Operational Risk is the most important Business Risk. Managing it correctly including hedging greatly strengthens business and investor performance.
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Operational Risk Definition
Operational Risk (Op Risk) is the core of all business risks and is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This is the basic definition of Op Risk and is the premise of more complex and derivative definitions used by global regulatory bodies (including the Basel Committee on Banking Supervision) and private institutions.
Operational Risk Examples
- Cyber attacks
- Political events/changes
- Economic downturns/crises
- Natural events/disasters
- Malfunction in computers
- Damage to equipment due to a failure in electronic or non-electronic systems
- Low Process Quality due to organizational functions (ex. tasks assigned incorrectly)
- Failure of internal communications linkages
- Workplace Safety issues
- Wrong decisions made by the Board of Directors or Management (ex. M&A, financing, other decisions)
- Employee or other internal Fraud (whether or not electronic in nature)
- Disputes leading to lawsuits (employment / shareholder / third party /etc.)
The above operational risk types and examples can be hedged against through different types of commercial insurance products. The insurance has to be reworded and triggered independently of any insurance broker or company.
Operational Risk of a Bank
The operational risk in Banks is more complex than most businesses due to its relationship to other forms of key banking risks such as market risk and credit risk. Each bank will have its own operational risk profile. Example, the operational risk measures of a bank that derives most of its revenues from residential mortgages within a particular geography will be vastly different than those of a bank deriving most of its revenues from commercial lending within a particular industry.
Investment Fund Operational Risk
Each type of investment fund including hedge funds will have its own operational risk profile depending on the asset class the funds invests in, turnover rates, underlying investments, historical performance, etc.
Operational Risk in Manufacturing Business
Each type of manufacturer would have its own operational risk profile. It is important to match commercial insurance for manufacturers to such operational risk profile.
Operational Risk in Food Industry
The operational risk of the food industry has its own dynamics, and each food operator will have its own unique set of operational risk data. A franchisor would face a different set of operational risks, which should be hedged through franchisor insurance, compared with a restaurant chain.
FAQ on Operational Risk
What Are Operational Risks?
These are risks that impact the operation of a business directly or indirectly. The comprehensive management of such risks is called operational risk management and includes measuring, hedging, and monetizing any or several operational risk types.
What Is Operational Risk In Banks?
Operational Risk in Banks is more complex than that of other businesses due to its high correlation to credit risk. Various banks around the world are regulated to post capital against their operational risk exposure. This is a different type of capital charge than that related to potential credit losses. The proper use of commercial insurance by such banks to hedge against operational risk can allow them to reduce the regulatory capital allocation to operational risk, which can be a significant amount of money for the bank to use freely.
What are Operational Risks in Business?
In general, Operational Risk has a single definition which applies to all Business as mentioned above. The difference from one business to another is the type of operational risk that is most relevant along with its probability of occurrence and severity. Each industry will have a different operational risk profile, and each business within such industries will have its own profile based on its unique operational risk data.