# Understanding Operational Risk: Key Concepts and Management Strategies

> **Definition**
>
> Operational risk is the potential for loss resulting from inadequate or failed internal processes, people, systems, or external events that affect a company's day-to-day business activities.

## What Is Operational Risk?

Operational risk summarizes a company's uncertainties and hazards when attempting to do its day-to-day business activities within a field or industry. A type of [business risk](https://www.investopedia.com/terms/b/businessrisk.asp), it can result from breakdowns in internal procedures, people, and systems—as opposed to problems incurred from external forces, such as political or economic events, or inherent to the entire market or market segment, known as [systematic risk](https://www.investopedia.com/terms/s/systematicrisk.asp).

Managing operational risk means fixing weak spots in a company's staff, systems, and controls to avoid problems and financial losses. This risk is a type of unsystematic risk, unique to a specific business or industry. It might be remedied through internal audits and training procedures to reduce the likelihood of employee error.

### Key Takeaways

*   Operational risk encompasses potential failures in a company's internal procedures, people, and systems, differing from risks associated with external factors like market fluctuations.  
    
*   Mitigating operational risk involves understanding key risk indicators (KRIs) and leveraging data to monitor these metrics, which can help anticipate and reduce the impact of potential disruptions.  
    
*   Operational risks originate from various sources, such as employee errors, inadequate internal processes, outdated systems, and unexpected external events, each needing strategic management.  
    
*   Companies can manage operational risk by conducting cost/benefit analyses, delegating decisions to upper management, and anticipating risks before they materialize.  
    
*   Operational risk can be categorized into distinct areas, including internal and external fraud, technology failures, and natural disasters, with each requiring tailored approaches to minimize impact.  
    

![Operational Risk](https://www.investopedia.com/thmb/QSAIodTgpp6JJXf3Hjse60T7uMY=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/operational_risk.asp-Final-4be32b4ee5c74958b22dfddd7262966f.png)

*— Investopedia / Dennis Madamba*

## Decoding Operational Risk: Internal Impact and Management

Operational risk focuses on how things are accomplished within an organization, not necessarily what is produced or inherent within an industry. These risks are often associated with active decisions relating to how the organization functions and what it prioritizes. While these risks don’t always lead to failure, reduced production, or increased costs, their severity is influenced by internal management decisions.

Operational risk, often called human risk, is the chance of business failures from human mistakes, as it relates to man-made processes and decisions. It changes from industry to industry and is an important consideration when making potential investment decisions. Industries with lower human interaction are likely to have lower operational risk.

Managing these risks is vital for financial institutions because operational losses can be unpredictable and costly. While traditional methods involve internal audits, processes, and insurance, the banking sector has adopted more advanced operational risk management frameworks to address growing complexities.

> **Important**
>
> Operational risk is a type of business risk, alongside strategic risk (failing to operate according to a plan), compliance risk (not adhering to laws and industry regulations), and reputational risk (factors that could damage an organization’s image or public perception).

## Identifying the Root Causes of Operational Risk

Operational risk comes from four main sources: people, processes, systems, and external events. Companies should reduce these risks when they can, knowing some risks will always exist.

### People

 People-related operational risk can stem from not having enough skilled employees. A company might lack staff with the right knowledge for specific problems or enough workers during busy times.

Companies can hire to reduce risks. But this brings new challenges like finding the right candidates, training them, and keeping them. As each of these aspects is resource- and time-intensive, operational risks caused by people are heavily tied to financial repercussions.  

### Processes

Each company has its own processes. A complex manufacturer, like a car company, differs from a service-based firm. In any case, if steps aren't followed in order, problems can occur. In either case, all companies have steps that must be [performed in sequential order,](https://www.investopedia.com/terms/f/functional-decomposition.asp) or else detrimental outcomes are possible.

In many cases, especially with companies that have experienced high turnover, companies may not have fully built out their processes or documented all the steps. In addition, some processes are also at risk of being taken advantage of through collusion and failed internal controls, putting the company at risk of losing money through theft.

### Systems

Many businesses now rely on software systems. Operational risk involves these systems being outdated, poor, or poorly set up. There are also performance considerations, as operational risk consists of the possibility that one company's systems aren't as efficient as a competitor's.

There also are operational risks relating to a system's technical aspects. Systems may have bugs or technical deficiencies, leading to more exposure to [cybercrime](https://www.investopedia.com/financial-edge/0112/3-ways-cyber-crime-impacts-business.aspx). Systems also have capacity constraints, and a company may be increasing its risk by placing too heavy a load of expectations on what its systems can do.

