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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.
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.
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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.
The following are some of the most widely recognised ORM frameworks and standards.
Basel III Framework
Relevance: Primarily used in the banking sector.
Focus: Sets out regulatory requirements for managing operational risks, including guidelines for capital requirements, risk identification, and mitigation practices.
Key Components: The Basel Committee on Banking Supervision (BCBS) requires banks to hold capital reserves against operational risks and encourages the use of advanced measurement approaches for risk quantification.
ISO 31000: Risk Management Standard
Relevance: Applicable to all types of organisations, regardless of size, industry, or sector.
Focus: Provides a comprehensive set of principles and guidelines for managing all types of risks, including operational risks.
Key Components: Emphasises creating a risk management culture, integrating risk management into organisational processes, and continuous improvement.
COSO Framework (Committee of Sponsoring Organisations)
Relevance: Widely used across various industries.
Focus: Provides a framework for enterprise risk management (ERM), which includes operational risk management.
Key Components: Covers governance, strategy setting, performance, risk appetite, and internal control as part of a broader risk management approach.
ITIL (Information Technology Infrastructure Library)
Relevance: Specifically focused on managing risks related to IT services and operations.
Focus: Provides best practices for managing IT services, which includes addressing IT operational risks.
Key Components: Frameworks for managing incidents, problem management, change management, and service continuity that address IT-specific operational risks.
NIST Cybersecurity Framework
Relevance: Particularly relevant for organisations seeking to manage cybersecurity risks as part of their operational risk management.
Focus: Provides a risk-based approach to managing cybersecurity threats.
Key Components: Identify, Protect, Detect, Respond, and Recover—core functions aimed at managing cybersecurity risks.
FAIR Model (Factor Analysis of Information Risk)
Relevance: Often used for managing and quantifying information and cybersecurity risks.
Focus: Provides a structured approach to understanding, analysing, and measuring risk in financial terms.
Key Components: Quantitative risk analysis methods, loss event frequency, and probable loss magnitude estimation.
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.
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.
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.
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