Operational Risk and its management

 Among the various risks that financial organizations face, operational risks are regarded as being the most important of them because they can lead to the destruction of a business. ... 'the risk of direct or indirect loss resulting from inadequate or failed internal processes, people or systems or from external events.

According to Medova and Kyriacou, [1] (2001) practitioners define operational risk as ‘everything not covered by exposure to credit and market risk.’ This definition is not easy to work with and cannot be the basis of operational risk measurement. The reason for this is that de¬ning operational risk as the difference between total risk and the sum of market risk and credit risk makes it impractical to identify activities that give rise to operational risk, which is a requirement for measuring and modeling this kind of risk.

The definition which was initially proposed by the British Bankers Association is extensively used and adopted by the Bank for International Settlement in January 2001. The operational risk was described as:

‘the risk of direct or indirect loss resulting from inadequate or failed internal processes, people or systems or from external events.’

The concept of operational risk appears at first glance not very innovative since the banks did not wait for the Basel Committee to organize their activities in the form of procedures, and to develop internal audit departments to verify the correct application of these procedures. However, spectacular failures, like Baring's, have attracted the attention of regulators on the need to provide banks with prevention and coverage mechanisms against operational risks (through the allocation of dedicated capital).

This definition is based on the fundamental causes of operational risk. It tries to ascertain why a loss happened and at a wider level, it distinguishes among four causes: people, processes, systems, and external factors.

Although there is no single agreed-upon definition of operational risk, risk professionals agreed among themselves that the definition should include:

‘Breakdowns or failures relating to people, internal processes, technology, or the consequences of external events.’ – International Association of Financial Engineers