### External Events

Often, operational risk comes from outside the company, like natural disasters affecting shipping or political changes restricting operations.the Some of these types of risk may be classified on their own (e.g., geopolitical risk). Others are simply a nature of business, such as a third-party defaulting on a contract agreement.

> **Fast Fact**
>
> Operational risk can never be 100% eliminated, and management must decide what level of operational risk it is comfortable accepting. While businesses often seek to reduce risk through contracts or agreements, external factors, such as supplier reliability, can still pose significant challenges.

##  The 7 Key Categories of Operational Risk

The four sources of operational risk can be expanded into seven main categories. These seven primary categories include (in no particular order):

1.  **Internal fraud**: Employees conspire and often collude to overtake internal controls and misappropriate company resources.
2.  **External fraud**: Independent parties outside the company attempt to bribe, thieve, forge, or cyberattack.
3.  **Technology failures**: Deficiencies exist in computer systems, hardware, software, or the interaction between any of their components.
4.  **Execution, delivery, and process management**: Management is unable to properly assess a situation and deploy the right strategy or fails to execute a correct strategy.
5.  **Employee practices and workplace safety**: There is a violation or risk of violation of workplace safety measures, whether physical, mental, or other.
6.  **Natural disasters and damage to physical assets**: Inclement weather, fire, or harsh winter conditions can put physical assets at risk and make it impossible for employees to perform their daily tasks.
7.  **Clients, products, and business practices**: These include operational activities that harm customers, misleading information, negligence, or accidentally not being in compliance with requirements.  
    

## Assessing Operational Risk: Metrics and Indicators

Assessing operational risk involves key risk indicators (KRIs) and data.

KRIs are [metrics](https://www.investopedia.com/terms/m/metrics.asp) a company may self-assign as risk benchmarks. They can help managers monitor risk levels, signal changes in exposure, assess the effectiveness of controls, and ensure that the organization operates within its set risk appetite. For example, if a company targets working only with highly creditworthy vendors, it may set a KRI that no more than three vendors default on a contract. Throughout the year, the company can assess whether this goal is being met, identify reasons if it’s not, and take steps to mitigate the risk.

KRIs are most often quantifiable; it's most useful to a company to have something they can actually track and measure. For this reason, the second key part of assessment is data. Without data, a company will never know whether its KRIs are on track or deficient. Companies may seek to build out robust information-gathering processes, whether through automation, third-party surveys, financial results, or industry data.

Some companies have predefined areas for tracking operational risks with KRIs and data. For example, banks might need certain processes, cash reserves, or system operations. Here, benchmarks are set, making risk assessment easier.

## Effective Strategies for Managing Operational Risk

There are several overarching strategies and overarching principles when it comes to managing operational risk. Though every company can choose how it approaches operational risk, here are four primary ways companies manage risk.

### Avoid Unnecessary Risk

It should go without saying, but companies should continually evaluate whether they're taking on risks with no real reward coming back to them. Consider the example above with vendors that may potentially default on contracts. Should there be equally good, if not better, vendors with better credit histories that a company could work with, it may be taking on risk by working with less-than-superior vendors.

As with all things in investing, there is usually a positive relationship between risk and returns. As companies take on more risk, they should be fairly compensated with greater returns. Therefore, companies can manage operational risk by eliminating processes that do not reward the company but instead solely incur unnecessary risk.

### Do a Cost/Benefit Analysis

[Cost/benefit analysis](https://www.investopedia.com/terms/c/cost-benefitanalysis.asp) is a data-driven method used to evaluate whether the potential benefits of a business decision outweigh its associated costs. Similar to the concept above, companies must manage risk by comparing the risks they take with the benefits they receive. Instead of focusing solely on risk, this step entails being mindful of the rewards a company may realize from taking a risk.

For example, a company may decide to expand into an international market. This move may involve tremendous operational risk. However, if the market is untapped and proper research has been conducted, the reward of expanding the business may far outweigh the operational risk. Sometimes, companies need to understand that risk is necessary to manage risk.

### Delegate Decisions to Upper Management

For companies to make the wisest decisions, it's usually best for upper management to decide how to approach operational risk. These team members often have the greatest insights into a company and know larger strategies that may work together.

Using the example above, a senior management team member should be assigned responsibility for the decision-making of the international expansion. That executive should work with members across all company teams to better understand the logistics, legal, procurement, and shipment risks. This type of responsibility isn't suitable for an individual contributor at a lower level.

### Anticipate Risk

One of the most important aspects of managing risk is understanding when it is approaching and anticipating its outcomes. By so doing, companies can preemptively decide whether to accept, mitigate, or avoid risk.

