Operational Risk Management in Banking

Introduction

The operational environment for today’s banking institutions has never been more challenging. Organizations are grappling with complex regulatory compliance requirements, heightened market volatility, fears of economic downturn, and industry consolidation as they face pressure to drive revenues and increase efficiency.

Based on recent industry data, banks face an average of 80% more operational risk incidents compared to other industries. To operate efficiently in such a high-stakes environment, banks continually strive to identify, assess, and mitigate these risks to safeguard their operations, reputation, and, ultimately, their customers' assets.

With the financial ecosystem becoming more complex and interconnected, managing operational risks has transcended traditional risk management approaches, urging banks to adopt more dynamic, technology-driven strategies. Unsurprisingly, banks constantly look for better ways to manage and monitor operational risks to strengthen risk preparedness and resilience.

In this article, we will discuss operational risks in banking, operational risk management (ORM) methodology, best practices, and emerging trends in ORM, along with a real-world example of how a leading bank improved its ORM processes.

Key Takeaways

• Operational risk in banks is the risk of loss stemming from ineffective or subpar internal systems, processes, or people or external systems or events. It encompasses various threats, including fraud, cybersecurity, third-party risks, regulatory compliance, and operational disruptions, requiring proactive management strategies.
• Banks face persistent challenges in fraud prevention, managing third-party relationships, safeguarding against cyber threats, ensuring regulatory compliance, and mitigating operational disruptions.
• Operational risk management is an ongoing process involving risk identification, assessment, mitigation, and continuous review and monitoring to improve the program and ensure it is aligned with the evolving business requirements.
• Advanced technologies like artificial intelligence (AI) and machine learning (ML), as well as the growing call to move from siloed to integrated approach, are transforming the way how banks manage operational risks.

What is Operational Risk in Banks?

Operational risk management in banks is the process of identifying, assessing, monitoring and mitigating banking risks such as fraud, cybersecurity, regulatory compliance, and operational disruptions.

In the recent past, banks worldwide have been plagued with headline-garnering scandals sparked by an inability to limit operational risk. Banks need to allocate resources to control operational risks despite being a challenging task. In comparison to financial risk, operational risks are more complicated and tough to limit and manage. 

Banks often fail to understand, measure, and manage the interrelated factors that add to operational risk, including interconnectedness of risks, administrative processes, IT systems, and human behavior. They struggle to build cultural, management, and administrative structures to control these risks.

Top 5 Operational Risks in Banks

Simply put, operational risks in banks pertain to the potential for loss resulting from inadequate or failed internal processes, people, systems, or external events. This broad definition encompasses a variety of risk elements, from human error and system failures to natural disasters and external threats like cybersecurity breaches. 

Operational risks can pose significant challenges to banks, necessitating vigilant risk management strategies. Below, we explore the top five operational risks that banks should prioritize in their risk mitigation efforts.

• Fraud and Financial Crimes

  Fraud and financial crimes remain at the forefront of operational risks faced by banks. This encompasses a wide range of illicit activities, from identity theft and forgery to embezzlement and money laundering.

  The intricacies of these crimes often involve sophisticated schemes and the exploitation of any loopholes in the bank’s security measures. What makes fraud particularly damaging is its dual impact; immediate financial losses combined with long-term reputational damage that can erode customer trust.

  Moreover, the rise of digital banking, while convenient, has opened new avenues for fraudsters to exploit, demanding that banks invest in advanced detection and prevention technologies.

  Also, with the rise of Generative AI tools in conversational contexts, bank customers may be unaware of what is a system-generated piece of communication, and what is a scam, resulting in significant additional risk.

  To augment this, banks need a proactive policy that keeps up with the changing times, and work with industry experts to catalog and address operational risks. Banks also must foster a culture of vigilance and integrity within their organization, emphasizing the importance of ethics and compliance at all levels. 

• Cybersecurity threats

  In the digital era, cybersecurity threats loom larger than ever, with banks being prime targets due to the vast amounts of sensitive financial information they hold.

  Cyberattacks can range from malware and phishing to sophisticated nation-state attacks aimed at destabilizing financial systems, leading to significant financial losses and compromising sensitive customer information. Moreover, compromised customer information can lead to identity theft, fraud, and regulatory penalties. 

  To combat these evolving threats, banks must implement robust cybersecurity measures, including firewalls, encryption protocols, multi-factor authentication, and employee training programs. An oft-cited statistic is that nearly 70% of cyber attacks occur due to user error. It is vital to understand that even the most well-intentioned person may still end up conducting themselves in a way that puts the bank’s cybersecurity measures at risk.

