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Operational risk management (ORM) is a crucial aspect of risk management that focusses on identifying, assessing, mitigating, and monitoring risks that arise from an organisation’s daily operations. Operational risks, unlike financial or market risks, are associated with the internal processes, people, systems, or external events of the organisation. These risks can affect the organisation’s ability to achieve its objectives through its business operations, lead to financial losses, or damage its reputation.
Table of Contents:
What is Operational Risk?
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, systems, or external events. It encompasses a broad range of risks, including:
Process Risks: Risks arising from inefficiencies or failures in business processes, such as errors in transaction processing or supply chain disruptions.
People Risks: Risks caused by human error, fraud, lack of training, or poor management.
Systems Risks: Risks related to technology, such as system failures, cybersecurity threats, or data breaches.
External Risks: Risks stemming from external factors, including natural disasters, regulatory changes, or economic shifts.
What are some examples of operational risks?
Operational risks can manifest in many forms, affecting different aspects of an organisation's business operations.
Transaction Processing Errors: Mistakes in financial transactions, such as double payments, missed payments, or incorrect entries, can lead to financial losses and reputational damage.
Supply Chain Disruptions: Delays, errors, or disruptions in the supply chain—caused by supplier failure, transportation issues, or quality problems—can impact production schedules, inventory levels, and customer satisfaction.
Cybersecurity Breaches: Cyberattacks, such as phishing, ransomware, or data breaches, can compromise sensitive data, disrupt operations, and cause reputational damage.
Inadequate Data Management: Poor data management practices, including inaccurate data entry, insufficient data backups, or lack of data integrity, can result in erroneous decision-making and compliance issues.
Non-Compliance with Regulations: Failure to comply with local, national, or international laws and regulations, such as health and safety standards, environmental regulations, or financial reporting requirements, can lead to fines, legal action, or loss of licenses.
Contractual Breaches: Failing to meet contractual obligations with customers, suppliers, or partners can lead to disputes, penalties, or loss of business.
Intellectual Property Infringement: Unauthorised use of intellectual property (e.g., patents, trademarks, copyrights) or failure to protect the organisation’s intellectual property can result in legal challenges and financial loss.
Causes of Operational Risk
Operational risk arises from various sources that affect an organisation’s ability to achieve its objectives. Understanding these causes is essential to proactively manage risks and ensure business continuity. Below are the primary causes of operational risk:
Internal Processes
Internal processes are critical to smooth operations, but inefficiencies, inconsistencies, and inadequate controls can create significant risks. These challenges can lead to errors, delays, increased costs, and compliance failures, impacting overall performance. Key risk areas include:
Process Inefficiencies: Ineffective or poorly designed workflows can lead to errors, delays, and increased costs.
Lack of Standardisation: Variability in processes across departments or regions can cause inconsistencies.
Failure of Controls: Insufficient or bypassed internal controls may result in errors, fraud, or compliance breaches.
Automation Failures: Over-reliance on automated systems without adequate oversight can exacerbate process failures.
People Risks
People are at the heart of every organisation, but human-related risks can disrupt operations and hinder efficiency. Common challenges include:
Human Error: Mistakes in decision-making or task execution can lead to costly disruptions.
Fraud or Misconduct: Deliberate actions, like embezzlement or insider trading, pose significant financial and reputational threats.
Inadequate Training: Employees lacking the necessary skills increase the likelihood of errors and inefficiencies.
Management Failures: Poor leadership and unclear accountability create operational inefficiencies and weaken organisational performance.
Technology and Systems
Technology drives modern operations, but its risks can be just as impactful as its benefits. Key areas of concern include:
System Outages: Downtime in critical IT systems can bring operations to a halt.
Cybersecurity Threats: Data breaches, ransomware, and other attacks compromise sensitive information and operational integrity.
Legacy Systems: Outdated technologies may fail to meet current demands or integrate with newer systems.
Software Bugs or Glitches: Unresolved errors in software can disrupt operations or produce inaccurate data.
External Events
External risks are often unpredictable but can significantly affect operations. These include:
Natural Disasters: Earthquakes, floods, and hurricanes can disrupt supply chains and facilities.
Regulatory Changes: Adjustments to laws or regulations may require rapid changes in processes.
Third-Party Failures: Reliance on suppliers or contractors introduces vulnerabilities when they fail to deliver.
Compliance and Legal Risks
Legal and compliance risks can lead to severe penalties and reputational damage if not managed properly. Key risks include:
Non-Adherence to Regulations: Failing to meet legal or regulatory standards may result in fines or lawsuits.
Contract Breaches: Unmet obligations to clients or partners can lead to disputes or financial losses.
