Business Finance

Operational Risk

Written by Clayton Reeves for Gaebler Ventures

Risk faces your business every day that it is in operation. Managing this risk can prove to be one of the more important tasks that you face. Modern techniques can help you better understand what sort of decisions you should be prepared to make.

Operational risk is the most significant risk that a firm will face.

Operational Risk

Although financial, market, and worker risk are all important, operational risk is more important by far.

In fact, without operational risk, the rest of the risks are significantly less important. Operational risk exaggerates the affect of all other risks. In fact, most of the major losses of the last twenty years have been driven by operational risk losses. Enron, Worldcom, and Societe Generale all experienced catastrophic losses because of operational risk misjudgments.

For small businesses, operational risk can have an equally potent, if not nominally equivalent effect.

A loss of $20,000 can sometimes doom a startup company. Therefore, it is even more important to protect the infant company from the dangers of operational risk. Usually, operational risk occurs when someone tries to do something that nominally is good for the company but lacks long-term vision. This can include anything from exaggerating statements to outright fraudulent activities.

There are several approaches to the management of operational risk. In the traditional sense, operational risk items that are severe in nature (high risk items) were usually defined as both high severity and high frequency. These items are few and far between, so there was usually a low capital charge associated with operational risk.

However, as Societe Generale has illustrated with their $7.2 billion derivative loss, operational risk can have an impact on any company. As a result of one worker's actions, Societe Generale had one of the worst financial losses in trading history.

One of the main problems with the traditional ORM model was that it required a firm to imagine all of the risks in their structure and apply a probability that it would occur. There are no gauges for severity of the risk or how much it will affect the company. Modern ORM corrects this, along with some of its other short-comings.

In the modern ORM model, high severity items with a low likelihood are now deemed high-risk items. In this sense, things like huge derivative losses and catastrophic events can be planned into a company's risk segment.

This can include anything from natural disaster coverage like hurricane and flood risk to market events such as a credit crisis. All of these things are being looked at retrospectively to determine what sort of measures could be taken to hedge against these kinds of arguably unforeseeable events.

Realistically, there will always be events that create losses for companies. Not every risk can be hedged against. However, if a company can protect itself from the ebbs and flows of these losses and have a smoother road, it can be positioned for sustainable success.

Even small companies need to protect themselves from catastrophes and market place failures. Operational risk management is a subject that managers can look into in order to accomplish this.

When he's not playing racquetball or studying for a class, Clayton Reeves enjoys writing articles about entrepreneurship. He is currently an MBA student at the University of Missouri with a concentration in Economics and Finance.

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