  Additionally, partnerships with cybersecurity firms and information sharing within the financial industry can enhance collective defense against cyber threats.

• Regulatory Compliance

  The banking sector operates under a tight regulatory microscope. Laws and regulations are not just complex but are also ever-changing, making compliance a significant operational challenge. Banks are required to navigate a labyrinth of domestic and international regulations, from anti-money laundering (AML) laws and data privacy regulations to the Basel Accords and beyond.

  Non-compliance can result in hefty fines, legal sanctions, and damage to a bank's reputation, all of which can have profound financial implications. For instance, failure to comply with AML regulations might lead to a scenario where a bank is unknowingly used as a conduit for money laundering, attracting not only financial penalties but also causing irreversible harm to the institution’s trustworthiness.

• Third-Party Risks

  As banks increasingly rely on third-party providers for a range of services – from IT support to customer service operations – they inadvertently extend their vulnerability to operational risks. These external entities can become weak links in the security chain, where their failure to comply with stringent security measures can result in data breaches, service disruptions, or compliance violations.

  The challenge lies in the bank's ability to effectively manage and monitor these third-party relationships. Despite rigorous oversight, the interconnected nature of these relationships means that banks can never entirely eliminate third-party risks. Therefore, establishing transparent communication channels and mutual understanding with vendors about risk management practices is crucial for mitigating potential issues.

• Operational Disruptions

  This risk is a stark reminder of the vulnerability inherent in every banking institution's day-to-day operations. It could be as simple as a software update gone wrong, leading to downtime in customer service portals, or as severe as a flood crippling the bank's data centers.

  Several global banks, for this reason, frequently conduct mock drills that simulate threats to Business As Usual (BaU). Outside of these measures, banks can also use virtual simulations and team-wide conversations to drive home the ubiquity of operational risks.

  The implications of such disruptions are far-reaching. Beyond immediate financial losses, they can erode customer trust — a commodity that’s painstakingly built over years but can be lost in an instant.

  In an age where banking is increasingly becoming digital, the cybersecurity dimension of operational disruptions looms large, underscoring the importance of robust IT infrastructure and proactive threat detection mechanisms.

How do You Identify Operational Risks in Banks?

Unearthing operational risks in banks requires a methodical approach that considers various internal and external factors impacting banking operations, such as:

• Comprehensive Risk Audits

  At the foundation, banks should regularly conduct comprehensive risk audits. This involves reviewing and documenting all processes, systems, and controls in place across the bank's operations. 

  By meticulously mapping out the landscape of their operational procedures, banks can pinpoint areas of potential vulnerability. These audits should not just be tick-box exercises but thorough evaluations that question the efficacy and resilience of existing frameworks against operational risks.

• Leveraging Risk Indicators

  Implementing key risk indicators (KRIs) is an essential strategy. These indicators act as the canaries in the coal mine, designed to flag potential risks before they balloon into significant issues. 

  KRIs can include metrics such as transaction errors, system downtimes, staff turnover rates, etc. – each providing insights into where operational faults might be brewing. By carefully monitoring these indicators, banks can proactively manage and mitigate operational risks.

• Scenario Analysis and Stress Testing

  Banks benefit from engaging in scenario analysis and stress testing, wherein they model the potential impact of various adverse operational scenarios.

  This could range from cyber-attacks to the sudden loss of critical staff or suppliers. Through these exercises, banks can assess their preparedness and response strategies, identifying weak links in their operational chain. 

  Moreover, stress testing against extreme but plausible scenarios ensures that banks can withstand unexpected shocks.

• Employee Feedback 

  A valuable but sometimes underutilized method of identifying operational risks is through direct feedback from employees. Those on the front lines are often the first to notice irregularities or inefficiencies that could signify deeper operational issues. 

  Establishing a culture where employees feel comfortable reporting concerns without fear of reprisal is crucial. Additionally, effective and anonymous whistleblowing channels can surface hidden risks, ensuring they can be addressed before escalating.

• Regulatory Compliance and Industry Benchmarking

  Keeping abreast of regulatory changes and industry best practices is crucial for banks in managing operational risks. Regulatory requirements often reflect responses to identified risks within the industry and can provide a blueprint for what banks should be monitoring. 

  Likewise, benchmarking against industry standards and peers can reveal areas of operational deficiency or highlight effective risk mitigation strategies to emulate.

