Operational Risk

Question 1

Operational risk

Answer 1

Represents losses arising from lapses (breakdowns or failures) of internal control, human errors & failures to adequately manage external events (e.g. economic downturns & new technology developments)

Basel Committee on Banking Supervision, 2005

Question 2

Reasons for operational risk

Answer 2

1. We may use an inappropriate risk management tool
2. Ignored known risks – ‘too good to true’ syndrome (This occurs when organisations are aware of potential risks but choose to ignore them, often driven by short-term gains or incentives.) e.g. Collapse of Barings Bank
3. Underestimate their frequency or potential impact.
4. Failure to identify & measure unknown risks – e.g., 9/11 terrorist event
5. Communication failures: breakdowns in the flow of information within an organisation, particularly when it comes to reporting important matters to higher levels of management or governance bodies.
6. Monitoring & management lapses: deficiencies in oversight and management practices (inefficient leadership)
7. Failure to learn from the past: often due to managerial short-sightedness or overconfidence

Question 3

Responses to Operational Risk

Answer 3

Heavily trust-based financial firms now have to hold regulatory capital to mitigate operational risks & prevent reputational damage

• Internal & external audit risk assessments
• More frequent and expanded statutory or regulatory audits conducted by line management.
• Increased operational risk awareness – e.g., through training & education & adoption of ERM
• Insurance protection – e.g., of cyber security breaches & business disruption (such as fire, floods etc)

Question 4

Internal control to mitigate operational risk

Answer 4

Achieved through a flexible mix of control mechanisms:

1. Controls over Input:
   
   • Human resources management
2. Controls over Processes:
   
   • Systems, procedures, and policies
   • Management and financial accounting
   • Purchasing and sales systems
   • Inspection schemes
   • Internal and external audit
   • Corporate governance
   • Regulators
3. Controls over Output:
   
   • Financial measures such as profit margins and sales per head
   • Non-financial measures like customer satisfaction scores, staff turnover, and productivity per head
   • Qualitative approaches such as surveys, focus groups, and market research.

Question 5

Dysfunctional Behaviour

Answer 5

• In organizations, conflicts arise between managers and shareholders, known as agency theory.
• This conflict can lead to operational inefficiencies, especially regarding internal tax strategies aligned with global corporate tax objectives, potentially resulting in shareholder dissatisfaction.
• Additionally, there’s a tendency to create slack, especially in budgeting, seen in the public sector’s “use it or lose it” approach. For example, engineering departments may rush to spend remaining budgets before the fiscal year-end, resulting in annual road works from Christmas to March 31st.
• Managers often engage in earnings smoothing to maintain a consistent upward trend, which is favored by markets and boosts managers’ bonuses by stabilizing share prices.
• To mitigate forecast bias, operational objectives like sales targets should reflect market realities to avoid significant forecast deviations.

Question 6

Problems with measurement

Answer 6

Tunnel vision – concentrating only on what is measured to the detriment of the rest of the business
Sub optimisation – diverting attention from improvements to the method of measuring whether or not improvement has actually occurred
Myopia – addressing short-term success at the expense of long-term investment
Convergence (desire to be ‘normal’) – blend into the crowd rather than innovate to improve; effect is to lower everyone to the lowest common denominator
Gaming – strategic manipulation of measures to improve reported position
Misrepresentation – creative accounting and fraud

Question 7

Organisational structures

Answer 7

1) Functional Structures:
- Decision-making centralized at the top.
- Departments allocated functional responsibilities (e.g., HR, Marketing).
- Emphasis on communication between departments.
- Control flows from top to bottom.
- Service departments provide centralized staff functions.
Advantages:
- Easy to understand.
- Clear lines of communication.
Disadvantages:
- Best suited for small firms with a narrow geographical footprint.

2) Divisional Structures:
- Head Office supported by senior staff for CEO.
- Divisions organised based on geography or products/services.
- Each division responsible for all functional areas.
- Operational control decentralised to each area.
- Strategy determined at Head Office.
Advantages:
- Centralised planning with local implementation.
Disadvantages:
- Risk of maverick (unpredictable) behaviour.
- Potential for inter-divisional disputes over resources.