Modern organizations operate in a highly complex environment. New technologies, increasing digitization, and evolving customer demands create risks that can disrupt operations, weaken cybersecurity, and harm the organization’s reputation or financial position – and above all, leave the organization unable to achieve its business objectives.
Understanding these risks can improve business practices and decision-making and allow risk managers to implement wise risk mitigation and management controls. On the other hand, confusion about risks undermines an organization’s ability to manage risk well.
This article addresses common questions about strategic and operational risk, such as:
- What are strategic risks and operational risks?
- How are they different?
- What are some examples of each?
Strategic and Operational Risk: A Brief Intro
Strategic risks threaten an organization’s ability to deliver expected outcomes, which can harm the organization’s ability to grow and prosper. Such risks can arise from technological change, an evolving competitive landscape, poor management, or changes in customer demands.
Operational risks stem from inadequate or failed internal procedures, employee errors, cybersecurity events, or external events such as weather disasters. A comprehensive Operational Risk Management (ORM) plan is critical to identify such risks and then implement practical risk management steps.
Risk assessments are essential to understand the different types of risks, possible risk events, and potential harm so that an organization can optimize company performance while mitigating unnecessary risks.
Enterprise Risk Management (ERM)
Strategic and operational risk management is part of the wider effort known as enterprise risk management (ERM). ERM includes financial, reputation, and compliance risk management as well.
ERM is a holistic approach that looks at risk management from the perspective of the entire organization, not just specific functional groups or business units trying to mind their issues. It requires firm-wide visibility and management-level decision-making that may not make sense for individual business units, but does make sense for the broader organization. As a result, organizations leveraging ERM are better prepared for risk control and know which risks can be mitigated or accepted.
What Is Operational Risk?
Operational risk is potential harm resulting from disruptions to day-to-day business operations. These risks can have a financial impact, affect business continuity, damage the organization’s reputation, and weaken its regulatory compliance. To minimize that harm, ongoing operational risk management is essential.
Examples of Operational Risk
Some common examples of operational risk include:
- Inadequate or failed internal processes
- Human error
- System failures and downtime
- Inadequately trained staff
- Breakdown of business process controls
- Fraud
- Cybersecurity events, such as data breaches
- External events, such as natural disasters or pandemics
In general, operational risk can be created by:
- Technology
- Hardware
- Software
- Cybersecurity
- Privacy
- People
- Employees
- Vendors
- Customers
- Other stakeholders
- Regulatory and compliance issues
Operational Risk Management (ORM)
ORM helps an organization complete risk assessments, make better decisions, and implement robust internal controls for operational risk. An effective ORM program happens in several stages to help reduce and mitigate critical risks:
- Risk identification
- Risk assessment
- Risk measurement and mitigation
- Implementation of controls
- Risk monitoring and risk data reporting
Since operational risks are constant, varied, and increasingly complex, ORM is an ongoing activity. That said, four fundamental principles guide it:
- Accept no unnecessary risk.
- Accept risk when benefits outweigh costs.
- Make risk decisions at the appropriate level.
- Anticipate and manage risk with planning.
What is the Operational Risk Management Process?
The organization must consider all of its goals while managing operational risk. The objective is to reduce and control all risks at acceptable levels, because the operational risk is widespread. Active risk management identifies who is responsible for managing operational risk and makes an effort to lower hazards through risk assessment, measurement, and mitigation, as well as through monitoring and reporting.
Four concepts serve as a guide for these stages:
- When the rewards outweigh the costs, take the risk.
- Don’t take any needless risks.
- Plan to anticipate and mitigate risk.
- Decide on risks at the appropriate level.
Step 1: Identifying the Risk
For a risk to be controlled, it must first be identified. Understanding the objectives of the organization is the first step in risk identification. Anything that keeps the company from achieving its goals is a risk.
Step 2: Risk Evaluation
The systematic process of assessing hazards according to likelihood and impact is known as risk assessment. Lists of known dangers are prioritized as a result of the risk assessment. The procedure of risk assessment may resemble the risk assessment carried out by an internal audit.
Step 3: Risk Reduction
The choice of a strategy for limiting particular hazards is part of the risk mitigation process. The four choices for risk mitigation in the operational risk management process are transference, avoidance, acceptance, and control.
