Definition of Operational Risk and Its Importance in Risk Management

Operational risk is an essential aspect of risk management that is often overlooked. It is defined as the risk of loss resulting from inadequate or failed internal processes, systems, or human errors. This type of risk can arise from a wide range of sources. This includes technology failures, employee misconduct, fraud, and natural disasters. Operational risk can have serious consequences for businesses, including financial losses, reputational damage, and regulatory fines. That is why companies must have a robust operational risk management framework in place to identify and mitigate potential risks.

In this article, we will explore the definition of operational risk and its importance in risk management. We will also discuss some of the key components of an effective operational risk management strategy that can help businesses avoid potential pitfalls and ensure long-term success.

What is Operational risk & its importance in risk management? 

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people,  systems, or external events. It can arise from any aspect of an organisation’s activities, including its people, processes, systems, or external events. Operational risks can result in financial losses, damage to reputation, legal liability, or even loss of life. It is the process of identifying, assessing, and mitigating these risks.

Types of operational risks

Operational risk is the potential risk that arises from inadequate or failed processes, systems, human error, or external events. There are four main types of operational risk that businesses face, and they are:

1. People Risk: This arises from the failure of people or employees to perform their duties or follow the company’s procedures. It may include issues such as fraud, theft, misconduct, inadequate training, or poor management.
2. Process Risk:  Process risk occurs from the failure of internal processes, policies, or procedures, which results in financial losses, reputational damage, or legal consequences. It may include issues such as ineffective controls, faulty procedures, or inadequate systems.
3. System Risk: This risk comes from the failure of technology or IT systems, which disrupts business operations and results in financial losses. It may include issues such as hardware failure, software glitches, cyber-attacks, or data breaches.
4. External Risk: This takes place from external events beyond the company’s control, such as natural disasters, political events, or economic instability. It may lead to business disruption, financial losses, or reputational damage.

Operational risk is a critical area that businesses need to manage proactively. Understanding the different types of operational risks can help business owners and managers recognise potential risks and develop strategies to mitigate them.

Common causes of operational risks

Operational risks can come from various sources. Businesses need to identify potential risks, develop strategies and guidelines to mitigate them and be prepared to manage them when they occur.

Here are some common causes of operational risks that businesses face:

• Human error: Mistakes made by employees can result in operational risks, such as data entry errors, processing mistakes, or even accidents on the job.
• Technology failures: Malfunctioning software, hardware, or network systems can cause operational disruptions, leading to lost productivity, missed deadlines, and potential legal liabilities.
•  Inadequate processes: Poorly designed or implemented processes can lead to inefficiencies, errors, and other operational risks. For example, a company may experience supply chain disruptions if they don’t have a system in place to manage inventory levels effectively.
• Poor management: Ineffective leadership can cause operational risks, including poor decision-making, lack of communication, mismanagement of resources, and failure to identify and address potential risks.
•  Regulatory and compliance issues: Noncompliance with laws and regulations can lead to legal and financial penalties, reputational damage, and other operational risks. For e, a company may face hefty fines if they don’t follow data protection regulation or information security.
• External events: External factors such as natural disasters, political instability, and supply chain disruptions can cause operational risks, which can impact the business’s ability to operate efficiently and effectively.

Key principles of operational risk management

Operational risk management is a critical process that organisations use to identify, assess, and mitigate risks associated with their operations.

The following are key principles of operational risk management:

1. Governance: An organisation’s operational risk management framework should have clear governance, documents, structures, roles, and responsibilities to ensure effective risk management.
2. Risk identification and assessment: An organisation should identify and assess its operational risks to understand the potential impact on its objectives and to prioritise risk management efforts.
3. Risk mitigation: An organisation should develop and implement risk mitigation strategies that are proportionate to the level of risk and consistent with its risk appetite.
4. Risk monitoring and reporting: An organisation should establish a process to monitor and report on its operational risks, including risk appetite, risk exposure, and risk incidents.
5. Information and communication: An organisation should ensure that relevant and timely information is available to support effective risk management decision-making and that there is effective communication between stakeholders.
6. Continuous improvement: An organisation should continually review, document, and improve its operational risk management framework to ensure it remains relevant and effective in identifying, assessing, and mitigating operational risks.

By following key principles of operational risk management, organisations can ensure they are prepared to manage risks and protect their operations.

The Role of risk culture and risk appetite in operational risk management

Risk culture refers to the values, attitudes, and conducts of an organisation’s employees and how they view and manage risk. It is essential to create a risk culture that supports effective risk management and encourages employees to take ownership of risks.

Risk appetite is the amount and type of risk an organisation is willing to take to achieve its objectives. It is an important consideration in operational risk management because it helps to define the level of risk that an organisation is willing to accept and manage.

Effective risk management requires a strong risk culture and a clear understanding of risk appetite. Organisations should develop a risk culture that supports effective risk management, and ensure that risk appetite is aligned with its objectives and values.

