What Is Operational Risk?

When people ask, “what are operational risks?”, the short answer is simple: they are problems that come from the way a business runs its day-to-day operations. These problems can lead to financial loss, reputational damage, or even business interruption.

Operational risk definition is frequently referred to as the threat of loss due to people, processes, or systems or external events. The most famous explanation is provided by The Basel Committee on Banking Supervision: operational risk defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

What, then, are operational risks in practice? They encompass numerous types of threats, for example, human errors, fraud, system failures, cyberattacks, and supply chain interruptions. They originate from the core of the daily activity an organization runs.

Consequently, such challenges related to day-to-day business operations in the management of business activities are unavoidable for both small and large organizations. .

Types and Categories of Operational Risk

When exploring what is an operational risk management, one of the first things a company should do is understand what are operational risks and how they are organized. To manage them effectively, organizations usually divide threats into clear categories, often focusing on four main types:

1. Internal operational risks, or process risks, stem from the disrupted or inefficient internal workflows. They can arise from ambiguous procedures, ineffective internal controls, or absence of standardization. To mitigate process them it is usually recommended to clearly define roles, standardize procedures, introduce internal checks, and perform periodic evaluation of the workflow. Implementation of these instrument risk management in operations enables a company to identify and correct weaknesses prior to the occurrence of major losses. 

2. Personnel risk, or people risk, is a significant source of operational losses. It stems from human behaviour such as errors, negligence, insufficient training or malfeasance. These threats exist in every organization because employees interface each day with systems and processes and customers. Managing threat means training employees, defining clear lines of authority and approval, monitoring performance, and creating a culture of responsibility. For example, strong governance and monitoring are crucial here for operational risk in banks, where human mistakes or fraud can cause enormous financial and reputational fallout. 

3. External to the organization, risks or external events that exist outside are related to the activities of the organization but are beyond the control of the organization, such as natural disasters, political unrest, or changes in regulations. Organizations can mitigate these threats by preparing business continuity plans, conducting scenario analyses, complement supply chains diversification with insurance and maintaining sufficient insurance. Proactive preparation for external threat is an integral component of business operational risk management. 

4. Technological risk, also called systems risk, relates to the collapse of IT infrastructure, including software, cybersecurity, and data processing. These threats can interrupt business operations or lead to information security breaches as organizations become more dependent on technology. Good mitigation include having backup systems, regular patching, enforced cybersecurity policies, and regular IT audits. Embedding technology risk controls into what is an operational risk management framework minimizes system downtime and ensures prompt attention if it does occur. 

But other forms of threat may also be defined by organizations. Such as operational risk examples: financial, strategic, legal. Nonfinancial and financial risks involving unforeseen expenses or cash flow difficulties, strategic — resulting from flawed planning or decision-making, and legal — including breaches of regulations or contractual disputes. 

Recognition and differentiation of risks according to type can be very helpful for their management. By dividing them into defined groups rather than treating each risk as a separate entity, entities have a structured overview as to where risks may lie and which areas may need focusing on. This facilitates risk management in operations in that it enables the focus on more specific areas, the prioritization of resources and the more effective use of operational risk management techniques. 

Risk categorisation into different types allows for specific mitigation plans to be formulated.

To give an example, risks associated with processes can be mitigated by standardizing workflows, risks related to people by providing training and supervision, risks related to technology through information technology (IT) system upgrades and cybersecurity, and external risks through contingency planning and obtaining appropriate insurance.

Knowledge of how each category operates also enhances operational threats assessment, enabling better tracking of performance, effectiveness of measurement, and discovery of new emerging threats. 

Operational Risk Management

The operational risk management process is what allows an organization to identify, evaluate, and reduce its exposure to threats that may affect the functioning of the organization. The objective is to mitigate possible losses, increase efficiency, and keep the business up and running. 

Performing a comprehensive what is operational risk assessment is the cornerstone of this process as it allows an organization to identify its potential areas of weakness in a methodical manner, quantify their effect, and decide on fund allocation for threat reduction in a most efficient manner.

Successful risk management in operations depends on a mix of strategic planning and practical, day-to-day measures. On the strategic side, organizations should put in place policies and frameworks that incorporate threat awareness across all business functions.

