Introduction of Operational Risks
Operational risks are the uncertainties and threats faced by a company in its regular business activities. Operational risks are caused by various factors, it can be both internal as well as external.
Operational risks are hazards and uncertain situations that the business has to encounter in their day to day operational business activities. It is happening of an event that disturbs the normal business process, and it can end up in financial loss or damage to the business operations and image of the company.
Some of the internal factors that cause the risk to business operations are internal procedures, system, people, policies, etc. and the external factors are political situations, economic events or other events which affects the whole industry and business operations. This type of risk is known as systematic risk. There can be some operational risk associated with a specific industry or company, which is known as unsystematic risk. Generally, operational risks can be controlled by continuous risk assessment and risk management policies through internal control, insurance, risk control strategies, etc.
What does Operational Risk Include?
Operational risk includes both internal factors and external factors that cause risk. Risk can be both measurable and quantifiable as well as it can be subjective and qualitative.
- Internal Operational Risks: Errors caused by employees of the company, failure of IT systems, fraudulent activities, loss of key management people, health and safety of the employees, etc.
- External Operational Risks: Business interruptions caused by economic or political events, product failure at the market, litigations against companies, loss of key suppliers and raw materials, natural disasters, loss of image/reputation, etc.
Examples of Operational Risks
Z Corp is a consultancy firm that manages the financial books of many entities. ABC Ltd is one of their clients and their books of accounts are being prepared and managed by Z Corp. Mr. X, an employee of Z Corp handles ABC Ltd accounts. While making an entry, by mistake he entered an expense as $1,000,000 instead of $100,000. This is increased both the expense as well as vendor payables and made the financial statements incorrectly.
Due to this operational risk, chances are there where Z Corp can lose its clients as there is no quality service.
Types of Operational Risks
Types of operational risks are given below:
1. Errors Caused by People
Errors caused by employees of the organization can affect the operational activities and may even cause financial loss. This error is caused by various factors like lack of skillset, incomplete information, lack of understanding and knowledge, genuine input error, etc. Though these errors are caused inadvertently it may affect the business activities. (E.g.) Excess payment made by cashier by mistake.
2. Technical or System Errors
Technical or system errors can affect business operations like system failure, system crashes, connectivity issues, system slowdown, errors caused by software applications, etc. Technical defects can bring out a wrong output and it is tough to identify and rectify it. (E.g.) Wrong interest calculation on loan done by banking software.
In certain cases, intentional frauds are done by internal people to the organization. Every organization has standard rules and regulations for employees for removing conflict of interest and fraudulent activities. Fraudulent activities can cause financial loss and damage the reputation of the organization. (E.g.) An employee making a deal with a supplier for purchases and enjoy commission from the supplier.
4. Uncontrollable Events
Few events are uncontrollable, and it will also affect business operations like political changes, weather changes, economic scenarios, technological advancements, etc. These factors can bring an impact on operational activities and can affect revenue and profitability and puts the organization at risk. (E.g.) A change of ruling party will impact the government project execution and it may affect the contractor.
How to Identify Operational Risks?
Operational risk needs to be identified so that it can be managed. Failure to identify the possible risks can lead to potential operational risk not being monitored and managed and can cause an impact on the business operations and profitability. Operational risks can be identified using different techniques. “Brainstorm” is a common technique used across different layers in an organization to identify the possible risks associated with a particular process. This technique helps to identify predominant risks in a short span of time. “Risk-based audit” is another technique used for identifying risks in the organization. In this technique, the risk is identified by instinctive or judgmental assessments, risk assessment matrix, or risk ranking.
Another technique used to identify risks is to look for key dependencies of the company in people, policies, processes, systems, etc., and identify the potential risk from the key areas. Once risks are identified it is categorized across functions and processes, the risk monitoring and management systems are placed to control the risks.
How to Manage Operational Risks?
Operational risks can be managed by evaluating the risk and it should be within the risk appetite of the organization. Risk tolerance varies from organization to organization based on their size and nature.
Once the risk is identified and evaluated it can be managed by the following methods:
- Identifying, Evaluating, and Accepting the Risk: Internal control system is established toidentify and evaluate the risks. Some risks are inherent, and it cannot be avoided completely like errors in work made by employees. The internal control system helps to reduce the risks predominantly and some inherent need to be accepted as it cannot be avoided, and it may cause material impact.
- Transferring the Risk: Insurance is the most common method used for transferring the risk from the organization (e.g.) Insurance of buildings and properties.
- Reduction of Risk Identified: Once a risk is identified steps and measures need to be taken by management to reduce the risk by establishing some internal checks and control processes.
- Avoiding the Risk: Few risks can be avoided by acting pro-active and by establishing a proper control system in the organization (e.g.) Maker-Checker concept, Bill preparer, and approver cannot be the same person, etc. It helps to avoid the risk of errors and fraud.
Risk is not a permanent concept it keeps on changing from time to time with the evolving of business, economic and political conditions, etc. So, risk mitigation strategy and risk assessment should be monitored regularly to avoid and reduce operational risks.
Every business has to deal with some or other risks in their business operations. Operational risk deals with uncertain situations and unavoidable situations that can place the organization at risk. In order to manage the risk, a proper risk management strategy and the risk management team have to be formed and put in place. Establishing internal controls helps to avoid errors and detection of frauds. Proper risk assessment and strategy help the business to continue its operations without much interruption.
This is a guide to Operational Risks. Here we also discuss the introduction and how to identify operational risks? along with examples and types. You may also have a look at the following articles to learn more –