Intellectual Property Risks: Poor protection of patents, trademarks, or copyrights exposes organisations to financial and reputational harm.
Cultural and Organisational Factors
An organisation’s culture and structure play a significant role in risk management. Common challenges include:
Siloed Communication: Poor collaboration between teams creates blind spots and inefficiencies.
Resistance to Change: Employees reluctant to adopt new processes or technology slow organisational progress.
Weak Risk Culture: A lack of accountability and awareness undermines efforts to manage risks effectively.
Supply Chain and Logistics
Operational risks within supply chains and logistics can disrupt production and delivery. Key issues include:
Disruptions in Supply Chain: Delays, quality issues, or supplier failures impact schedules and customer satisfaction.
Transportation Failures: Interruptions in logistics networks, like strikes or port closures, halt the movement of goods and affect operations.
Strategic Misalignment
Misalignment between strategy and operations can expose organisations to risks that impact growth and performance. Key sources of risks include:
Unrealistic Objectives: Overly ambitious goals strain resources and operations, leading to inefficiencies.
Inadequate Planning: Poor preparation during expansions, mergers, or digital transformations creates bottlenecks and operational challenges.
Importance of Operational Risk Management
ORM is essential for a variety of reasons:
Protects Against Financial Loss: By identifying and mitigating risks, organisations can prevent significant financial losses resulting from inadequate or failed internal processes people and systems or from external events.
Enhances Reputation: Effective ORM helps maintain a company's reputation by preventing events that could lead to negative publicity or regulatory penalties.
Ensures Compliance: ORM ensures that the organisation complies with relevant laws, regulations, and standards, reducing the risk of legal consequences.
Improves Decision-Making: A structured ORM framework enables better decision-making by providing a clear understanding of potential risks and their impact.
Supports Business Continuity: By managing risks effectively, organisations can ensure continuity of operations even during unforeseen events.
Need some help? Don’t hesitate to reach out to Aevitium LTD and we will help you to structure an ORM framework that works for your organisation.
Is ORM a framework?
Operational Risk Management (ORM) is not a single, standardised framework but rather a process or discipline that involves a series of activities designed to manage operational risks within an organisation. However, many organisations adopt or adapt various frameworks, guidelines, and standards to implement ORM effectively.
There are several established frameworks and standards that provide structured approaches to implementing and improving operational risk management. These frameworks outline principles, guidelines, and best practices to help organisations manage their operational risks systematically.
You will find more details in our article Operational Risk Management Frameworks: Building a Resilient Organisation.
When does an organisation need to manage operational risks?
All organisations, regardless of their size, nature (e.g., for profits, government agencies, non-profits, charities, etc.), and their activity(ies), face some sort of operational risk. So, they all need operational risk management (ORM) and, potentially, a supporting framework at various points in their lifecycle to ensure their operations are resilient, efficient, and aligned with strategic objectives.
Here are some key situations and triggers in which an organisation should prioritise ORM and consider adopting a structured framework.
Regulatory and Compliance Requirements
When Required by Law or Regulations: Organisations in highly regulated industries, such as banking, insurance, healthcare, and energy, often face specific legal requirements for managing operational risks. For example, Basel III mandates banks to maintain adequate capital reserves against operational risks.
To Comply with Industry Standards: Compliance with industry standards such as ISO 31000, COSO, or NIST may be necessary to meet stakeholder expectations, regulatory mandates, or to obtain certifications that enhance market credibility.
Strategic Decision-Making
During Strategic Planning or Expansion: When an organisation is planning strategic changes such as expansion into new markets, mergers, acquisitions, or launching new products or services, ORM helps assess potential risks associated with these initiatives, enabling more informed decision-making.
When Developing New Business Models or Processes: Introducing new business models or changes to operational processes can create new risks. ORM ensures these risks are identified, assessed, and managed from the outset.
Operational Disruptions and Incident Response
After Experiencing Significant Operational Disruptions: If an organisation has experienced a major operational disruption, such as a cybersecurity breach, data loss, supply chain interruption, or natural disaster, implementing a robust ORM framework can help prevent similar incidents in the future.
In Response to Increased Incident Frequency: An uptick in operational incidents, such as equipment failures, process errors, or customer complaints, may signal underlying risks that require a systematic approach to identification and mitigation.
Risk Appetite and Management Needs
When the Organisation Has a Low Risk Appetite: Organisations that have a low tolerance for risk—such as those in sectors with high reputational stakes or critical service delivery responsibilities—need a structured ORM framework to proactively identify and mitigate risks.
To Support Enterprise Risk Management (ERM): ORM is a critical component of a broader Enterprise Risk Management (ERM) strategy. Organisations focused on managing risks across all areas (strategic, financial, compliance, and operational) should integrate ORM into their ERM framework.
