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What Is An Operational Risk?

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Operational risk is a loss resulting from inadequate or failed internal processes, people and systems or from external events. Operational risk as the term already indicates, the potential losses associated with operating or “working” in the broadest sense can be well illustrated by examples, but it is not easy to find a definition that is both comprehensive and functional. For this reason, the focus has long been on listing the risks not constituting operational risk, i.e. neither credit risk nor market risk, and thus “defining” it as the residual risk. Apart from the disadvantages of such a negative definition for identifying and measuring operational risk, which may lead to gaps and duplication in coverage, this only provided a generic heading for a broad range of highly diverse and poorly quantifiable risks. For example, according to this definition, business risk would form part of operational risk although it constitutes the enterprise’s inherent risk of strategic management decisions and, therefore, is beyond the risk manager’s control and competence. In June 1999, the Basel Committee on Banking Supervision decided to highlight the importance attributed to operational risk in banks by advocating an explicit regulatory capital charge for other risks. One of the reasons for doing so was the fact that the capital held as a cushion against residual risks, including operational risk, was increasingly reduced due to the more and more accurate measurement of credit risk.

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In January 2001, the Basel Committee narrowed down these other risks by drafting the first definition of operational risk that was eventually finalized in a working paper presented by the Basel Committee in September 2001. Thus, the basis was essentially created for taking account of this risk category in the requirements for risk management and capital adequacy. The Basel Committee focused on the causes of (potential) loss events in order to differentiate operational losses from events falling in other risk categories. Legal risk is included in the definition’s scope, while strategic and reputational risks are not explicitly excluded. Depending on the precise risk definition of a bank, this may play a significant role in considering management mistakes or reputational consequences of operation-related incidents because, by definition, operational risk management processes relate to all the risk areas covered.

The consistent use of an operational risk definition in a bank is of key importance no matter whether it is in line with the official definition or not. As a central element of delimitation, it is the fundamental basis for all other measures of operational risk management.

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