• Data Analysis and Trend Observation

  Utilizing data analytics tools to track and analyze historical data regarding past operational risk incidents can reveal patterns and trends that may not be immediately apparent. For instance, if a specific process or system has failed multiple times in the past, it might indicate a higher-risk area that needs immediate attention. Similarly, monitoring external data can help identify emerging risks in the broader financial and geopolitical environment.

How Do Banks Manage Operational Risks?

There are four key steps involved in risk management in banks:

• Risk identification With risk identification, banks can take stock of where they begin to comprehend and control operational risks.
• Risk analysis This process seeks to identify, assess, and control various operational risk exposures or hazards facing a bank and lets them know if an adverse event may negatively impact their business.
• Risk mitigation Banks must ensure effective controls exist at the various risk-evolution stages. The sooner the controls are put in place in the risk journey, the more robust the risk detection and mitigation mechanism will be.
• Continuous monitoring and improvement Managing operational risks is an iterative, ongoing process. It requires risk teams to continuously monitor the risk landscape to identify emerging risks, internal controls to ensure they are working as intended, and the ORM program to ensure it meets evolving business needs and the changing risk and regulatory environment.
  
  Improvements in operational risk management depend a lot on the willingness of senior management to be proactive and prompt while appropriately addressing operational risk managers’ concerns.

Best Practices for Managing Operational Risks

A complete approach to ORM involves four broad areas:

• Regulation - Ensuring Compliance 

  Regulators have issued a number of operational risk management regulations and guidelines that banks need to follow since the global financial crisis. Adhering to these regulatory requirements involves establishing robust controls and monitoring them to ensure their relevance and effectiveness. Being compliant goes a long way toward enabling banks to manage their operational risks efficiently and proactively.

  Banks functioning in several territories may have to confront conflicting and overlapping regulatory systems. Errors can be costly and upsetting, causing customer defections and regulatory sanctions. The pace and scale of regulatory shifts can be overwhelming. As banks try to control costs, they must invest in people, systems, and processes that promote compliance.

• People – Creating Risk Awareness

  Even today, employees and the customers they converse with can cause significant damage when they do not perform tasks appropriately, either unintentionally or on purpose. Trouble can occur from several other factors, such as deliberate and unlawful policy breaches, poor execution, lack of training and knowledge, and unclear procedures. The top management and leadership should implement measures to build and nurture a risk-aware culture across the enterprise, including encouraging frontline engagement in risk management program, conducting training and workshops, supporting a speak-up culture to report any observation, issue, or anomaly, etc.

• Process – Establishing Effective Processes and Workflows 

  Banks should streamline their operational risk management processes and activities end-to-end. This requires defining and documenting roles and responsibilities of risk teams along with the clear lines of accountabilities, establishing appropriate workflows for risk identification, assessment, and mitigation, capturing operational risk incidents and losses, identifying and remediating issues, and reporting. Lack of effective processes could result in gaps or blind spots that can lead to operational failure.

• Technology – Implementing Purpose-Built Software Solutions

  In today’s hyper-digitized environment, technology is the most critical element of a robust ORM program. Banks can implement software solutions specifically designed to help them meet their operational risk needs. These tools improve process efficiencies by automating repeatable tasks, enhance risk visibility and foresight, streamline issue and action management, simplify reporting, and more. By providing actionable insights in real time, technology-based solutions enable banks to drive effective and timely business decisions.

Operational Loss Management in Banks

Internal loss events are key components of the operational risk framework toolkit. While key risk indicators (KRIs), scenario analysis, and risk and control self-assessment (RCSA) involve different degrees of subjectivity, internal loss event data offers the most objective source of information as the losses can be quantified and verified.

Internal losses appear from real events, i.e. the materialization of operational risks, and reflect the bank’s own experience. Hence internal loss events can be used as a basis for assessment and management response.

Losses arising from a lack of control or some unanticipated event represent a view of the past while risk management must be forward-looking. But, unless controlled, events that have taken place could occur again, and involve more substantial impact, especially if linked to consequential loss events or additional control failures. In this manner taking the opportunity to learn from hindsight can help in building foresight.

If executed properly, the positive results of the internal loss event process will not only be a response to current risks but will also help in managing future risks. 

With MetricStream, you can minimize loss events by capturing, analyzing, categorizing, and remediating internal risk events and losses across multiple impacted organizations in compliance with industry regulations like the Basel Accords.