Effective operational risk management depends on a range of carefully planned risk mitigation strategies aimed at lowering both the chances and consequences of potential failures. For example:

1. Risk avoidance is about eliminating activities or practices that have the potential to introduce threat. That could mean changing workflows, imposing rigid compliance rules, or simply avoiding business lines with a clearly high risk profile. Those safeguards are important aspects in mitigating business operational risk and ensuring that day-to-day business can be conducted effectively. 

2. Risk reduction is the pursuit of a way to lessen either the probability or the consequences of a risk when the threat cannot be wholly eliminated. They do this by staff training, process changes, secure IT systems and contingency plans. For example, preventive measures in operational risk in banks are necessary to reduce the potential of monetary loss as well as loss in reputation. 

3. Risk transfer is the process of transferring the financial impact to a third party, usually achieved by insurance, outsourcing, or other contractual arrangement. 

4. Risk acceptance is the acknowledgement of a particular threat along with the determination that it is either manageable or otherwise acceptable. In these situations, organizations keep a close eye on the threat and have contingency plans in place to mitigate potential effects. Conducting what is operational risk assessment helps determine which risks can be accepted without threatening overall business stability.

Operational risk management is also applicable to strategic business processes. The correct execution of company formation, bank account opening, tax efficient structuring, and tax compliance (including VAT/VIES) is essential because errors or omissions in those matters can create significant business operational risk.

For instance, mistakes in the process of registring a company or setting up a bank account can cause delays, limits on financial transactions, or barrier to accessing capital. Poorly managed tax planning or failure to observe VAT/VIES rules may lead to penalties, fines or litigation which not only compromises an entity's finances but also its reputation. These risks, although they are far less evident than the occasional keystroke error in a firm’s day-to-day operations, may also prove far more disastrous, particularly for firms with global operations, or those in regulated industries such as financial services.

These strategic areas need to be addressed, as they are the root of the problem, for which the symptoms are observed in operations. Bringing them together in an operational risk management framework minimizes both the regulatory and the financial risk, which in turn enables the long-term stability and growth of the institution. 

At the end of the day, good operational risk management is a matter of expecting that things will go wrong, having sensible protections in place, keeping an eye on the goings-on, and learning as you go. When these approaches are embedded in the fabric of daily operations, organizations can run more secure, make better decisions, and be sustainable over the long term. 

Lessons learned from operational failures

Operational failures are difficult to completely avoid, even with the best planning, as numerous extraneous factors can affect the outcome. Once these failures are encountered, they will expose areas where processes have gaps, and controls within the organization are insufficient or threat management in the operations is weak. 

For example, recurring process errors can suggest that internal processes are not well-defined, and technology-related failures can reveal legacy IT systems or inadequate cybersecurity protections. Likewise, those staff-caused incidents also demonstrate how training, supervision and clear structures of accountability are necessary. These elements are pivotal in operational risk in banks where mistakes can have material financial and reputational outcomes. 

Understanding what are operational risks and learning from past failures is therefore a crucial part of effective risk management.

Learning from these failures involves a comprehensive review of operational risk categories and types of operational risk. This lets organizations identify areas where threats were underestimated or where they went off course. By performing a detailed what is operational risk analysis, businesses can more accurately assess the probabilities and potential consequences of each threat and adjust their strategies in line with the operational risk management meaning. 

In practice, the knowledge gained from failure is used to create stronger controls, better processes, better training for employees, and more robust IT infrastructure. They further promote a proactive outlook which anticipates and deals with future risks before they happen rather than after they have happened. . Embedding these learnings on an ongoing basis enhances business operational risk resilience, enables better decisions, and makes it less likely they will come across the same type of mistake in the future. So in the end, the ability to learn from failure operationally is a fundamental to sustainable, effective what is an operational risk management in any organization management system, and something any organization should look to support. 

Conclusion

Operational risk is an inherent threat in every business. They stem from people, processes, systems and external events, and if left unmanaged can result in financial loss, damage to reputation and/or disruption to operations. Understanding its nature, how to execute effective operational risk management and which are the adequate threat mitigation actions to be applied are key elements in keeping your business running and stable in the long run. 

As a legal firm experienced in this field, we help companies to manage legal operational risk including the regulation of company formation and ongoing corporate compliance, the setting up and running of bank accounts, fulfilling tax obligations and the regulation of relationships with employees and contractors via the use of well-drafted contracts. Through expert advice in these matters, we enable businesses to enhance business operational risk resilience, to remain compliant and to do business safely in a challenging legal and regulatory environment.