Internal and External Changes
Significant Organisational Changes: Changes such as restructuring, leadership changes, or shifts in organisational culture may bring about new operational risks that need to be identified and managed.
Changes in the External Environment: External factors, such as regulatory changes, technological advancements, economic shifts, or geopolitical events, can introduce new risks or change the profile of existing risks, necessitating an ORM framework to adapt to these changes.
Digital Transformation and Cybersecurity Needs
During Digital Transformation Initiatives: As organisations undergo digital transformation, including the adoption of new technologies (AI, cloud computing, IoT), they face new risks related to data security, privacy, and system integration. An ORM framework can help manage these technology-related risks.
To Enhance Cybersecurity Posture: As cyber threats become more sophisticated, organisations need robust ORM to manage cybersecurity risks, protect sensitive data, and ensure the integrity of their systems and operations.
Performance Improvement Goals
To Improve Operational Efficiency and Resilience: Organisations looking to improve operational efficiency, reduce costs, and enhance resilience benefit from ORM practices that identify process inefficiencies, bottlenecks, and potential failure points. Learn more in our article Building Operational Resilience.
To Strengthen Decision-Making Processes: Effective ORM supports better decision-making by providing a comprehensive understanding of operational risks, their potential impact, and mitigation strategies.
Stakeholder Expectations
To Meet Stakeholder Demands: Investors, customers, employees, and partners increasingly expect organisations to manage risks proactively. An ORM framework can demonstrate the organisation's commitment to risk management and build stakeholder trust.
In Response to Audits and Reviews: If internal or external audits reveal deficiencies in risk management practices, an organisation may need to implement or strengthen an ORM framework to address these gaps.
Business Continuity and Crisis Management
To Develop a Business Continuity Plan: Organisations need ORM to identify critical operational risks that could disrupt their business, allowing them to develop and implement robust business continuity and disaster recovery plans.
For Crisis Preparedness and Response: Effective ORM helps organisations prepare for potential crises (e.g., natural disasters, cyberattacks, pandemics) by identifying risks in advance and establishing response protocols.
Competitive Advantage and Market Differentiation
To Gain a Competitive Edge: Organisations that proactively manage operational risks are often seen as more reliable and resilient, which can provide a competitive advantage in the marketplace. An ORM framework can help position the organisation as a leader in risk management.
To Meet Client and Partner Requirements: In some industries, clients or partners may require organisations to demonstrate their risk management capabilities before entering into business agreements. Implementing a recognised ORM framework can help meet these requirements.
The Process of Operational Risk Management
Operational risk management typically involves the following key steps:
Risk Identification
The first step in ORM is to identify the potential risks that could impact the organisation's operations. This involves:
Conducting Risk Assessments: Reviewing internal processes, systems, and practices to identify areas where risks may arise.
Analysing Historical Data: Examining past incidents, near misses, and trends to identify recurring risks.
Engaging Stakeholders: Consulting with employees, managers, and other stakeholders to gather insights into potential risks.
Risk Assessment
Once risks have been identified, they must be assessed to understand their potential impact and likelihood. This involves:
Risk Measurement: Quantifying risks in terms of their potential financial impact, frequency, and severity.
Risk Prioritisation: Ranking risks based on their potential impact and likelihood to focus on those that are most critical to the organisation.
Risk Mitigation
After assessing the risks, the next step is to develop strategies to mitigate or reduce them. Common risk mitigation strategies include:
Implementing Controls: Establishing policies, procedures, and controls to minimise risks (e.g., segregation of duties, internal audits, and access controls).
Enhancing Training: Providing regular training to employees to raise awareness of risks and promote best practices.
Improving Processes: Streamlining and automating processes to reduce errors and inefficiencies.
Investing in Technology: Deploying technology solutions to enhance data security, monitor risks, and improve overall operational efficiency.
Risk Monitoring and Reporting
Effective ORM requires continuous monitoring of risks and the effectiveness of mitigation strategies. This involves:
Regular Audits and Reviews: Conducting regular internal and external audits to evaluate the effectiveness of risk management controls and strategies.
Performance Metrics: Establishing key risk indicators (KRIs) and other performance metrics to monitor risk levels and detect potential issues early.
Reporting Mechanisms: Developing clear reporting lines and protocols for escalating risk-related information to senior management and the board of directors.
Who is responsible for ORM?