Key Emerging Trends in Operational Risk Management

Conventionally, measuring operational risk is very challenging. Basic statistical models have grappled with the unavailability of data. However, several banks and other financial institutions have observed the following key trends:

• Digitization of operations The entry of digital fintech players in the banking sector has transformed how traditional banks operate as customers prefer the ease with which they can transact. Once these risks are identified, steps can be taken to mitigate them. Without a doubt, digitization can increase risks for community banks that do transform. The answer to this problem is enhanced digital banking risk management.
• The role of technology in transforming risk management Technology is at the top of the list of transformative forces in the banking sector. The move from monolithic players toward the platform economy is producing a more interdependent and interconnected marketplace. While this creates prospects for incumbents, new market players, and customers, it also raises key questions about regulation and accountability, especially as customer data becomes more valuable.
• Changing regulations influencing risk management policies To shield their business from changing regulations, it is imperative for banks to make sure their ORM program stays agile. They must be able to incorporate new regulations into their program as they are introduced. It is important that they leverage internally and externally sourced broad-spectrum threat intelligence to keep the risk management processes on alert.
• Moving away from a siloed approach Business complexity with regulatory and market scrutiny, is pushing firms to embrace a structured approach to not just ORM but the overarching governance, risk, and compliance (GRC) program. The objective is to effectively define, control, and observe the business environments. A siloed approach to managing GRC activities and processes is no longer effective. An integrated approach brings together various elements like risks, assets, controls, regulations, policies, processes, etc., providing a 360-degree view of the bank’s GRC posture and contextual risk information for better-informed decision-making. Technology has an enabling role in offering consistency, sustainability, transparency, and efficiency across this integrated GRC approach.
• AI and ML driving business innovations Advanced technologies such as artificial intelligence (AI), machine learning (ML), robotic process automation (RPA), etc. have an extensive role to play in the context of operational risk management. These technologies can significantly accelerate the decision-making process by providing insights into hidden risk trends and patterns, loss data, control environment, issue and action management, and more while improving process efficiencies and freeing up the bandwidth of risk teams to focus on other core risk management activities.

Accelerate Business Performance with MetricStream Operational Risk Management

The MetricStream Operational Risk Management (ORM) software offers an extensive range of features to support the implementation of a robust operational risk management framework in banks and financial services institutions. Built on the MetricStream Platform, the ORM software empowers organizations to embrace a pervasive approach to managing operational risks, fostering enhanced collaboration across all business functions, including executives, risk managers, and business process owners. With MetricStream’s powerful and efficient ORM tool, organizations can facilitate risk-informed, timely business decisions, ultimately boosting business performance and minimizing losses.

To learn more about MetricStream Operational Risk Management, request a personalized demo today.

Case Study: Global Bank Streamlines Operational Risk Management

As a leading multi-national banking institution, operating 1200 branches in 70 countries, relied on various disjointed and legacy systems for managing operational risks and business continuity. This, along with lack of standardized taxonomies and processes, resulted in siloed information that was difficult to aggregate and analyze. As a result, there was often a delay in rolling up the insights to the key personnel, hampering effective decision-making.

MetricStream helped the bank integrate various firm-wide risk initiatives to create a single source of truth. With common risk taxonomy and standardized processes as the foundation, the bank deployed modules for libraries, risk and control self-assessment (RCSA), loss management, issues and actions, and reports, effectively streamlining operational risk management. The bank has shortened the cycle time and costs of performing risk assessments, resulting in improved overall efficiency.

Click on the link to read the complete case study: Global Bank Enhances Business Decision-Making with MetricStream

Frequently Asked Questions (FAQ)

• What are the operational risk events of banks?

  The Basel Committee has classified operational risk events of banks into 7 categories:

  • Internal fraud
  • External fraud Employment practices and workplace safety
  • Clients, products, and business practice
  • Damage to physical assets
  • Business disruption and system failures
  • Execution, delivery, and process management

• How do banks mitigate fraud and financial crimes?

  Banks mitigate fraud and financial crimes by implementing robust detection and prevention measures. This includes employing advanced fraud detection technologies, monitoring transactions for suspicious activities, conducting thorough customer identity verification, and enhancing employee training on recognizing and reporting fraudulent behavior.

• Why is regulatory compliance crucial for banks?

  Regulatory compliance is crucial for banks to maintain trust, avoid legal penalties, and safeguard financial stability. Non-compliance with regulations such as anti-money laundering (AML) laws or Basel Accords can lead to hefty fines, reputational damage, and operational disruptions.

• What is the biggest operational risk for a bank?

  One of the most significant operational risks for banks is cybersecurity threats. As banks increasingly rely on digital systems to manage transactions and customer data, they become prime targets for cyber attacks. These include sophisticated malware, phishing scams, and data breaches, which can lead to financial losses, reputational damage, and regulatory penalties.