Operational Risks Definition Types Limitations Examples

Operational Risks Definition

With firms, operational risks include system errors, human errors, improper management, quality issues, and other operation-related errors. In the case of individuals, we can drill it down to error because of self-process or other technical problems.

Types of Operational Risks

The following are types of operational risks.

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#1 – Human Error

We can also refer to this as a fat finger input error. This error is the most common and significant risk to the organization or individual. It may also relate to the skill issue of the processor. This type of error evolves when incorrect input is because of human error. The reasons for incorrect input may be multiple, including incomplete information, incomplete understanding, insufficient knowledge, inconsistent processing, genuine input error, or more. However, processing such an error may affect the output seriously and may also lead to a loss.

#2 – Technical Error

This includes system glitches. Even though everything is perfect, there are sometimes system issues like a slowdown, connectivity, system crashes, incorrect calculation by application, or a new missing bridge. Sometimes, the output received may be off from the expected result, but because of unknown technical defects, it may be challenging to catch.

#3 – Gap in Flow

Sometimes, information is missing from the source itself because of data lag or restrictions. In such cases, the output gets affected. The required production varies from that desired and may put the process at risk.

#4 – Uncontrollable Events

These include effects from an external environment like political scenarios, weather changes, syndromes affecting living beings, outdated technology, etc., which affect the performance and quality of processors and put the output at risk.

#5 – Intentional Frauds

There have been cases where intentional conflict of interests has arisen, resulting in an illegal profit to trade executors. Most organizations have a clause in their policies that the employees have to abide by fighting against conflict of interests and fraudulent practices, failing which they meet with extreme consequences. However, if such an event occurs, the firm has to bear monetary and defame losses, which are sometimes irrecoverable.

Examples of Operational Risks

Below are examples of operational risks.

Operational Risks – Example #1

ABC Corp deals in providing financial services to its clients. They process their client’s credit ratings based on various parameters. In one case, the processor made an input error, wherein he inputted $1,000,000 instead of $100,000. As a result, the client’s credit rating changed from B to AA.

This gave an incorrect picture of the client’s creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more in markets and resulted in an overestimation of debt repayment capacity.

This is one of the operational risks that ABC Corp faces, and if repeated, may lead to disastrous results.

Operational Risks – Example #2

Anna is a technical analyst who works on applications for her organization. She created an application recently for the accounts department to create invoices. Operation departments use such applications to produce output.

At the end of the month, the actual cash outflow was more than that flowing into this application. Upon more investigation, the team found out that one of the account payableAccount PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more inputs was getting doubled after execution.

Such an error is a technical error that creates operational risk and can be identified only upon considerable effects. It may be possible we may miss them for smaller immaterial transactions.

Operational Risks – Example #3

Below are the personal account entries created by Mr Brown for August.

Based on the above, Mr. Brown should have savings of $6,000 at the end of the month. However, the actual cash left with him is only $4,000.

After tallying all expenses and income, Mr. Brown discovered that he was missing out on a donation of $2,000 he makes once a year. After including this expense, his accounts were tallied.

Thus, there is an operational risk of data inclusion for accurate output.

Disadvantages

Effects due to operational risks may create irrecoverable losses. Sometimes, the losses can also lead to the cancellation of licenses for the responsible employee and the organization.It creates damage to the brand name of the employee as well as to the organization. It can lead to lifetime losses and trust in the market for such employees and the organization.

Limitations

The effect created due to operational risk can be identified and assessed only after significant losses are met. Every organization has a bar for immaterial losses incurred only when the cause of a material loss is investigated.Once an error is noticed, it may or not be reversible and corrected. Even if it can be reversed, there are chances of losses already incurred. Hence, it is best to create proper control checks at all steps of any process.

Conclusion

Operational risk is inevitable in any process or transaction. This is one type of risk that is controllable; however, not guaranteed to be eliminated. Even if all control checks are in place, there is scope at various steps for such errors. The best thing to do is to have a robust quality check process at the end of any product processing. This quality check process should be in-built within departments before the product is delivered to clients/end-users. Such quality check owners become responsible for the entire product processing and are liable for any work-related questions/clarifications required later.

It becomes the organization’s responsibility, at the end of all, to deliver a quality product as per the norms and agreement between them and the client. After all, for the client company’s promised delivery is all that matters.