Operational risk is the risk of losses caused by inadequate or failed internal processes, people, systems, or external events. It is a broad category of risk that can affect any organization, regardless of size or industry.
Operational risk can be classified into different categories in a number of ways. One common approach is to use the seven categories defined by the Basel Committee on Banking Supervision (BCBS):
- Internal fraud: This type of risk is caused by intentional acts of deception or dishonesty by employees or other insiders.
- External fraud: This type of risk is caused by intentional acts of deception or dishonesty by third parties, such as customers, vendors, or competitors.
- Employment practices and workplace safety: This type of risk is caused by inadequate or ineffective human resource management practices, such as poor hiring practices, inadequate training, or unsafe working conditions.
- Clients, products, and business practices: This type of risk is caused by problems with an organization’s products or services, or with its relationships with its customers.
- Damage to physical assets: This type of risk is caused by damage to an organization’s physical assets, such as its buildings, equipment, or inventory.
- Business disruption and systems failures: This type of risk is caused by disruptions to an organization’s business operations, such as power outages, system failures, or natural disasters.
- Execution, delivery, and process management: This type of risk is caused by problems with the execution of an organization’s processes, such as errors in processing transactions or inadequacies in risk management.
Another approach to operational risk classification is to use the five categories defined by the Risk Management Initiative in Microfinance (RIM):
- People risk: This type of risk is caused by inadequacies in human capital and the management of human resources.
- Process risk: This type of risk is caused by failed internal business processes within every aspect of the business.
- Systems risk: This type of risk is caused by failed internal systems.
- External events risk: This type of risk is caused by the occurrence of external events typically outside of an MFI’s control.
- Legal and compliance risk: This type of risk is caused by non-compliance with internal and external regulations and laws.
The specific categories used to classify operational risk will vary depending on the organization and its industry. However, the goal of any classification system is to provide a framework for understanding and managing operational risk.
Operational Risk MCQs
- Which of the following is NOT a category of operational risk according to the Basel Committee on Banking Supervision?
- Internal fraud
- External fraud
- Employment practices and workplace safety
- Financial risk
- The correct answer is financial risk. Financial risk is a different type of risk that is caused by changes in the financial markets.
- Which of the following is NOT an example of an operational risk event?
- A data breach
- A system outage
- A natural disaster
- A change in interest rates
- The correct answer is a change in interest rates. Interest rate risk is a type of financial risk, not operational risk.
- Which of the following is the most common category of operational risk?
- Internal fraud
- External fraud
- Employment practices and workplace safety
- Business disruption and systems failures
- The correct answer is business disruption and systems failures. This category of risk is the most common because it includes events that can have a significant impact on an organization’s business operations, such as power outages, system failures, or natural disasters.
Conclusion
Operational risk classification is an important tool for understanding and managing operational risk. By classifying operational risk into different categories, organizations can identify the risks that are most likely to affect them and develop appropriate mitigation strategies.