Operational Risk

What is Operational Risk?

Operational risk involves the risk of direct or indirect loss resulting from inadequate or failed internal processes, human errors, systems, or external events. The control of operational risk has gained substantial attention in recent years, particularly noted in the Basel Accords concerning the capital adequacy of banks and the UK’s Turnbull Report. Operational risk can even lead to changes in the regulation of financial institutions and the listing requirements for public companies.

Key Components of Operational Risk

Operational risks can be grouped into several major categories:

• Internal Fraud: Acts of fraud committed by employees, such as embezzlement or forgery.
• External Fraud: Illegal activities committed by external parties, such as theft or hacking.
• Employment Practices and Workplace Safety: Risks related to discriminatory practices, employee injuries, or non-compliance with health and safety regulations.
• Clients, Products, and Business Practices: Risks associated with product misrepresentation, privacy issues, or regulatory compliance related to client communications.
• Damage to Physical Assets: Losses resulting from natural disasters, terrorism, or vandalism, including cyber-vandalism.
• Business Disruption and System Failures: Issues arising from IT failures, utility outages, or infrastructure problems.
• Execution, Delivery, and Process Management: Errors in transaction processing, data entry mistakes, or client account discrepancies.

Examples of Operational Risk

Fraud and Theft

• An employee manipulates accounting records to embezzle funds.
• A hacker infiltrates a company’s IT system to steal sensitive customer data.

Legal Actions

• A customer sues a bank for misrepresenting a financial product.
• An employee files a lawsuit citing workplace discrimination.

Natural Disasters

• A hurricane forces a company’s manufacturing plant to shut down.
• An earthquake damages significant infrastructure, impacting service delivery.

Vandalism (including Cyber Vandalism)

• Hackers deface a company’s website, damaging brand reputation.
• Activists physically break into a facility and disrupt operations.

Computer System Failure

• A core banking system crashes, leading to a halt in customer transactions.
• A data center experiences a power outage, causing service interruptions.

Frequently Asked Questions

Q: How does operational risk differ from other types of risks?

• A: Unlike market or credit risks (which relate to financial markets and lending activities), operational risk pertains to the functioning of internal processes, human factors, system operations, and external events.

Q: What frameworks help manage operational risk?

• A: Notable frameworks include the Basel III guidelines for banks and the Enterprise Risk Management framework by COSO.

Q: Can operational risk be completely eliminated?

• A: No, operational risk cannot be completely eliminated, but it can be mitigated through proper controls, policies, and procedures.

Q: How do businesses generally measure operational risk?

• A: Businesses use various methods such as key risk indicators (KRIs), loss event data, risk and control self-assessments (RCSAs), and scenario analysis.

Related Terms

Basel Accords

• Definition: A set of international banking regulations developed by the Basel Committee on Banking Supervision (BCBS) that provide recommendations on banking regulations concerning capital risk, market risk, and operational risk.

Turnbull Report

• Definition: A guideline published in the UK that provides principles for effective internal control within public companies, specifically aimed at managing risks.

Capital Adequacy

• Definition: The ability of a bank or financial institution to absorb losses while maintaining sufficient capital to continue operations and safeguard depositor funds.

Online Resources

• Basel Committee on Banking Supervision
• Turnbull Guidance on Internal Control
• COSO’s Enterprise Risk Management Framework

Suggested Books for Further Studies

• “Operational Risk Management: Best Practices in the Financial Services Industry” by Ariane Chapelle - A detailed exploration of operational risk management techniques and best practices.
• “The Basel Handbook: A Guide for Financial Practitioners” by Michael K. Ong - A comprehensive guide to Basel regulations.
• “Introduction to the Management of Risk” by Roland W. Salmon and Michel T. Frankel - This book covers multiple aspects of risk management, including operational risk.

Accounting Basics: “Operational Risk” Fundamentals Quiz

Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!