Fundamentals of Risk Management

TAbLE 
30.2
Operational risk for a bank

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Risk governance
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risks are hard to quantify since loss histories are usually not available and some risks 
cannot easily be quantified.
Many banks have undertaken detailed evaluation and quantification of their
operational risks. In general, it has been discovered that the size of the bank (measured 
in terms of number of employees) influences the size of losses that will be suffered. 
This appears to indicate that larger banks tend to have larger clients. The other
general trend being identified is that the number of losses is strongly correlated to
the number of customers that use the bank.
Difficulties of measurement
The development of interest in operational risk has been based on the need to quan-
tify operational risk in financial institutions. The challenges of quantifying opera-
tional risk have been considerable. Expected levels of loss can only be estimated, 
even if the probability of loss is fairly accurately known. Although statistical
approaches have been adopted and developed, a universally accepted approach is 
still not available.
The expected losses can have a direct and indirect cost. Indirect costs are often 
larger, and include the loss of a customer. This loss can be represented by the present 
value of that customer and all future gains from that relationship. Actions that 
should be taken will include internal control measures as well as evaluation by
internal audit. Internal audit within a financial institution has the familiar, but
vitally important, responsibility of checking whether procedures are followed in 
practice and whether the procedures themselves are likely to be effective in reducing 
the level of operational risk.
Table 30.3 illustrates the different natures of operational risk faced by financial 
and industrial companies. The table provides a comparison of the nature and impact 
of human error in a financial institution, compared with an industrial undertaking. 
It is clear that the control of staff behaviour and actions is much more difficult in 
financial institutions than in manufacturing facilities.
It is worth noting that operational risk quantification is possible for non-financial 
institutions, and a transport company (for example) could investigate the opera-
tional risks associated with its activities. The risks associated with the operations 
include the price of fuel, tax obligations and the financial impact of delivery mistakes. 
Operational risks can arise from road traffic accidents or other delivery delays and 
changes by customers that have not been correctly incorporated into the delivery 
schedule.
It is likely that the most important operational risks faced by a transport company 
would be incorrect customer deliveries and road traffic accidents. The quantification 
of risk exposures associated with the various categories of operational risk will help 
a transport company focus on those risks with the greatest potential to cause disrup-
tion to normal efficient routine operations, and then take the appropriate control 
actions to reduce these operational risk exposures.

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