Operational risk management

Operational risks are usually hazard risks that can sometimes be mitigated by risk transfer using insurances. Nowadays, operational risk has become a specific issue in financial institutions. Chapter 29 of Hopkin’s (2014) book provides a definition of operational risk and ways to measurement it.

Please watch this video looking at operational risk management:

Definition of operational risk

Operational risk applies to all forms of organisations, including financial institutions. In the context of banks, Basel II (discussed in Unit 6) provides a definition of operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events” (Hopkin 2014, p 297). This definition includes legal risk but excludes strategic and reputational risk. It identifies four types of risk categories:

• people risks
• process risks
• system risks
• external risks

The losses associated with a failure to manage operational risks can be substantial, as seen during the financial crisis of 2008.

Measuring operational risk

Operational risk can be measured using a number of methods. Basel II offers three approaches:

• basic indicator approach
• standardised approach
• advanced approach

Banks measure their operational risk. In general, this risk tends to be proportional to the size of the bank and its number of customers. Often, the quantification of operational risk tends to be seen as a compliance requirement, rather than a business opportunity. The measurement of operational risk in financial institutions remains a challenge. This was especially true during the global crisis, which showed that the operational risk exposure was greater than what most banks believed. The Risk and Insurance Managers Society (RIMS) has undertaken an evaluation of the causes of the global crisis and its link to the use of ERM tools. The conclusion of this evaluation was that the global crisis was not caused by the failure or ERM tools but by numerous factors that could be summarised as an overall reliance on financial models to justify the pursuit of profit.

Additional reading on the subject of operational risk can be found in Chapter 13 of Crouhy’s (2006) text. The author focuses on financial institutions and provides eight key elements to achieving best practice in operational risk management: policy, risk identification, business process, measurement methodology, exposure management, reporting, risk analysis and economic capital. The chapter concludes by highlighting that operational risk should be managed as a partnership between business units and corporate governance and that senior management must select, train and reward staff to foster a risk-aware business culture.

Please watch this video on operational risk modelling and measurement:

Activity 7.3

Consider the Y2K event (https://en.wikipedia.org/wiki/Year_2000_problem ). What was the operational risk and how was it managed? Post your findings to the Discussion Board and label the message appropriately (The link to the Discussion Board is not available in this course taster).