Operational Risk Management has become a major component in the business practice of all enterprise including banks. Operations Risk Management has been spurred on by regulatory compliance and events such as upswing in terrorist activities, extreme weather conditions, natural disasters and financial crisis.
An Operational Risk is a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company or bank operates. It also includes other categories of risk such as fraud risks, legal risks, physical or environmental risks.
A popular and widely used definition of operational risk is the one contained in the Basel II regulations. This definition states that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
The approach to managing operational risk differs from that applied to other types of risk, because Operations Risk, unlike other types of risk is not used to generate profits. As an example, credit risk is used by banks to create profit, market risk is used by traders and fund managers, and insurance risk is used by insurers, all with the profit motive as the end objective.
However, whether you are a bank or a trader or a fund manager or an insurer or just any other firm, you still have to manage operational risk to keep losses within your risk appetite - the amount of risk that the organization is prepared to accept in pursuit of its objectives. What this means in practical terms is that banks and firms accept that their people, processes and systems are imperfect, and that losses will arise from errors and ineffective operations.
The size of the loss they are prepared to accept, because the cost of correcting the errors or improving the systems is disproportionate to the benefit they will receive, determines their appetite for operational risk. To keep the right balance operational risk need to be managed.
Managing risk exposures is second nature for banks – after all credit risk and liquidity risk is part and parcel of banking.
Operational risk management as a discipline is relatively new. The rapid change in focus to operational risk management has been driven by a number of factors, led in the first instance by the compliance requirements of bank regulators across the globe.
Other critical factors that lie behind this changing focus include;
The increased attention to Operational Risk has also been driven by a number of major events in recent years attributed directly to operational failures.
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