- Transference. Move the risk to a different party, such as via outsourcing a risky process or paying for an insurance policy. Management cannot fully delegate the duty of risk management while outsourcing. A portion of the financial burden of the risk is transferred to the insurance firm through risk insurance.
- Avoidance. You can choose a different course of action to avoid an unnecessary risk. For example, if you want to rely on one particular vendor but its security risks are high, you can avoid that by working with a different vendor instead.
- Acceptance. Management may accept the risk when the potential benefits exceed the potential harm. For instance, when a company installs new coffee machines in the break room, there is the possibility that an employee will burn himself. Management takes the risk and installs the new machines anyway, because the advantage of increased employee happiness from new coffee makers outweighs the danger of an employee inadvertently burning himself.
- Control. Control is an organization’s action to reduce the potential harm of a risk. For instance, putting data behind a firewall reduces the chance that hackers will find the data, and backing up the network so that you can restore it to a particular state lessens the damage of a hacked network.
Step 4: Implementing Control
Once you decide on risk mitigation steps, implement them. The controls you implement should prioritize preventive measures rather than detective or corrective ones (which only go into effect after a risk has struck).
Step 5: Observation
A manager should monitor your risk controls since they might be carried out by error-prone individuals or become obsolete in a shifting environment. In addition, monitor and test controls to assure that they still work over time and changing conditions. Any exceptions or problems should be brought to management, along with action plans.
Why is Operational Risk Management Important?
A company must establish operational risk management programs to achieve its strategic goals and to assure business continuity during operational interruptions. Strong ORM also shows customers that the business is prepared for loss and crises. ORM programs can also give organizations better competitive advantages, including:
- More exposure for the C-suite.
- Better risk-taking in business.
- Enhanced product functionality and increased brand recognition.
- Improved connections with stakeholders and customers.
- It increased investor assurance.
- Better reporting on performance.
- Better, more accurate long-term financial forecasts.
Operational Risk Management Best Practices
Although ORM is an appealing concept, several obstacles exist, including conflicting goals, a lack of knowledge, problems allocating resources, and a failure to see the value in the operational risk framework.
Complex ORM programs and the absence of standardized risk assessment methods and measurement methodologies can make it difficult for firms to manage operational risk.
But by adhering to the following recommendations, businesses may successfully control operational risk and guarantee company continuity.
Create, Implement, and Maintain an Operational Risk Management Framework
An operational risk management framework, integrated into the organization’s overall risk management procedures, is crucial since the operational risk is present in all company products, activities, processes, and systems. All organizational levels, including group and vertical business levels, as well as new business goods, activities, processes, and procedures, should be integrated into the ORM program.
Create the Appropriate Operational Risk Governance Framework
Management of operational risks requires a solid and efficient governance system. Top management to create such a structure and secure the board of directors’ approval before rolling it out throughout the firm.
Evaluate operational risk when approving new products and systems
Operations risk exposure rises when an organization:
- Takes part in novel activities
- Creates novel items
- Enters new markets
- Adopts new operational procedures or technology systems
- Participates in ventures situated far from the headquarters
Keep a Strong Operational Risk Reporting Mechanism in Place
A robust reporting process should include participation from everyone involved in operational risk management, including the board, senior management, and business verticals. The company must make sure operational risk reports are comprehensive, accurate, consistent, and actionable.
What Is Strategic Risk?
Strategic risk threatens your organization’s plans to achieve its business objectives. Put another way, strategic threat jeopardizes the possible paths your company can take to achieve its goals. We can divide strategic risk into two sub-categories: business risks and non-business risks.
Business Risks
Any risk that arises from business decisions made by senior management constitutes a business risk. For example:
- The management team might make poor decisions about expanding into new markets or developing new products.
- The company might price its offerings too high and lose market share or too low and miss profit goals.
- The company might use a technology that curtails its operating flexibility, such as on-premises IT rather than cloud-based services.
Non-Business Risks
These risks don’t arise from poor management decisions. Instead, they happen in the external environment but have implications for your company’s strategic plans. For example:
- A competitor might unveil a radically new business model that appeals to your customer base (such as Airbnb threatening the hotel industry).
- Economic conditions might make your product less palatable; think of the decline in cryptocurrency values disrupting online trading apps.
