Definition Of Operational Risk Management – Operational risk summarizes the uncertainties and dangers that a company faces when trying to conduct its day-to-day operations in a particular field or industry. One type of business risk, it can arise from the failure of internal procedures, people and systems – as opposed to problems caused by external forces, such as political or economic events, or which are inherent to the entire market or market segment, known as systemic risk.
Operational risk can also be classified as a number of unsystematic risks, which are unique to a particular company or industry.
Definition Of Operational Risk Management
Operational risk focuses on how things are achieved in an organization and not necessarily what is produced or contained in an industry. These risks are often related to active decisions related to how the organization operates and what it prioritizes. While the risks are not guaranteed to result in failure, reduced production, or higher overall costs, they are considered higher or lower depending on various internal management decisions.
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Because it reflects man-made procedures and thought processes, operational risk can be summarized as human risk; there is a risk that business operations will fail due to human error. It changes from industry to industry and is an important consideration when looking at potential investment decisions. Industries with less human interaction are likely to have less operational risk.
Operational risk falls under the category of business risk; other types of business risk include strategic risk (not operating according to model or plan) and compliance risk (not complying with industry laws and regulations).
Operational risk typically comes from four different sources: people, processes, systems, or external events. For many aspects of operational risk, companies must simply try to reduce risk within each category as best they can with the understanding that some operational risk is likely to always be present.
Man-made operational risks can arise due to a lack of employees or understaffing. For example, a company may not have employees who have the knowledge needed to deal with a particular problem. On the other hand, a business may not have a reasonable amount of staff on hand to handle peak or busier times of the year.
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To reduce this kind of risk, companies can simply look to the markets to recruit workers. However, this introduces new people-centric operational risks such as finding the right candidates to hire, training staff and securing high-level staff. As each of these factors is resource and time consuming, operational risk caused by people is strongly linked to financial consequences.
Each company has its own processes. More complex manufacturing companies (ie a vehicle manufacturer) will have different processes compared to a service-only law firm. In both cases, all companies have steps that must be performed in order, otherwise adverse results are possible.
In many cases, especially in companies that have experienced high turnover, companies may not have fully developed their processes or documented all steps. In addition, there is a risk that certain processes will be exploited through collusion and failed internal controls to put the company at risk of losing money due to theft.
Businesses are increasingly dependent on software and systems to run their business. Operational risk includes the possibility that these systems are outdated, inadequate or not an installed asset. There are also performance considerations, as operational risk includes the possibility that one company’s systems may not be as efficient as those of competitors.
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There are operational risks associated with the technical aspects of a system. Systems may have errors or technical deficiencies that lead to increased exposure to cybercrime. Systems also have capacity limitations, and a company can increase its risk by having high expectations of what the systems can do.
In many cases, operational risk arises outside the company. This can range from natural disasters that block a company’s shipping process to political changes that limit how the company can operate. Some of these risk types can be grouped on their own (ie geopolitical risk). Others are simply companies as a third-party breach of contract.
Operational risk can never be 100% eliminated. Managers must decide what operational risk they are comfortable accepting.
The four reasons above can be expanded and divided into 7 main operational risk categories. These 7 main categories include (in no particular order):
Managing Operational Risk
KRIs are calculations that a company can assign to itself as a benchmark for risk. For example, a company may aim to only work with the most creditworthy suppliers. Therefore, KRI notes that there may not be more than three suppliers who violate the contract. As the year progresses, the company can assess whether KRI’s goals are met, the reasons why it is not and take the necessary measures to manage this risk.
KRIs are usually measurable; it is most useful for a company to have something it can actually track and measure. For this reason, the other key component is data. Without data, a company will never know if its KRIs are on track or missing. Companies can seek to develop robust processes for intelligence, either through automation, third-party surveys, financial results, or industry data.
In terms of KRIs and data, some companies may have defined operational risk areas that are worth monitoring. For example, banking standards may require banks to have certain processes in place, cash on hand or systems that operate in a certain way. In these cases, targets have been set for the company and it is much easier to assess operational risk as the KRI criteria have already been set.
There are several overarching strategies and principles when it comes to managing operational risk. While any company can choose to approach operational risk, here are four main ways companies manage risk.
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It should go without saying, but companies should constantly evaluate whether they are taking risks without real rewards. Consider the example above of suppliers failing to honor contracts. Should it be the same if there are no better suppliers that the company can work with that have a better credit history, the company can take a risk by working with less than better suppliers.
As with all things in investing, there is usually a positive relationship between risk and return. As companies take on more risk, they should be fairly compensated with higher returns. Therefore, companies can manage operational risk by cutting out processes that do not reward the company, but only create unnecessary risks.
Companies can manage risk by continuously assessing and assessing cost/benefit situations. Similar to the concept above, companies must manage risk by comparing the risks they take on with the rewards they receive. Instead of focusing only on the risks, this step involves paying attention to what benefits the company.
For example, a company may decide to expand into an international market. There could be high operational risk with this operation. But if the market is untapped and proper research is done, the benefits of expanding the business can far outweigh the operational risks. To manage risk, companies sometimes need to understand that risk is necessary.
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For companies to make the wisest decisions, it is usually best for senior management to make decisions about how to approach operational risk. These members of the team often have the most insight into the business and know the bigger and bigger strategies that can work together.
Consistent with the example above, a senior member of management should be responsible for the decision-making process for international expansion. This manager should work with members of all teams across the company to better understand logistics, legal, procurement and shipping risks. This kind of responsibility is not suitable for a lower level person.
Perhaps one of the most important aspects of risk management is understanding its approach and anticipating its outcomes. By doing so, companies can make decisions in advance whether to accept, reduce or avoid risks.
In the global expansion example above, a company can easily conduct extensive research to better understand geographic limitations, political risks, or differences in consumer preferences in this new market. The first step to accepting or managing risk is to understand what could happen in the future and have a plan already in place to overcome it.
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In a corporate context, financial risk refers to the possibility that a company’s cash flow will prove insufficient to meet its obligations – that is, the repayment of loans and other debts. Although these inefficiencies may be related to or caused by the decisions of management (especially corporate economists), as well as the performance of the company’s products, financial risk is considered to be distinct from operational risk. Most often, it is related to the company’s use of financing and debt financing, rather than the day-to-day efforts to make the company a profitable business.
Market risk is usually referred to as the risk of price changes for a financial instrument. These changes in price are often based on investor sentiment toward the stock and company, interest rates, or economic factors.
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