What Are Operational Risks?
“Operational Risks” is a risk that includes errors because of the system, human intervention, incorrect data, or because of other technical problems. Every firm or individual has to deal with such an operational risk in completing any task/delivery.
With firms, operational risks include system errors, human errors, improper management, quality issues, and other operation-related errors. In the case of individuals, we can drill it down to error because of self-process or other technical problems.
- Operational risks involve mistakes caused by system failures, human interference, incorrect data, or other technological issues. These risks are inherent in every company’s or individual’s activities or services.
- Examples of operational risks include human error, technical errors, gaps in operational processes, uncontrollable events, and intentional fraud.
- The impact of operational risk may only become evident after significant losses occur. Organizations often limit immaterial losses once the source of a material loss is identified and examined.
Operational Risks Explained
The business operational risks are the ones that arise from various uncertainties and problems that the business or an entity faces during their day-today operations. They are the result of problems like internal frauds and mismanagement, lack of communication, inadequate or improper strategic planning or technological breakdown.
The operational risk framework is inevitable in any process or transaction. This is one type of risk that is controllable; however, not guaranteed to be eliminated. Even if all control checks are in place, there is scope at various steps for such errors. The best thing to do is to have a robust quality check process at the end of any product processing.
This quality check process should be in-built within departments before the product is delivered to clients/end-users. Such quality check owners become responsible for the entire product processing and are liable for any work-related questions/clarifications required later.
It becomes the organization’s responsibility, at the end of all, to deliver a quality product as per the norms and agreement between them and the client. After all, for the client company’s promised delivery is all that matters. Thus, if the company is not able to meet the client’s expectations, then it affects all departments of the organization in a negative way.
It is necessary for organizations to periodically assess the situations and try to identify areas that need improvement, modification or upgradation using some key indicators and data.
The following are types of operational risk framework that the business may face during the daily working. Let us try to analyse and understand each of those risk in details.
#1 – Human Error
We can also refer to this as a fat finger input error. This error is the most common and significant risk to the organization or individual. It may also relate to the skill issue of the processor. This type of error evolves when incorrect input is because of human error. The reasons for incorrect input may be multiple, including incomplete information, incomplete understanding, insufficient knowledge, inconsistent processing, genuine input error, or more. However, processing such an error may affect the output seriously and may also lead to a loss.
#2 – Technical Error
This includes system glitches. Even though everything is perfect, there are sometimes system issues like a slowdown, connectivity, system crashes, incorrect calculation by application, or a new missing bridge. Sometimes, the output received may be off from the expected result, but because of unknown technical defects, it may be challenging to catch.
#3 – Gap in Flow
Sometimes, information is missing from the source itself because of data lag or restrictions. In such cases, the output gets affected. The required production varies from that desired and may put the process at risk.
#4 – Uncontrollable Events
These include effects from an external environment like political scenarios, weather changes, syndromes affecting living beings, outdated technology, etc., which affect the performance and quality of processors and put the output at risk.
#5 – Intentional Frauds
There have been cases where intentional conflict of interests has arisen, resulting in an illegal profit to trade executors. Most organizations have a clause in their policies that the employees have to abide by fighting against conflict of interests and fraudulent practices, failing which they meet with extreme consequences. However, if such an event occurs, the firm has to bear monetary and defame losses, which are sometimes irrecoverable.
Below are examples of business operational risks. These examples will help us the understand the concept.
ABC Corp deals in providing financial services to its clients. They process their client’s credit ratings based on various parameters. In one case, the processor made an input error, wherein he inputted $1,000,000 instead of $100,000. As a result, the client’s credit rating changed from B to AA.
This gave an incorrect picture of the client’s creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan. in markets and resulted in an overestimation of debt repayment capacity.
This is one of the operational risks that ABC Corp faces, and if repeated, may lead to disastrous results.
Anna is a technical analyst who works on applications for her organization. She created an application recently for the accounts department to create invoices. Operation departments use such applications to produce output.
At the end of the month, the actual cash outflow was more than that flowing into this application. Upon more investigation, the team found out that one of the account payableAccount PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period. inputs was getting doubled after execution.