- Consumer tastes might move in a new direction that threatens your product offerings and value proposition.
Other examples of Strategic Risk
The list of possible strategic risks is long. Among them:
- Business decisions that are unclear or poorly communicated
- The introduction of new products or services
- Changes in senior management
- Unsuccessful mergers or acquisitions
- Changes to customer demands or expectations
- Damage to the company’s reputation
- Financial challenges (such as poor cash flow)
- Emergence of new competitors
- Problems with suppliers, vendors, or other stakeholders
Strategic Risk Management
Strategic risk management (SRM) is essential to identify, assess, and reduce strategic risks. It focuses on internal and external scenarios that introduce risk into the enterprise, and its goal is to help the organization to achieve its strategic objectives.
The organization may accept some strategic risks in the short term, but take action to eliminate or reduce them over a long time. For instance, the company might risk supply fluctuations of particular raw materials to maintain business continuity. But in the longer term, the company may redesign its product to minimize (or eliminate) its dependence on that material.
For maximum effectiveness, the SRM program must account for all risks related to the following:
- Shifts in customer demand
- New competitive pressures
- Technology changes such as the evolution of big data, artificial intelligence (AI), machine learning (ML), and so forth
- Increasing performance pressures from stakeholders
Management must also clarify when a particular risk should be avoided, either because pursuing some business opportunities may be harmful or because potential losses (risks) are likely to exceed potential returns (rewards).
The Difference Between Strategic and Operational Risk
Strategic and operational risks are both parts of ERM. Strategic risk management, however, is a high-level review that considers the firm’s objectives and overall strategy. SRM decisions have a long-term focus and must be considered carefully since they can affect the organization’s future.
Operational risk brings a more tactical, ground-level view of an enterprise’s risk profile. These risks relate to systems, people, and business processes – anything that can affect its ongoing business activities.
Many organizations focus on operational risk remediation since such risks drive day-to-day operations and business continuity. That’s short-sighted. Companies must focus on both strategic and operational risks. Doing so creates a more comprehensive and balanced picture of the company’s risk position, so senior management can grow the business while reducing the harm of loss events.
Executives must also consider strategic risk from quantitative and qualitative perspectives. A structured risk management process (complete with metrics) helps to guide decision-making about risky investments and initiatives.
Which Risk Assessment Methodologies Can Be Used?
Organizations can perform risk assessments in several different ways, depending on each organization’s needs. Also, remember that you can use several risk assessments together to get the complete picture of the risk you need.
That said, all risk assessments do follow the same basic steps:
- Determine the dangers
- Determine who could be the most harmed and how
- Make a security risk assessment and a prudent decision
- Keep a record of your discoveries and decisions
- Repeat your risk assessment regularly (say, annually) to see whether any circumstances have changed
For any risk assessment to succeed, the person conducting the evaluation should understand the risk being examined: financial, compliance, security, operational, and so forth. The assessor should also be competent in the mechanics of risk assessment.
Qualitative Risk Assessment
Qualitative risk assessments try to gauge risks by their potential severity or disruptive threat when the organization doesn’t necessarily have complex data to make specific estimates. Typically these risks are graded on a high-medium-low scale. For example, the company might evaluate the threat of specific IT systems going offline or certain physical locations suddenly not being available.
Quantitative Risk Assessment
The quantitative risk assessment uses numbers and data to estimate the cost of risk. For example, if an organization ships $1 million of sales daily, you can calculate the aggregate cost of downtime due to an operational loss event.
Generic Risk Assessment
Generic risk assessments are designed to save paperwork and duplication of effort. As a result, they will frequently be applied for similar activities or equipment across several sites, divisions, or business units. In addition, it can serve as a template for risk assessments, outlining the dangers and risks often associated with a specific action.
Dynamic Risk Assessment
A dynamic risk assessment is a method for determining risk at the moment. This risk assessment is often used to address unknown dangers or emerging and evolving conditions.
For instance, emergency services or healthcare professionals may employ dynamic risk evaluations. In these risk scenarios, the setting, circumstances, and individuals you are dealing with will vary from case to case, so you must constantly evaluate the risks given the shifting conditions.
When performing this assessment, the assessor should consider whether the initial risk assessment is still valid in the event of substantial changes. For example, should you try to handle the situation, or should it be escalated to more senior management?
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