I am an entrepreneur and I worry about my operations. For example: -Are my employees happy with their working environment or not, is anyone plotting any fraudulent activities, Strike, Machinery working properly or not etc. So it is important to measure the operational risk because if my machinery fails it will breakdown my business and induce harm. Operation risk will be covered in the Valuation and risk model of FRM-I.
Operational risk in brief:-
Until recently, most of the focus was on measuring and managing credit and market risk. However, as the time passed by, there was a shift from the previous approach and now operational risk is also included in the ambit of risk management programme.
These days, the firms and regulators are increasingly focussing on risks other than credit and market risks. These are collectively referred to as “Operational Risks”. But how do we actually define’ Operational Risks’?
Prima facie, it appears to be a very simple task: the risk of financial loss from an operational failure. But “operational failure” encompasses in itself myriad possible events, actions and inactions etc. It includes everything from:
- System failures
- Natural disasters like floods, earthquake etc.
- Internal or External Fraudulent activities
- Employee errors
- Clients, products and business practices
- To conscious violation of policy, law and regulation.
In essence, the firms had been managing these risks from the very beginning, however the new mandate was to manage them in a more structured and systematic manner. Operational Risk was not formally recognized as a legitimate issue, until recently when the Basel Committee highlighted its significance
Adverse consequences of Op Risk
- It has been asserted by many financial experts that the underlying cause behind major losses over the past two decades has been ineffective operational risk management.
- This includes the $180 billion bailout of American Insurance Group (AIG) and the famous publicized fiascos of Barings Bank, LTCM, Societe Generale etc.
Methods of Operational Risk Measurement
Presently there are three techniques widely used to measure Op Risk i.e.
- Basic Indicator
- Advanced Measurement
You will gain deep insights into all the above techniques in this session. Op Risk, till date happens to be a controversial topic. Still, it is of utmost importance to take care of this risk by the companies and shareholders alike. Howsoever daunting it might appear, it is not impossible to tackle with.
Organizations can take several steps to mitigate losses arising out of operational events. For example:
- Insurance can be bought for damages arising out of natural disaster.
- Losses due to internal factors, like employee fraud or flaws in product can be mitigated via effective use of strong Internal Auditing procedures.
- Losses from business disruption such as electricity failure can be managed by establishment of back up facilities.