Operational Risk

Operational risk was initially defined in the negative as any form of risk that is not market or credit risk. This negative definition is rather vague as it does not tell us much about the exact types of operational risks faced by banks today, nor does it provide banks with a proper basis for measuring risk and calculating capital requirements.

A better definition is provided by the Basel Committee, who define operational risk as:

"The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."

This definition includes legal risk, but excludes strategic and reputational risk. However, because operational risk is a term that has a variety of meanings, banks are permitted to adopt their own definitions, provided the minimum elements in the Committee's definition are included.



Operations Risk Vs. Operational Risk

There exists an important distinction between operations risk and operational risk.

Operations risk relates to the activities carried out by the operations or back office department of a bank. The back office is the area of a bank that looks after most of the administrative side of any trades undertaken by the front office. It is therefore responsible for the accurate and timely settlement of all transactions in accordance with trade deadlines.

Operational risk is a much broader concept incorporating not just the activities of back office departments, but also many other possible risk events across the whole organization. In its 2003 paper on 'Sound Practices for the Management and Supervision of Operational Risk', the Basel Committee (in conjunction with the banking industry) identified seven loss event categories that can potentially result in substantial operational losses.

1. Internal fraud
2. External fraud
3. Employment practices and workplace safety
4. Clients, products, and business practices
5. Damage to physical assets
6. Business disruption and system failures
7. Execution, delivery, and process management