Operational Risk Management is a shared responsibility involving multiple stakeholders across the organisation. While the Board of Directors and Senior Management provide oversight and strategic direction, the Risk Management Department, Chief Risk Officer (CRO), Business Unit Managers, and Employees are actively involved in day-to-day risk management activities. The Internal Audit and Compliance functions provide independent assurance and ensure regulatory compliance, while external stakeholders, such as regulators, set the standards for ORM practices.
Tools and Techniques for Operational Risk Management
Several tools and techniques can aid in the effective management of operational risks:
Risk and Control Self-Assessments (RCSAs): A systematic approach for identifying, assessing, and mitigating risks by involving stakeholders across the organisation.
Key Risk Indicators (KRIs): Metrics used to monitor risk levels and provide early warning signs of potential risk events.
Scenario Analysis: A technique that involves simulating different risk scenarios to assess their potential impact on the organisation.
Incident Management Systems: Tools used to track and manage operational risk events, incidents, and near misses.
Business Continuity Planning (BCP): Developing plans and strategies to ensure the continuity of critical operations during and after a disruptive event.
What are the key challenges in Operational Risk Management?
While ORM is crucial, it comes with several challenges:
Complexity of Risks: Operational risks are diverse and can arise from various sources, making them difficult to identify and assess.
Data Limitations: Lack of accurate and timely data can hinder risk assessment and decision-making.
Changing Regulatory Landscape: Constant changes in regulations require organisations to adapt their ORM practices continuously.
Resource Constraints: Limited resources, both in terms of personnel and budget, can impact the effectiveness of ORM efforts.
Human Factors: Human error, cultural issues, and resistance to change can pose significant obstacles to effective ORM.
Best Practices for Effective ORM
To achieve effective operational risk management, organisations should consider the following best practices:
Develop a Strong Risk Culture: Foster a culture of risk awareness and accountability at all levels of the organisation.
Integrate ORM into Business Processes: Embed ORM practices into daily operations and decision-making processes.
Leverage Technology: Use advanced tools and technologies, such as data analytics, artificial intelligence, and machine learning, to enhance risk identification, assessment, and mitigation.
Conduct Regular Training: Provide ongoing training and awareness programs to employees to ensure they understand the importance of risk management.
Engage Senior Management: Ensure senior management and the board of directors are actively involved in overseeing ORM activities.
Continuously Review and Improve: Regularly review and update ORM policies, procedures, and controls to adapt to changing risks and regulatory requirements.
Conclusion
Operational risk management is a dynamic and continuous process that plays a critical role in safeguarding an organisation's assets, reputation, and overall sustainability. By identifying, assessing, mitigating, and monitoring operational risks, organisations can enhance their resilience, ensure compliance, and achieve their strategic objectives. The key to effective ORM lies in adopting a proactive approach, leveraging technology, and fostering a strong risk culture throughout the organisation.
FAQs: Operational Risk Management
1. What is Operational Risk Management (ORM)? Operational Risk Management is the process of identifying, assessing, mitigating, and monitoring risks that arise from an organisation’s internal processes, systems, people, and external events. It helps prevent operational disruptions, financial losses, and damage to reputation.
2. Why is ORM important? ORM is essential because it protects against financial loss, ensures compliance with regulations, enhances decision-making, and supports business continuity by managing risks that can impact an organisation's operations.
3. What are examples of operational risks? Examples of operational risks include transaction processing errors, supply chain disruptions, cybersecurity breaches, non-compliance with regulations, and intellectual property infringement.
4. Who is responsible for Operational Risk Management? ORM is a shared responsibility across the organisation. The Board of Directors and senior management provide oversight, while risk management departments, business unit managers, and employees are responsible for day-to-day risk management activities.
5. What are the key frameworks for ORM? Several frameworks and standards support ORM, including Basel III (for banking), ISO 31000 (general risk management), COSO (enterprise risk management), and NIST (cybersecurity risks).
6. What are the common challenges in ORM? Some challenges include the complexity of risks, limited data for risk assessment, evolving regulatory requirements, resource constraints, and human error.
7. How does ORM differ from other types of risk management? ORM focuses specifically on risks that arise from an organisation's internal operations, unlike financial or market risk management, which deals with external market factors like interest rates or currency fluctuations.
8. When should an organisation implement ORM? ORM should be implemented throughout an organisation's lifecycle, especially during major changes like digital transformation, mergers and acquisitions, or strategic planning, as well as in response to regulatory requirements.
9. What tools are used in ORM? Common tools for managing operational risks include Risk and Control Self-Assessments (RCSAs), Key Risk Indicators (KRIs), incident management systems, and scenario analysis.
10. What are the best practices for effective ORM? Best practices include fostering a strong risk culture, integrating ORM into business processes, leveraging technology, conducting regular training, and ensuring continuous review and improvement of ORM practices.