Wikipedia of Finance - e-learning course on Risk Management Wikipedia Chapter - What is Operational Risk Management? Definition, Examples, Framework

What is Operational Risk Management? Definition, Examples, Framework


Operational Risk Definition:

The risk of an amendment in value generated by the fact that real losses, acquired for insufficient or unsuccessful internal procedures, personal and organizations, or from external events such as legal risk, vary from the anticipated losses is known as operational risk. Close to quality management and good management, risk in operation is a broad discipline and it consistently possesses prominent threats to client reputation, contentment, shareholder value while elevating business instability. The European Union Solvency II Directive adopted this definition and it differs from the one adopted by Basel II regulations.

It was in October 2014, when the Basel Committee on Banking Supervision projected reconsideration to its operational risk capital structure that lays down a new homogeneous and standard approach to reinstate the fundamental gauge approach and the standardized approach for scheming operational risk capital. Risks such as security risk, fraud, privacy protection, legal risks, physical risks e.g. infrastructure shutdown or environmental risks can be entailed in operational risks.

Unlike the risks like credit risk, market risk, insurance risk, equity risk, etc., operational risks are usually not readily incurred nor are they income driven. Furthermore, they are non diversifiable and cannot be laid off until or unless organizational personal, systems and procedures linger to be flawed. In order to eliminate operational risks, the organization has to ensure the righteousness from within.

Operational Risk Management:

Operational risk’s, nevertheless, controllable and manageable just like any other risk e.g. constraining the losses within echelon of risk acceptance (because a wise man understands that he’ll have to encounter one or other kind of risk if he were to achieve the desired goals and objectives), based on corresponding the costs of expansion against the expected profits.

In this era of globalization and modernization, in the age of internet and the rise of social media, amongst all increase in awareness among people which is accompanied by the increasing demands for better business liability worldwide, has undoubtedly strengthen the need for an optimized operational risk management.

Types of Operational Risk with Examples:

Here we will discuss about various different types of operational risk in banks, business and financial planning. Basel II – Seven Event Types are as follows:

1. Internal Fraud – Internal fraud means embezzlement of assets, intended mis-marking of positions, tax equivocation, bribery, etc.

2. External Fraud – Pilfering of information or deliberately leaking it for that matter, hacking damage, third-party theft and counterfeit is known as external fraud.

3. Employment Practices and Workplace Safety – Special favors for a few workers and discriminating the rest, workers compensation, employee health and safety.

4. Clients, Products, and Business Practice – Market exploitation, trust breach, inappropriate trade, product shortcomings, fiduciary violation, account agitation. This are the major operational risk in banking sector.

5. Damage to Physical Assets – Natural calamities, terrorism, vandalism, etc and other damage to physical assets can be disastrous too.

6. Business Interruption and System Failures – Utility disturbance, software failures and hardware failures cause business disruptions.

7. Execution, Delivery, and Process Management – Data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets

Operational Risk Management Framework:

Various Supervisory bodies of the countries including Base II have approved numeral robust operational risk management frameworks and standards for Operational Risk Management for Banks and analogous Financial Institutions. To harmonize these standards, Basel II has proffered direction to three broad techniques of Capital calculation for Operational Risk and they are as follows:

1. Basic Indicator Approach – Based on annual revenue of the Financial Institution, this instrument is much simpler than the alternatives.

2. Standardized Approach – This approach is based on annual income of each of the extensive commerce lines of the Financial Institution.

3. Advanced Measurement Approaches – AMA is based on the internally urbanized risk measurement structure of the bank sticking to the standards approved (methods entail Scenario-based, IMA, LDA, Scorecard etc.)

The Operational Risk Management structure should entail characterization, identification, monitoring, measurement, reporting, and controlling and mitigation structural design for Operational Risk. In this chapter we have learned about operational risks in banks, business and operational risk management framework and techniques in various sectors like banking and finance services which are widely followed. Hope this e-learning tutorial has enhanced your knowledge.

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