In the international expansion example above, a company can easily perform vast research to better understand geographical limitations, political risks, or consumer preference differences in this new market. The first step to accepting or managing risk is to understand what may happen in the future and have a plan to overcome it.

## Operational Risk vs. Other Types of Risk

### Differentiating Operational Risk From Financial Risk

In a corporate context, [financial risk](https://www.investopedia.com/terms/f/financialrisk.asp) refers to the possibility that a company's cash flow will prove inadequate to meet its obligations—that is, its loan repayments and other debts. Although this inability could relate to or result from decisions made by management (especially company finance professionals), as well as the performance of the company products, financial risk is considered distinct from operational risk. It's most often related to the company's use of financial leverage and debt financing, rather than the day-to-day efforts of making the company a profitable enterprise.  

### Contrasting Operational Risk With Market Risk

[Market risk](https://www.investopedia.com/terms/m/marketrisk.asp) is usually referred to as the risk of price movements for a financial instrument. These changes in price are often based on investor disposition towards a stock and a company, interest rates, or economic factors. Whereas market risk is primarily focused on investments and securities, operational risk is mostly focused on the internal operations of a company, its resources, and its people.

### Exploring the Differences Between Operational and Strategic Risks

These two types of risks may blend together in certain areas, though the greatest distinction is that strategic risk is usually long-term and may involve more external parties. A new competitor entering a market is a strategic risk, though how the company handles that on a day-to-day basis is an operational risk. The competitor may have also decided to enter the market because they felt their level of operational risk could be less than that of other companies.

## Examples of Operational Risk

One area that may involve operational risk is the maintenance of necessary systems and equipment. If two maintenance activities are required, but it is determined that only one can be afforded at the time, choosing to perform one over the other alters the operational risk depending on which system is left in disrepair. If a system fails, the negative impact is associated directly with the operational risk.

Other areas that qualify as operational risk tend to involve the personnel within the organization. It is considered an operational risk, for example, if a sales-oriented business chooses to maintain a subpar sales staff due to its lower salary costs or another factor. The same can be said for failing to properly maintain a staff to avoid certain risks. In a manufacturing company, for example, choosing not to have a qualified mechanic on staff, and having to rely on [third parties](https://www.investopedia.com/terms/t/third-party.asp) for that work, can be classified as an operational risk. Not only does this impact the smooth functioning of a system, but it also involves additional time delays.

The willing participation of employees in fraudulent activity may also be seen as an operational risk. In this case, the risk involves the possibility of repercussions if the activity is uncovered. Since individuals make a decision to commit fraud, it is considered a risk relating to how the business operates.

## What Are the 5 Levels of Risk?

Companies often gauge risk by determining whether it is highly likely, likely, possible, unlikely, or highly unlikely that an event will occur. Highly likely is often assigned a percentage of greater than 90%, while likely includes a range that is always above 50%. Management uses these percentages to determine the best course of action when evaluating the cost of mitigation against the cost of a detrimental outcome.

## How Do You Identify Operational Risk?

Operational risk is identified by assessing what could go wrong in the day-to-day aspects of a company. Management often identifies operational risk by asking questions such as "what if a certain system breaks down?" or "what if a certain supplier is unable to deliver goods on time?" Management can come up countless areas of operational risk; it is up to that team to decide which aspects are most important to mitigate and which to accept.

## What Are the 4 T's of Risk Management?

The four T's of risk management are:

*   **Tolerate**: Management decides it is okay with a certain operational risk and does not take action to stop it.
*   **Terminate**: Management is not okay with any level of risk associated with a certain activity and decides to stop that activity.
*   **Treat**: Management puts in place certain maneuvers that decrease the potential total risk.
*   **Transfer**: Management wants to perform an activity but seeks a third-party to incur the risk on its behalf (i.e., it buys insurance).

## Who Is Responsible for Managing Operational Risk?

Senior management is often responsible for managing operational risk by being aware of what risks are in place and the strategies for overcoming them. Though lower-level field managers are more involved in a company's day-to-day aspects, senior management should oversee their activities to make sure the operational risk strategies are being properly carried out.

## The Bottom Line

Operational risk is the risk of loss resulting from many normal aspects of business. This includes the risk of loss caused by failed processes, unskilled employees, or inadequate systems, as opposed to the risk from financial crises and external events. Companies can seek to reduce operational risk through internal controls and procedures to reduce the occurrence of these errors.

However, some operational risk is inevitable, and it is important to have an accurate understanding of business risks to make informed decisions.  

> **Article Sources**
>
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>     
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>     
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>     
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>     
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>     
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>     
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