Operational Risk Management (ORM): An overview

Kiran Malik

26 Apr, 2023

Operational risk (ORM) refers to the risk of loss resulting from poor or failed internal processes, people, systems, or external events that can disrupt the flow of corporate operations. Financial losses might happen either directly or indirectly. A poorly trained employee, for example, may lose a sales opportunity, or poor customer service may hurt a company’s reputation. Both the risk of running a firm and the procedures employed by management for defining, teaching, and enforcing rules are examples of operational risk. Overlooked issues and control failures, whether minor or big, contribute to risk materialization, which may result in an organizational failure that hurts a company’s bottom line and reputation. Examples of Operational risk includes employee conduct, cybersecurity attacks, technology risks, business processes and controls, physical events, internal fraud and external fraud.

Process Of Operational Risk Management

Operational risk management reduces and controls any risks to an acceptable level through risk identification, assessment, measurement, and mitigation, as well as monitoring and reporting. It is guided by various principles: accept risk when the benefits outweigh the costs, anticipate and manage risk through planning, and make risk decisions at the appropriate level.

• Risk Identification: To manage operational risk, one must first identify potential problems. To ensure completeness, it is excellent practice to use or construct a control framework.
• Risk Assessment: After been identified, risks are graded using an impact and likelihood scale.
• Measurement and Mitigation: Throughout the risk assessment, risks are evaluated to a common scale in order to be prioritized and assessed against one another. The measurement also accounts for the cost of risk management related to potential exposure.
• Monitoring and Reporting: To monitor risks and spot any changes over time, a continuous risk assessment is performed. Senior management and the board are aware of the risks and any changes to assist in decision-making.

Objective Of Operational Risk Management

ORM procedures are primarily focused on controls and risk elimination, whereas other risk disciplines, such as ERM, emphasize optimizing risk tolerances to balance risk-taking and possible benefits. The ORM framework begins with identifying risks and deciding on a mitigation strategy. Operational Risk Management aims to protect the organization by eliminating or reducing risk. It can cover various issues, including fraud risks, technological risks, and the day-to-day operations of finance teams. The Risk Management Association defines ORM as the risk of loss caused by inadequate or failing internal processes, people, systems, and external events. Using a control framework, whether formal or internally produced, can help in the design of internal control processes. One method for understanding how ORM processes appear in an organization is to categorize operational risks such as people, technology, and regulatory risks.

• People

The people category includes employees, consumers, vendors, and other stakeholders. Employee risk includes both unintentional wrongdoing and purposeful malfeasance, such as fraud. Policy violations, insufficient education, inadequate training, poor decision making, and fraudulent actions are all risks. There are several operational risks that include people who are not employees of the organization. Employees, customers, and vendors all pose a risk while using social media. Monitoring and regulating the people component of operation risk is one of the most comprehensive areas of coverage.

• Technology

Technology risk includes hardware, software, privacy, and security from an operational approach. Technology risk affects both the overall organization and the people mentioned above. Hardware limitations may limit productivity, particularly in a remote work environment. When applications increase efficiency or employees lack training, software can reduce productivity. Software may also have an impact on how customers interact with your company. External hazards include hackers attempting to steal data or hijack networks. This can lead to the disclosure of client information and data privacy issues.

• Regulations

Almost every business is vulnerable to regulatory noncompliance. Although certain industries are more strictly regulated than others, all laws come down to the adoption of internal controls. In the last decade, the quantity and complexity of laws, as well as penalties, have increased. 

Risk Mitigation Strategies In Operational Risk Management

There are four risk mitigation methods in the Operational Risk Management process: transfer, avoid, accept, and control.

• Transfer:

The risk is transferred to a different organization. The two most popular types of transfer are outsourcing and insurance. When outsourcing, management cannot completely offload risk management obligations. Insuring against the risk transfers some of the financial weight of the risk to the insurance company. Cloud-based software enterprises are an excellent example of risk transfer. When a company purchases cloud-based software, the contract almost always contains a data breach insurance clause. The customer guarantees that the vendor will pay for any losses incurred as a result of a data breach. Meanwhile, the vendor will request that its data centre provide SOC reports indicating that proper controls are in place to decrease the likelihood of a data breach.

• Avoidance:

Avoidance keeps the organization from being entangled in a risk issue. For example, when selecting a vendor for a service, the corporation may choose to accept a higher-priced bid if the lower-cost vendor has suitable references.

• Accept:

 Based on a cost-benefit analysis^[1] of the risk vs. the expenditure of control, management could accept the risk and proceed with the riskier option. For example, if the company installs new coffee makers in the breakroom, an employee may burn themselves. The benefit of modern coffee makers to employee satisfaction outweighs the risk of an employee unintentionally burning himself on a hot cup of coffee. Therefore, management accepts the risk and installs the new equipment.

• Controls

Controls are methods that an organization uses to lessen the impact of a risk if it occurs or to increase the likelihood of achieving the goal. Installing software behind a firewall, for example, reduces the likelihood of hackers gaining access, and backing up the network lessens the impact of a hacked network because it can be restored to a safe state.

Challenges Of Operational Risk Management

ORM is a component of enterprise risk management (ERM). Common problems include the assumption that firms do not have the resources to engage in ORM, the need for more communication and education about the importance of ORM, a lack of uniform methodology for measuring and assessing risk, and a lack of common risk language. Because of technological advancements, ORM systems can be manual, fragmented, and too complicated, and they are sometimes mixed in with other functions, such as compliance and IT.

Benefits Of Operational Risk Management

Establishing an effective operational risk management program can assist a company in meeting its strategic objectives while ensuring business continuity in the event of an interruption in operations. A strong ORM also demonstrates to clients that the firm is prepared in the event of a tragedy or loss. Organizations who successfully create a strong ORM program can obtain competitive advantages such as:

• Improved corporate risk-taking.
• Product performance has improved, as has brand recognition.
• Improved customer and stakeholder ties.
• Increased investor trust.
• Improved performance reporting.
• Financial forecasting is more long-term.

Conclusion

Thus, we can conclude that Operational risk management is a critical aspect of managing a business. It involves risk identification, assessment, measurement, and mitigation, as well as monitoring and reporting. The objective is to eliminate or reduce risk and the challenges and benefits of implementing an effective Operational Risk Management program. Operational Risk Management is essential for ensuring business continuity and achieving strategic objectives while mitigating potential risks.

Read our Article: Managing Operational Risks in Banking