Operational Risk Management
Operational Risk Management is an emerging area in risk management. The goal is to control and to mitigate operational risks when there is economic reason to do so.
Unlike Credit Risk and Market Risk, Operational Risk has no agreed upon universal definition. Many banks define operational risk as any risk that is not Credit or Market risk. The Basle Committee defines operational risk as risk of financial losses related to breakdowns in internal control and corporate governance. Such breakdown can be the result of human error, technical error or major events such as fires or other disasters.
Royal Bank of Canada has a slightly different definition of Operational Risk (from their annual report 1998): "The risk of financial loss occurring from inadequate internal policies, system and control failures, human error, fraud or management failure and natural disasters."
The Basle Committee defines transaction risk as financial loss due to problems with service and product delivery. It is a function of internal control, information systems, employee integrity and operating processes. Transaction risk exists in all products and services.
The Basle Committee also seems to look at compliance/legal risk and reputational risk as different from operational risk. Compliance/legal risk occurs when business is done in violation or non-conformance with laws, rules and regulations. This type of risk can be due to incorrect legal advice, and can lead to loss of reputation (reputation risk).
Here is our proposal to define the relationships between the risks referred to above. In our view, however, it is more important that all types of risk are taken into account than how they are grouped.
In the basic system all risks are looked upon individually without taking into account other exposures of the enterprise. To help assessing the risks, enterprises should consider collecting data on historical cost/loss experience on other firms as well as their own. It is our view that monitoring individual risks offers an acceptable basis for controlling risks for most enterprises. It can also be complemented by various forms of stress tests. It does not, however, give the same incentives and guidance for risk mitigation actions that a more advanced system can.
In the advanced system simultaneous calculation of total operational risks is carried out. Preferably correlation of the main categories of risk should be taken into account. The maximum potential loss (Earnings at Risk/Value at Risk) can be estimated, and equity capital can be allocated also for operational risk. That gives a good basis for evaluating the effects of risk mitigating measures.
Below important elements of Operational Risk Management are illustrated. The grey boxes show the basic system. In an advanced system, also the red boxes are necessary.
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