What is the operational risk?
Operational risk is the risk a company faces because of what its employees may or may not do, either deliberately or through human error. In other words, it relates to the risks resulting from failures in internal procedures, people and systems. It is different from financial risk and systematic risk and varies from industry to industry.
Operational risk is the accumulation of threats a business encounters while being active within a certain industry. It’s a type of business risk that derives from internal problems as opposed to external factors.
Where have you heard about operational risk?
Banks and other financial institutions are paying a lot of attention to operational risk in the wake of the financial crisis of the previous decade. Many experts believe that poor operational risk management has been the underlying cause of every major financial downturn over the past two decades.
What you need to know about operational risk...
It’s important to consider operational risk when looking to invest. Unfortunately, there are no existing models that would allow a company’s management and boards of directors to accurately measure their operational risks: there are too many variables.
However, high operational risk can be assumed by investors when a company is operating in certain sectors, such as power generation, mass transport, pharmaceuticals and banking and finance. Companies that are actively trying to mitigate their risks are a safer investment than those that aren't.
As it strongly depends on human behaviour, thinking and decision making, operational risk can be also called human risk. This type of risk usually arises when business operations fail due to human error. Therefore, economic sectors which require less human interaction are considered to be less risky from the operational perspective.
Operational risk is often high in business areas which require maintenance of systems and equipment. In cases when two maintenance activities should be performed and only one of them can actually be done in time, the necessity to make a choice poses a threat — or a probable operational risk.
Businesses that require human-to-human interactions with a personal approach are also often risky from the operational standpoint. For example, if a company is sales-oriented but can’t afford a professional sales team, it can be considered as operationally risky.
If it’s a manufacturing company, a decision to rely on third parties for equipment maintenance can be also regarded as an operational risk.
Operational risk should be distinguished from financial risk. Although a company’s failure to meet its financial obligations — for example, debts and loan repayments — could derive from wrong decisions made by its managers, financial risk is considered as a separate issue, more related to the company’s debt financing than to everyday workflow.