, right from manufacturing or supply and distribution to payroll or marketing, could be disrupted. The risk of such an event occurring is termed operational risk.
How operational risk works?
Operational risk is predominantly an internal risk. It mainly occurs when there is an unexpected breakdown of one or more processes that are required to keep a company running and functional. Any disruptions in the internal procedures of an organisation — whether it involves people, procedures or other systems — is a manifestation of operational risk.
Operational risk is an interplay of various elements within a business that can go wrong and cause financial losses. When the people within an organisation make mistakes or engage in fraudulent activity, it disrupts normal operations. Faulty internal processes can also lead to inefficiencies in operations. To mitigate operational risk, businesses need to constantly adapt to these dynamic challenges and minimise losses.
What are the different causes of operational risk?
Operational risk may occur because of any of the following reasons. Sometimes, a combination of the below factors can also lead to a manifestation of operational risk.
- Failure of internal processes: This includes errors in transaction processing, regulatory non-compliance, inadequate controls and other gaps in internal operational procedures.
- People-oriented causes: Operational risk can also occur because of manual error, fraud or gaps in training. This could lead to financial loss and a lack of trust.
- System failures: Systems may also fail and cause operational disruptions. For instance, an organisation may experience IT failures, cybersecurity breaches or software bugs.
- External causes: Operational risk may also occur due to external events like natural disasters, external fraud or political instability. Such events may disrupt business processes.
How to measure operational risk?
Since operational risk is a complex concept that has several triggers, there is no single formula or method to measure this type of risk. However, the following strategies can be useful for businesses that want to quantify the risk posed to their operations from different sources. These strategies include:
1. Using Key Risk Indicators (KRIs)
KRIs are metrics that help monitor the level of risk within an organisation. Some examples of KRIs include system downtimes, incident reports, supply chain failures and failed transactions. These KRIs can help identify risk areas.
2. Analysing loss data
Businesses can also collect and analyse historical data about losses that stemmed from operational failures. By examining this data, it is possible to identify patterns and potential areas of concern.
3. Scenario analysis
Companies can also rely on scenario analysis to evaluate the impact of hypothetical events that pose a risk. This involves assuming and assessing scenarios like a major system failure or a financial fraud within the company.
4. Stress testing
Stress testing is all about checking how well a company’s operations withstand extreme risks. This makes it easier to understand how much the entity may be affected if operational risk materialises.
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Example of Operational risk
Operational risk can affect a business in many ways. Any element that impacts a business’s operations, either directly or indirectly, can be a source of this risk. Let us discuss a couple of examples to understand this risk better.
Take the case of a company whose operations are heavily reliant on machinery and equipment that need to be maintained and serviced regularly. Any disruptions or negligence in the maintenance routine can affect the efficiency of the machinery involved. This, in turn, directly affects the business’s operations. So, the possibility that the maintenance routine may not be strictly followed is a source of operational risk.
Another example can be a simple case of a human error. If an employee enters incorrect data in a purchase order, this small slip can have substantial consequences. For instance, if the purchase order is raised for 1,00,000 units instead of 10,000, the company will receive 10x more inventory than required. If the inventory is perishable or in seasonal demand, selling the products before they expire can be challenging or impossible — and lead to a massive financial loss.
7 different categories of operational risk
To fully appreciate how operational risk can stem from various sources, check out the different categories of this type of risk that businesses commonly face.
1. Internal fraud
This source of risk involves the potential for fraudulent activities within the organisation. For instance, tax evasion, embezzlement of funds, manipulating financial records or inflating prices to cover up kickbacks.
2. External fraud
Operational risk can also stem from external frauds that can be traced back to third parties who have no relationship with the business. Some examples include phishing scams, data breaches, identity theft and fraudulent claims from lenders or customers.
3. Technology failures
The technology and systems used to run the business operations could also fail, leading to operational disruptions and losses. For instance, server crashes, outdated systems or even failed software updates could cause unexpected downtimes.
4. Failures in process execution
Various processes within an organisation keep the business running. A failure in any process — no matter the department it belongs to — can cause operational issues. Some examples of such failures include incorrect order fulfilment, missed deadlines or poor quality control.
5. Safety breaches
Operational risk also includes any safety breaches that compromise employee safety in the workplace. Examples include lack of safety protocols, unavailability of personal protection equipment and poor emergency response plans.
7. Natural disasters
This is a source of operational risk that is entirely out of the business’s control. Floods, earthquakes, fires and harsh climates could disrupt various operations across the supply chain or daily business activities.
8. Adverse business practices
Sometimes, the business practices employed by an organisation may be the source of operational risk. For instance, providing misleading information to customers, insider trading, unethical labour practices and producing substandard products all fall into this category.
The five stages of managing operational risk
Companies may have various strategic approaches to managing operational risk. However, the following stages are typically useful for companies in the early phases of developing their risk management strategy.
Stage 1: Identifying the risk
The first step is to identify the different sources of risks that could interfere with a company’s operations.
Stage 2: Brainstorming ideas
The next step involves bringing together the required personnel and professionals to brainstorm ideas to deal with these operational hazards.
Stage 3: Conducting a risk audit
This stage involves conducting a risk audit to evaluate the existing risk mitigation procedures, identify gaps in the strategies and conduct scenario analysis for more clarity.
Stage 4: Identifying crucial action plans
Based on the results of the risk audit, the company needs to identify the steps that need to be taken to successfully manage potential risks and threats to its operations.
Stage 5: Observing and reporting
The last stage involves observing the newly implemented procedures, reporting on their efficiency and taking corrective measures if required.
Challenges in the assessment of operational risk
Assessing operational risk can be difficult because of the following issues and challenges:
- Unavailability of the required data
- Difficulty in quantifying available data
- Complexity in the different causes of operational risk
- New sources of risk that emerge as a business expands
- Lack of a clear measure to quantify this risk
- Gaps in scenario analysis that may not accurately reflect potential real losses
Key takeaways
- Operational risk is the possibility of internal or external triggers causing disruptions in business operations.
- This could result in financial loss and/or reputational damage to the business.
- Some common sources of operational risk include internal or external fraud, technology failures, natural disasters and safety breaches.
- To manage such risks, companies need to have an actionable plan to effectively identify operational hazards and implement measures to curb them.
Conclusion
Operational risk is only one of the different kinds of business risks that companies face. While some of the effects of these risks do not affect investors, others (like reputational damage or financial losses) can impact investor wealth. This is why it is crucial to factor in all these aspects before making an investment decision.
If you are finding it difficult to assess multiple factors before deciding on which company to invest in, mutual fund schemes may be a more convenient alternative. By investing in mutual funds, you can benefit from the expertise of fund managers who make these tough decisions for you.
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