Typology of operational risks

What is operational risk?
Operational risk is the risk associated with operating the business. One can subdivide
operational risk into two components: operational failure risk and operational strategic
risk.
Operational failure risk arises from the potential for failure in the course of operating
the business. A firm uses people, process, and technology to achieve business plans,
and any one of these factors may experience a failure of some kind. Accordingly,
operational failure risk is the risk that exists within the business unit caused by the
failure of people, process or technology. A certain level of the failures may be
anticipated and should be built into the business plan. It is the unanticipated and
therefore uncertain failures that give rise to risk. These failures can be expected to
occur periodically, although both their impact and their frequency may be uncertain.
The impact or the financial loss can be divided into the expected amount, the severe
unexpected amount and the catastrophic unexpected amount. The firm may provide
for the losses that arise from the expected component of these failures by charging
revenues with a sufficient amount of reserve. The firm should set aside sufficient
economic capital to cover the severe unexpected component.
Operational strategic risk arises from environmental factors such as a new competitor
that changes the business paradigm, a major political and regulatory regime
change, earthquakes and other factors that are generally outside the control of the
firm. It also arises from a major new strategic initiative, such as getting into a new
line of business or redoing how current business is to be done in the future. All
businesses also rely on people, processes and technology outside their business
unit, and the same potential for failure exists there. This type of risk will be referred
to as external dependencies.
In summary, operational failure risk can arise due to the failure of people, process or technology and external dependencies (just as market risk can be due to
unexpected changes in interest rates, foreign exchange rates, equity prices and
commodity prices).