Operational risk in the banking system is not a new concept. However, it’s only recently been elevated to a distinct risk category that can shape the risk profiles of financial institutions. This elevation is mainly due to the Basel Committee on Banking Supervision (BCBS).
In one of its papers, the BCBS defines operational risks for banks as: “the risk of loss resulting from inadequate or failed internal processes, people, and systems, or external events.”
Since the global financial crisis, financial institutions have established advanced systems to control financial risk. However, they haven’t been able to deal with operational risk as effectively.
One reason is that operational risk is more complex, involves many risk types, and is not always easy to measure. Another is that active risk management requires advanced visibility into diverse processes and activities across the organization.
Banks and other financial institutions must evaluate and manage operational risk through various tools and mitigation strategies.
Operational Risks versus Strategic Risks
In banking, as in other industries, operational risk is often confused with strategic risk. However, the two concepts are distinct and should be managed as such.
Strategic risks arise when an initial business strategy fails to deliver the expected objectives, thus affecting the financial organization’s progress and development. Such risks can be created due to a technological change, the entry of a new competitor, or changes in consumer demand.
The different types of operational risk, on the other hand, arise from failed internal procedures, employee errors, breaches, fraud, or some external events that disrupt operations.
Top Operational Risks in Banking and Financial Services
New business models, complex value chains, regulatory challenges, and increasing digitization have created unknown operational risks for banks in recent years. These include:
Even as financial institutions ramp up their cybersecurity efforts, cyber risks, including ransomware and phishing, have become more frequent and influential, affecting their operational continuity.
This is especially true in the post-pandemic world where threat actors leverage security weaknesses in firms’ IT infrastructure to perpetrate serious (and profitable) cyberattacks.
Increasingly, financial institutions are relying on third-party providers, which means they have to thoroughly identify, evaluate, and control third-party risks throughout the lifecycle of their relationships with those companies.
However, with increasing digitization and hyper-connectivity in the financial landscape, vendors, suppliers, and contractors that their third-party vendors work with also create risks that must be identified, evaluated, and managed.
Internal Fraud and External Fraud
According to one survey, in 2020, almost 40% of mid/large digital financial services organizations experienced an increase in fraud since before COVID-19. Operational risk losses from internal scams can stem from asset misappropriation, forgery, tax non-compliance, bribes, or theft.
Fraud committed by external parties includes check fraud, theft, hacking, system breaches, money laundering, and data theft. The risk of both internal and external frauds arises from diverse factors, including the massive growth in transaction volumes, the availability of sophisticated fraud tools, and the security gaps created by increasing digitization and automation.
Business Disruptions and Systems Failures
Hardware or software system failures, power failures, and disruption in telecommunications can interrupt any financial organization’s business operations and lead to financial loss.
In addition to the operational risks identified above, other risk or loss events could harm financial companies, increase reputational risk, or lead to legal problems. These include:
- Missed deadlines
- Accounting and/or data entry errors
- Vendor disagreements
- Inaccurate client records
- Loss of client assets through negligence
Losses from operational risks can be financially devastating to a financial firm. They can also negatively affect its business continuity, reputation, and compliance position.
As the financial services landscape becomes increasingly complex, banks and other financial companies must control operational risk by adjusting their risk management strategies, systems, and procedures.
Operational Risk Management in Banking
Operational risk management should be at the center of every financial institution’s operations. This ongoing process involves risk assessment, risk decision-making, and adopting internal controls to mitigate or avoid different kinds of risk, including:
- Behavioral risk
- Cyber risk
- Credit risk
- Compliance risk
- Regulatory risk
- Third-party risk
These business practices and controls must be incorporated into the firm’s systems, processes and culture, so it can continue to operate effectively, execute business strategy, and prevent large-scale or severe risk issues.
It’s also crucial to refocus on boosting business resilience and addressing critical vulnerabilities by adopting data-driven risk measurement and real-time monitoring.
Operational Risk Management Strategies for Banks and Financial institutions
In the financial sector, operational risk management can help create more secure and profitable organizations. This requires risk managers to build an effective operational risk management program by following these strategies:
Evaluate the Risk Profile
To reduce operational risks and improve its information security, every financial company should evaluate its risk profile. It should also assess the resiliency of its business processes, map them to associated risks and controls, and create a database of potential operational risk events.
Develop Key Risk Indicators
Key risk indicators can alert leadership to potential issues. The real-time testing of operational processes, controls, and risk metrics can provide visibility into determinants of risk levels, such as spikes in transaction volumes and any areas operating under stress. Organizational leaders can then use these risk indicators to identify, categorize, and mitigate risks.
To ensure the effectiveness of its operational risk management program, employees must be made aware of potential risks. This is especially important when a business unit is about to do something new, such as change a customer interface, roll out a new product or service, or adopt business process outsourcing.
Combine Cybersecurity with Operational Risk Modeling
Operational risk and cybersecurity risk are intrinsically linked because of the extensive impact of a potential data breach on the financial organization’s operations.
As such, combining cybersecurity best practices with operational risk modeling objectives can help these firms develop better plans to prevent, mitigate, and remedy operational risks.
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