Operational Risk
Quick Definition
The risk of loss resulting from inadequate or failed internal processes, people, systems, or external events within a financial institution or business.
What Is Operational Risk?
Operational risk encompasses losses from failed internal processes, human errors, system failures, or external events. It's one of the three major risk categories alongside market risk and credit risk.
Categories of Operational Risk:
| Category | Examples |
|---|---|
| People Risk | Employee fraud, key person departure, human error |
| Process Risk | Failed trade settlement, accounting errors |
| Systems Risk | IT outages, cybersecurity breaches, data loss |
| External Events | Natural disasters, regulatory changes, pandemic |
Notable Operational Risk Failures:
| Event | Type | Loss |
|---|---|---|
| Knight Capital (2012) | Software glitch | $440M in 45 minutes |
| Barings Bank (1995) | Rogue trader (Nick Leeson) | $1.3B — bank collapsed |
| Equifax (2017) | Cybersecurity breach | $1.4B+ in costs |
| FTX (2022) | Governance/control failure | $8B+ customer losses |
For Individual Investors:
- Broker Risk: Your brokerage could face operational failures
- Mitigation: Use SIPC-insured brokers, diversify across brokerages for large portfolios
- Cybersecurity: Use strong passwords, 2FA on all financial accounts
- Record Keeping: Maintain independent records of your holdings
Basel Framework: Banks measure operational risk under Basel III accords and must hold capital reserves against potential operational losses.
Operational Risk Example
- 1Knight Capital lost $440M in 45 minutes due to a software deployment error — pure operational risk
- 2FTX collapse: operational risk from lack of internal controls and governance
Related Terms
Risk Management
The systematic process of identifying, assessing, and mitigating financial risks to protect portfolio value and achieve investment objectives.
Model Risk
The risk of loss arising from using incorrect or misapplied mathematical models to make financial decisions, value assets, or assess risk.
Regulatory Risk
The risk that changes in laws, regulations, or government policies will adversely affect an industry, company, or investment strategy.
Reputational Risk
The risk that negative public perception, scandals, or controversies will damage a company's brand value and stock price.
Standard Deviation
A statistical measure of how spread out returns are from the average, quantifying investment volatility and risk.
Hedging
An investment strategy that uses offsetting positions to reduce the risk of adverse price movements in an existing asset or portfolio.
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