What is Operational Risk ?: What is it, Risk Factors, Types, How to Measure it and MORE

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To start reading about What is Operational Risk? You must know what all the errors or risks that can happen within any business environment are about. That is, they are the failures that occur as a result of the daily work of the employees.

These errors can be reflected in real losses, such as pThey can be monetary and financial, it can also be produced by unexpected events. If you want to know more about this We invite you to continue reading this article!

What is Operational Risk?

The Operational Risk are all the errors or risks that can happen within any business environment. These errors can be reflected in real losses. They happen due to internal processes, inadequate or failed people and systems, or external events (including legal risk).

It is considered different from the expected losses. This definition, taken in a different way, was adopted by the European Solvency II Directive for insurers. This is a variation of the one adopted in the regulations of Basel II for all banks.

Previously, operational risk was negatively defined in Basel I. The definition was that the Operational Risk they are all hazards that are not market risk or credit risk. Therefore, some banks have also used this type of term as a synonym for non-financial risks.

In October 2014, the Basel Committee on Banking Supervision proposed a revision of its operational risk capital framework that establishes a new standardized approach to replace the basic indicator approach and the standardized approach for calculating operational risk capital.

It may also include other kinds of risks, such as fraud, security, privacy protection, legal, physical risks (for example, infrastructure closure), or environmental risks. The study of operational risk is a broad discipline, close to good management and quality management.

Similarly, operational risks affect customer satisfaction, reputation, and shareholder value, while increasing business volatility. So it is important to prevent these errors, if possible.

Despite being preventable, they cannot disappear. This means that as long as people, systems and processes remain imperfect, risk cannot be completely eliminated.

What are the Operational Risk Factors?

There are some risk factors in operations that must be considered by companies worldwide. These are a number of things to keep in mind when avoiding these risks. These are:

Human Resources

One of the operational risk factors is the activities carried out by the staff, whether due to the skills, ethics or power of the officials. That is, everything that the people who work for the company can do.

When employees are unable to transact within their authority, they may change confidential information or have confidential customer or company data for their use, which can lead to fraud, theft, sabotage, etc.

Lack of division of responsibilities

One of the principles of internal control of the company is the separation of functions. This includes the separation of activities so that the responsibility for one or more areas of the company does not fall on a single person. In this way, no official should manage all the stages of the transaction.

When there is no separation of duties, users can access transactions to perform unauthorized or fraudulent actions. Therefore, this is an important operational risk factor.

Many banks, such as JP Morgan Chase, Banco Barings or Banco Société Générale, lost many large losses, due to various problems due to the lack of division of functions.

User and password management

The system, infrastructure, storage availability and management of the company’s network are factors of operational risk. Therefore, it is considered that the security of the entire system of a company must be protected.

In this sense, if users access the company’s sensitive information systems or have access to users or passwords that are not their responsibility, the risk of loss of confidentiality may increase or subject the data to unauthorized modifications.

Failure in the Processes

The process or stage of development of the product or service, as well as the internal record of the client or the transactions that are not entered correctly in the system can generate operational risks.

Within the operational risk factors in the same category are those transactions with incomplete records, incorrect information or outside the corresponding accounting period. Here you can download a book where it is explained more thoroughly about this.

If input data is incorrectly formatted or does not match existing data, accounting records can be seriously affected. A good practice to manage and reduce the impact of risks is through the design and implementation of risk indicators.

Classes of Operational Risk

  • Internal fraud

Theft, bribery or non-compliance with regulations by direct employees or third parties contractually linked to your company are risks caused by internal fraud.

  • External fraud

This type of risk originates from the actions of people external to the entity. They can be presented in different ways such as theft, forgery or computer attacks on the platforms.

  • Technological failures

If your company is exposed to failures in the company’s computer systems, hardware or software, you must identify the risks that these events generate. That is why it is recommended to update such software and hardware.

  • Execution and management of processes

Errors in process management also pose a risk to your company. In this sense, the capture of transactions, the monitoring, the reporting and the documentation of clients, as well as the management of accounts must be evaluated to recognize possible operational risks.

  • Labor relations and workplace safety

Any action that violates labor legislation and safety at work can generate a clear risk. So be on the lookout for potential personal injury claims or workplace discrimination within the company.

  • Damage to tangible assets

Fortuitous circumstances such as fires, earthquakes, terrorist acts, among others, can put the physical assets of your entity at risk, so identify the damages that these events may cause.

  • Customers, products and business practices

Finally, this last class of operational risk refers to acts such as unfair competition, damage to customers and misleading information about products, which can imply a risk of inadvertent and negligent non-compliance.

What is Financial Operational Risk?

To know about this type of risk, it should be known that the financial operational risks they are related to the financial activities of a company. That is, they are all those errors where the economy of any company is affected.

This type of operational risk includes the risks generated by poor cash flow management, risks related to low returns and low investments. Possible causes include:

  • Poor financial management.
  • High levels of indebtedness.
  • Exposure to interest rates or changes in exchange rates.
  • Low efficiency and accuracy of information for decision making.
  • Operations or investments with a high percentage of risk.

How is Operational Risk Measured?

Basic indicator approach to measure operational risk

The basic indicator approach is much simpler than the other techniques for measuring operational risk and is therefore recommended for small financial institutions whose operations are not very complex.

This method calculates the operational risk for the entire organization and then assigns the result to operational lines. The basic indicator is measured as a percentage of gross income over that of the previous three years.

Standard approach to measuring operational risk (SA)

According to this method of measuring operational risk, the activities of banks are divided into eight business lines: corporate finance, stock trading and sales, retail banking, commercial banking, payments and settlements, agency services, asset management, and retail brokerage.

Within each business line, gross income serves as an indicator to measure the scale of business operations and, therefore, to calculate the possible exposure to operational risk in each line.

Advanced Measurement Approach (AMA)

Of the three approaches to measuring operational risk, this is the most sophisticated method. With the advanced measurement approach model, banks can create their own empirical model to quantify the capital required for operational risk.

An advanced measurement approach model or AMA framework should include the use of four quantitative elements for its construction: internal loss data, external data, scenario analysis and business environment or internal control factors.

Thanks for reading!

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