Operational Risks Definition
“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.
Types of Operational Risks
The following are types of operational risks.
#1 – Human Error
We can also refer to this as a fat finger input error. This type of error is the most common and most 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 of 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 actual 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effects from an external environment like political scenarios, weather changes, syndromes affecting living beings, outdated technology, etc.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 hence puts 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 of the organizations have a clause in their policies which the employees have to abide by, for 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.
Examples of Operational Risks
Below are examples of operational risks.
Operational Risks – Example #1
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, during which he inputs $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 creditworthiness in markets and results 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.
Operational Risks – Example #2
Anna is a technical analyst who works on applications of her organization. Operation departments use such applications to produce output. She created an application recently for the accounts department to create invoices.
At the end of the month, the actual cash outflow was more than that flowing into this application. Upon more investigation, the team finds 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 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.
Operational Risks – Example #3
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 found out that he was missing out on a donation of $2,000 he makes once during the year. After including this expense, his accounts were tallied.
Thus, there is an operational risk of data inclusion for accurate output.
- 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/or the organization as a whole.
- It creates damage to the brand name to the employee as well as to the organization. It can lead to lifetime losses and trust in the market for such employees and/or the organization.
- The effect created due to operational risk can be identified and assessed only after significant losses are met. Every organization has a bar made for immaterial losses incurred, only when the cause for 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 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 type of error. The best that can be done 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-user. Such quality check owners become responsible for the entire product processing and are liable to 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.
This has been a guide to what are Operational Risks and its definition. Here we discuss the top 5 types of operational risks along with examples, disadvantages, and limitations. You can learn more about risks from the following articles –