Operational risk
Operational risk as the name suggests, is the risk that arises from an organisation day to day activities. It is a broad topic since the organisation consists of numerous operational units (Hakan & Mike, 2011, p. 300). The running of every aspect of the organisation and every functional unit of the company exposes the organisation to different and unique risks. The risk may arise from people, business systems or any other parameter under which the organisation operates under (Bertsimas & Lo, 1998, p. 100).
Sources of operational risk
Operational risk emanates from several sources which are operational related. These sources include: inadequate information in the bank, disruptions in operations which may result in system breakdown, employees engaging in illegal actions such as fraud and money laundering and so on. This is probably the widest form of risk that a bank is exposed to (Baker, 1998, p. 198). And as such adequate measures ought to be taken in order to cushion the institution from such risks (Amihud & Mendelson, 1991, p. 136).
The widest source of operational risk to banks comes from disruptions in operations which cause system break down. This disruption may be accidental or intentional. Accidental breakdown may come from the banks’ normal day to day operations that put the system into stress causing a breakdown in the system. Malicious disruption may arise from individuals who work in the bank and are driven by such ill motives such as theft and so on, or may originate from external sources such as individuals who try to hack into the system with the same malicious intentions of stealing from the bank. This is a case of cyber crime and usually happens when the bank’s system gets attacked by external persons.
Assessing and measuring the operational risk
The assessment of operational risk is largely dependent on the organization in terms of size and the nature of the operations of the bank. Large banks usually deal with higher operational risks. This is because the operations of the bank are numerous and as such, are exposed to operational risk. As a result the measurement of operational risk largely depends on the size of the organisation. Operational risk as defined earlier on results from the potential loss arising from the operation of the organisation (Daniels, 1997, p. 263). The Basel committee on banking regulation came up with the following formula that is used to measure operational risk among banks.
(Operational Risk)i = Ψ(Size)i
Where: Ψ is the parameter that the bank has established in relational to the operational risk. And the measures of size depend on such factors as gross revenue, profits, operating costs etc. The application of these parameters is backed by the fact that the bank that has more operations or larger span of operations is more exposed to operational risk than other the banks that have narrower span of operations. Since assessing of operational risk is largely dependent on the nature of operations, the and is therefore unique to the bank, management of the bank is required to come up with its own established operational risk measurement parameter that is used alongside other measurement criteria such as the measures of size.
Managing operational risk
Basel committee of banks regulation set up guidelines for operational risk management which involve setting of operational principles by the banks with the aim of achieving operational efficiency. The management of operational risk involves the identification, measurement, and mitigation of the frameworks that govern the operational risks. There are four main principles that govern the management of operational risk. These principles provide the guidelines that the management of the organisations should follow to effectively manage the operational risk (Bhushan, 1991, p. 180).
The first principle states the risk is acceptable of the when the benefits of a certain operation or activity outweighs the cost. The importance of this is that the organisation should only engage in the activities which provide a net benefit to the achievement of the set goals. These benefits may be in terms of profitability or in terms value addition to the net worth of the company.
The second principle state that the management should not accept unnecessary risk. This simply means that the risk ought to be matched with the possible return and a mismatch between the risk and the return of the company’s activity makes the risk unacceptable to the management. This is in light of the fact that the operational management deals with the management setting the allowable levels of risk (Eldred 1989).
The other principle dictates that the management ought to anticipate a risk and therefore plan the operations of the company in such a way that they minimise the exposure to possible losses. This principle basically advocates for planning in anticipation of the risk. The final principle states that the management of the bank ought to manage the rick decisions at the right levels. This means that the decisions made by the management must not be too ambitious such that the y exposes the company to potentially huge risks (Bessis 2010).
The Basel committee on banking and regulation provides for the management of operational risk through its first pillar. This first pillar posits that the management of the bank ought to incorporate advanced management approaches and also using the standardised approach to the management of the risks.
Conclusion
The management of operational risk largely depends on the controls that the banks management has put in place to guard the bank. These controls range from the internal control to the policies that must be adhered to in a strict manner. The operations of a bank are very crucial and in addition to sound management practices, the banks’ management ought to incorporate as much controls measures as possible in order to effectively manage the risk exposure to the bank. The challenge is therefore with dealing with the outsiders who come in as consultants and technicians who may fail to conceal confidential information about the bank’s system that has been entrusted to them.
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