Operational risk is any risk that arises from your company’s business processes and could result in financial loss or disruption to your ability to serve customers. Operational risk management (ORM) is the art of protecting your company from such risks and minimizing any damage that may occur.
ORM began in financial institutions and became streamlined and codified over the years via the Basel Committee on Banking Supervision (BCBS). Operational risk management soon spread to other industries, and is now a standard component of many strategic risk management programs.
Operational risk is a broad concept. Examples include internal issues such as employee misconduct, human error, poorly designed business practices, and weak internal processes. External events such as cybersecurity breaches and natural disasters qualify as operational risks, too. The common factor in all these events is their ability to affect your daily operations and create a risk of loss.
Understanding the principles and components of ORM will allow you to prioritize the risks that have the highest probability of the most significant loss, and then react accordingly.
What Are the Principles of Operational Risk Management?
Every organization has its own unique risk profile, depending on the needs and circumstances of your company. Most programs, however, are designed around these fundamental principles:
- Take on only those risks with more significant benefits than the potential costs.
- Don’t take on unnecessary risks.
- Plan to predict and mitigate risk events.
- Address risks at the appropriate level.
The level of risk determines which risks are time-critical and must be handled immediately, as opposed to strategic risks that require broader, more deliberate decision-making. Ideally, a company would have the resources to assess and address all risks; in reality, you’ll need to make decisions based on which risks have the potential to do the most damage.
Risk levels can be defined as strategic, deliberate, and time-critical.
Also known as in-depth, these risks are not time-sensitive and can be assessed over the long term. This level is best suited for newer risks that require more study to understand fully.
This mid-level category is appropriate for most risks. It is thorough and intentional but is designed for risk decisions that don’t require the amount of research that a strategic risk requires.
As the name suggests, this level is designated for immediate risks. In addition, this level is intended for a threat that requires decisive action in a short period.
Becoming familiar with these principles can help you adapt a general ORM framework to one that will suit your company-specific needs.
What Is the Difference Between Strategic and Operational Risk?
Strategic risks are subtle, slow-moving threats that can ultimately limit an organization’s ability to achieve its objectives. For example, when a company’s expansion plan is ill-conceived or new products are poorly researched and developed, strategic risks can arise. Strategic risks could also be blamed on technology changes, a new competitor that you ignore, unexpected changes in consumer demand, or an increase in raw material prices.
Operational risk is a sudden breakdown in a business’s routine operations. Technical problems, cybersecurity attacks, human error, or natural disasters may cause such failures. For example, say an employee writes a corporate check for $10,000 instead of $1,000. This error indicates that a more secure payment process may have prevented human and technical mistakes. The issue may have been avoided by using an automated system or approval process for payments.
Mitigating Operational Risks for Businesses
Preventing risk and minimizing loss is the primary objective of operational risk management. To determine what risks affect you and what you can do to avoid them, follow these steps:
- Risk identification
- Risk assessment
- Risk mitigation
- Continuous monitoring
Risk mitigation is perhaps the most important, as this is the step where you’ll decide exactly how to address the risks discovered in your risk assessment. You can use many approaches to risk mitigation (alone or in combination) depending on the severity of each critical risk and the potential for loss.
Transferring risk involves sharing or assigning your risk to another organization. For example, you might purchase an insurance policy or store your data with a cloud-based SaaS (software-as-a-service) provider.
To avoid risk, you must refrain from entering situations where the risk may be prevalent. (Say, not entering highly corrupt foreign markets.) This conservative approach will lessen your risk exposure but may prevent you from taking opportunities that could expand your business.
Not all risks can be avoided. Sometimes the best choice is to move ahead, knowing that some risk is inevitable. Acceptance focuses on preventing damage and developing a plan to minimize loss rather than avoiding danger.
Accepting inherent risk does not mean ignoring it. Implementing controls can lessen the consequences of a risk that comes your way. A thoughtful series of internal controls can significantly decrease the adverse effects of your identified risks.
Once your risk mitigation decisions have been made, it’s essential to observe their effectiveness over time. Processes for operational resilience and business continuity are crucial for judging your risk mitigation efforts.
Operational resilience is the organization’s ability to withstand and adapt to disruptions. Business continuity assures that your company has contingency plans in place to keep delivering services through the disruption. Examining your risk management process in depth will assure that your operational risk management program grows with your company.