Such an error is a technical error that creates operational risk and can be identified only upon considerable effects. It may be possible we may miss them for smaller immaterial transactions.
Below are the personal account entries created by Mr Brown for August.
Based on the above, Mr. Brown should have savings of $6,000 at the end of the month. However, the actual cash left with him is only $4,000.
After tallying all expenses and income, Mr. Brown discovered that he was missing out on a donation of $2,000 he makes once a year. After including this expense, his accounts were tallied.
Thus, there is an operational risk of data inclusion for accurate output.
The various advantages of operational risk management is as given below.
- It helps to improve the efficiency and reliability of the business process because the management remains conscious about it and tries to identify them in a periodical manner, thus improving the entire process.
- The entire risk management process gets a boost because the weak areas, the loopholes and the frauds committed are taken care of. This helps in mitigating the risk of the organization to a large extent and in the process, enhance the effective implementation of resources.
- The management can modify and upgrade the decision making process by controlling the operational risk. The decisions taken are effectively and properly implemented if this type of risk is identified along with the factors that cause them. The management decisions are always based on what are the pros and cons of the business process and how they can be enhanced or controlled respectively. Thus, risk identification always leads to better results and management decisions.
- Any unlawful and unethical activities going on inside the entity are identified on time due to the knowledge of operational risk control. Such early identification helsp in streamlining the business process in the right direction.
Therefore, this kind of risk may affect the business for a short period of time, but if they are taken care of immediately, they can be used to upgrade and enhance the business to achieve the maximum profit with minimum cost.
It is always necessary to evaluate the advantages as well as disadvantages of any financial concept to use them in an optimum manner. Let us try to understand the disadvantages as given below.
- Effects due to operational risks may create irrecoverable losses. Sometimes, the losses can also lead to the cancellation of licenses for the responsible employee and the organization.
- It creates damage to the brand name of the employee as well as to the organization. It can lead to lifetime losses and trust in the market for such employees and the organization.
- The effect created due to operational risk management can be identified and assessed only after significant losses are met. Every organization has a bar for immaterial losses incurred only when the cause of a material loss is investigated.
- Once an error is noticed, it may or not be reversible and corrected. Even if it can be reversed, there are chances of losses already incurred. Hence, it is best to create proper control checks at all steps of any process.
Operational Risk Vs Strategic Risk
The above are the two type of risks that companies often face but there some differences between them as given below:
- The former is related to risk from internal problems whereas the latter may be due to internal and external problems.
- The operational risk control deals with the process of how the management controls and mitigates any risk that threatens the business and the latter deals with how external factors affect the internal working of the business.
- Examples of the former are human error, technical breakdown, internal fraud, cyber threats, etc and examples of the latter are market competition, financial challenges, ineffective management decisions, etc.
Thus, it is important to understand the various types of risks that the companies face in order to deal with them in an efficient manner.
Frequently Asked Questions (FAQs)
The responsibility for raising an operational risk incident lies with the individuals who identify or discover the incident. This could include employees, managers, or even customers who observe or experience an event that poses a potential risk to the operations of a business or organization. Prompt reporting of operational risk incidents is crucial to mitigate further damage and address the underlying causes effectively.
An operational risk manager is responsible for identifying, assessing, and managing organizational risks. They analyze potential risks arising from internal processes, systems, or external factors and develop strategies to minimize them. Their role involves implementing risk management frameworks, conducting risk assessments, establishing controls and mitigation plans, and ensuring compliance with regulations.
Operational risk analysis is important in banking because it helps financial institutions understand and manage the potential risks associated with their day-to-day operations. Banks deal with numerous activities, such as lending, trading, and processing transactions, which are vulnerable to operational failures. Analyzing operational risks allows banks to identify and prioritize potential issues, assess their potential impacts, and implement appropriate risk mitigation strategies.
This has been a guide to what are Operational Risks. We explain them with examples, types, differences with strategic risks, advantages & disadvantages. You can learn more about risks from the following articles –