The steps involved in identifying, assessing, and mitigating operational risks

The process of identifying, assessing, and mitigating operational risks is an essential component of risk management. Operational risks refer to the potential risks that arise from a company’s day-to-day operations, such as inadequate internal controls, human error, fraud, or system failures.

The following are the steps involved in identifying, assessing, and mitigating operational risks:

1. Risk identification: The first step in operational risk management is to identify the risks associated with an organisation’s operations. This can be done through a variety of methods, including risk assessments, control self-assessments, and key risk indicators.
2. Risk assessment: Once the risks have been identified, they should be assessed to determine the likelihood and impact of each risk on the organisation. This will help prioritise risks and determine which risks require further attention.
3. Risk mitigation: After the risks have been identified and assessed, risk mitigation strategies should be developed and implemented. These strategies should be proportionate to the level of risk and consistent with the organisation’s risk appetite.
4. Risk monitoring and reporting: An organisation should establish a process to monitor and report on its operational risks, including risk appetite, risk exposure, and risk incidents. This will help to identify emerging risks and ensure that risk management strategies remain effective.

Tools and techniques used in operational risk management

Operational risk management is a critical aspect of any business or organisation in Australia that involves identifying, assessing, and managing risks associated with operational processes. There are several tools and techniques used in operational risk management, including:

1. Risk assessments:

   Risk assessments are used to identify, assess, and prioritise risks associated with an organisation’s operations. It may include the use of risk matrices or risk registers to identify and assess risks.

2. Control self-assessments:

   Control self-assessments involve evaluating the effectiveness of existing controls in mitigating operational risks. By assessing controls, businesses can identify gaps and implement additional controls to manage risks.

3. Key risk indicators (KRIs):

   Key risk indicators are metrics used to track and monitor the level of operational risk in an organisation. These metrics provide early warning signals to identify potential risks before they materialise.

4. Scenario analysis:

   This involves the use of hypothetical scenarios to assess the impact of operational risks on the business. The analysis helps businesses to identify potential risks and develop risk mitigation strategies.

5. Business continuity planning (BCP):

   BCP is a process of developing a plan or design to ensure that critical business functions can continue in the event of a disruption. BCP involves identifying critical processes, developing contingency plans, and testing the plans regularly.

Overall, the use of these tools and techniques can help organisations and communities effectively manage operational risks and minimise the impact of disruptions on business operations.

The connection between operational risk management and other risk management disciplines

Operational risk management is basically a critical element of an organisation’s overall risk management strategy. It deals with the risks and security issues associated with the organisation’s processes, systems, consultants, and external events.

The connection between operational risk management and other risk management disciplines further to credit risk, market risk, and liquidity risk, is that they all contribute to a comprehensive risk management framework.

Credit Risk Management

Operational risk and credit risk management are interrelated because poor operational processes could lead to difficulties in credit risk management.

Lastly, inaccurate or incomplete technical standard data could lead to credit decisions being based on incorrect information, leading to a higher risk of default in the economic sector.

Market Risk Management

Similarly, operational risk and market risk are connected because external events, especially market disruptions, can lead to operational issues.

For e.g, a sudden stock market crash may lead to high volumes of sales orders, which could overwhelm operational systems, leading to errors and delays.

Liquidity Risk Management

Liquidity risk and operational risk are also linked because operational failures can prevent an organisation from meeting its liquidity needs.

For example, if a bank consultant experiences a system failure, it may not be able to process customer transactions, which could lead to a loss of customer confidence and liquidity problems.

The interconnection between operational risk management and other risk management disciplines is vital to ensure effective risk management throughout the organisation. By understanding these connections, organisations can create a more comprehensive and robust risk management framework that addresses all prudential risks.

Future trends in operational risk management and how to stay ahead of them

The future of operational risk management will be shaped by advances in technology, changes in regulatory requirements, and emerging risks. To stay ahead of these trends, organisations should:

1. Embrace technology: Organisations should leverage technology to improve their operational risk management practices, such as using websites, artificial intelligence, and machine learning to identify and assess risks.
2. Monitor regulatory changes: Organisations should stay up-to-date with regulatory requirements and changes to ensure that their operational risk management practices comply with current regulations.
3. Consider emerging risks: Organisations should be proactive in identifying and addressing emerging risks, such as cyber threats and environmental risks, and developing risk management strategies to mitigate these risks.
4. Foster a strong risk culture: A strong risk culture is essential for effective operational risk management. Organisations should focus on developing a culture that supports effective risk management and encourages employees to take ownership of risks.
5. Leverage professional certificates and continuous learning: Professional certificates, especially the Certified in Risk and Information Systems Control (CRISC) and the Certificate in Operational Risk Management (CORM), can provide individuals with the skills and knowledge to stay ahead of the latest trends in operational risk management. Continuous learning and development are also important for keeping up-to-date with best practices and emerging trends.

Operational risks can have a huge impact on business. If they don’t own a robust operational risk management system in place. This article has provided a brief overview of the different types of operational risks businesses face and the dangers they pose. Business owners and managers need to be familiar with these risks and develop strategies that help to mitigate them.