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WHY is Operational Risk (Op Risk) important?

THE IMPORTANCE OF OPERATIONAL RISK (OP RISK) TO A BUSINESS

For many businesses, Operational Risk (Op Risk) is their # 1 Risk, and for all other businesses around the world including Global Financial Institutions and Corporates, Op Risk is one of their Top 3 Risks.

Correlation of Op Risk to other risks
Source: KPMG Business Dialogue, 23 May 2012


Why?

Many of the factors* that create Op Risk also create various other types of Risk. It is due to this common linkage between Op Risk and other types of Risk that creates a significant overlap (ie. strong correlations) between Op Risk and various other types of Risk to businesses. Op Risk is therefore at the core of any business operations.


Given the above, when Op Risk is managed correctly, the business enjoys a significant drop in its overall risk levels because material portions of other risks are hedged against automatically by virtue of managing Op Risk.

Op Risk Definition

Op Risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Learn the technical definition of Operational Risk (Op Risk) here.

Op Risk Management

The management of Op Risk (aka. ORM) entails:

1. measuring the risk including its correlations with other forms of risk;

2. implementing controls to reduce the amount of Op Risk an organization faces; and

3. purchasing tailored commercial insurance to hedge against different types of Op Risk and to further reduce Op Risk quantums.

It is important to note that Op Risk Management can be a substitute to Enterprise Risk Management (ERM). Many organizations focus on ERM and make Op Risk Management a subset of their ERM strategy. However, the statistical correlations between Op Risk and other forms of risk show us that Op Risk is the nucleus of all business risks and can therefore serve as a base for managing risk across an entire organization. That said, Op Risk Management is most effective if Op Risk correlations are measured correctly and commercial insurance is structured right to produce high insurance payout ratios on relevant loss scenarios.

Sample list of Op Risk incidents

Company Loss Event Year
Lehman Brothers (U.S.) Bankruptcy 2008
Home Capital Group (Canada) Major Stock Drop 2017
Toshiba (Japan) Major M&A Loss 2016-2017
Parmalat (Europe) Bankruptcy 2003

In all of the above-mentioned cases, it was within the hands of Management and the Board of Directors of such companies to avoid such Loss Events. They were either (a) unaware of the importance of Op Risk and/or their ability to manage it; (b) aware but did not care or want to manage Op Risk; (c) aware but chose to hire inadequate service providers to manage their Op Risk; or (d) some other reason. In all cases, it was ultimately investors who lost money.

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