What Is a Risk Assessment?
A risk assessment is a systematic procedure that involves detecting hazards, assessing any related risks, and implementing feasible control measures to eliminate or minimize them.
How to Conduct Risk Assessments
A risk management framework can provide a template for the assessment process. To start, it’s beneficial to define the scope of the assessment, the resources required, the stakeholders involved, and the applicable compliance regulations you’ll need to follow. Then carry out the following five stages:
List Specific Risks
Identifying the risks your staff and company face is the first step in developing a risk assessment plan. For example:
- Natural disasters
- Workplace mishaps
- Deliberate actions
- Risks posed by technology
- System failures
- Outsourcing or supply chain issues
Investigate various business units and functional groups to identify weak internal processes or business practices. Include all facets of the organization, such as a remote workforce, cybersecurity, health and safety concerns, and physical security. To determine what risks have previously harmed your business, review incident reports and survey stakeholders.
Estimate Potential Impacts
Consider how business operations could be affected and the likelihood of each risk event. Just because a risk event is unlikely to occur, that doesn’t mean you should ignore it. It’s essential to also consider the potential impacts so you can prioritize and make appropriate risk decisions.
Implement Risk Mitigation Initiatives
After prioritizing potential risks, implement the appropriate risk mitigation strategies. Unnecessary risks should be avoided. Internal controls and robust business practices can eliminate or reduce human error and fraud risks. Technology investments minimize the likelihood of system failures and improve cyber security. Each specific risk should be tied to an initiative.
Document Your Discoveries
Compliance and risk management frameworks require you to document your risk assessment. The risks you’ve identified, the individuals they affect, and your mitigation strategy should all be included in your plan. Proper documentation allows you to continuously improve your risk management process.
Because your workplace and environment are constantly evolving, so do threats to your business. Each time new tools, procedures, or personnel are introduced, there is a chance that a new danger may arise; new dangers can also arise themselves, even if your business model holds steady. To keep up with these emerging risks, you should evaluate and update your risk management program often.
Develop key risk indicators (KRIs) and metrics to allow senior management and stakeholders to constantly monitor the organization’s risk profile.
Types of Risk Assessment Methodologies
There are two primary types of risk assessment methodologies: qualitative and quantitative. Each method has advantages and disadvantages, and most organizations use a combination of both.
The more frequent qualitative risk assessments rely on employee experience and the authorized assessor’s expertise to produce precise risk models. Usually risks are categorized as low, moderate, or high; and describe possible harm as low, medium, or severe.
Quantitative risk evaluations rely on hard facts and figures. Daily sales revenue and assets have financial values assigned to them. Financial information is used to perform scenario analysis and simulate the possible cost of every risk. This cost-benefit analysis may be constructive when justifying risk management investments to board members or senior management.
Various uses exist for both qualitative and quantitative evaluations. In addition, both approaches may be used for other risk assessment techniques.
Generic risk assessments are easy-to-use templates and can be modified for your business. These kinds of evaluations might be helpful if you are just starting out. This method is convenient, but be careful when implementing a generic assessment because it may not suit every situation your business faces. Typically, generic evaluations work best when combined with other approaches.
As the name suggests, this technique focuses on how risk is influenced by environment and location. An assessor might customize an otherwise generic evaluation to a specific department, business unit, or site. You can aggregate site-by-site results to view the risk exposure for the overall enterprise.
Dynamic risk assessments are beneficial in settings or circumstances where risk is constantly changing. They are carried out in tandem with conventional risk assessments, typically on the spot when a new danger materializes. These evaluations are constructive for occupations with a higher risk level, such as emergency services or health and safety.
Automate Operational Risk Management with Reciprocity ZenRisk
Effective operational risk management is easier with a clear view of your company’s risks. That said, decision-making can be compromised when using outdated methods to track your risk mitigation efforts such as spreadsheets. To protect your company from operational risk, you must invest in tools that can adjust to your needs.
Reciprocity ZenRisk is a unified, integrated risk management solution that tracks and monitors risk throughout your organization. With automation and real-time reporting, ZenRisk gives you complete visibility of your company’s risk and compliance efforts.
Schedule a demo to see how ZenRisk can get you out of your spreadsheets and develop an effective risk management program.