Operational impact

Operational impact
See also

Operational impact is the various consequences and consequences resulting from inadequate or failed internal procedures, errors in people and systems or from external events, including legal risks and those affecting the overall condition of the company (P. Leone, P. Porretta 2018, pp. 25). The operational impact is related to the materialisation of operational risk and consists in the loss of resources or the loss of control over those resources (P. Leone, P. Porretta 2018, pp. 25).

Operational impact is dealt with by two scientific disciplines of economic sciences: Finance and Management Science. In financial terms, the aim is to assess the level of operational risk in such a way that it is possible to determine the necessary financial reserves to cover potential losses related to this risk, i.e. to determine the so-called capital adequacy (P. Leone, P. Porretta 2018, pp. 27). In terms of management sciences, which complements the financial approach, it is about analysing the nature of operational risk (causes, vulnerabilities, risk fulfillment mechanism, effects) in order to be able to take organisational measures to prevent causes and vulnerabilities, as well as the nature of business continuity plans in relation to possible effects (P. Leone, P. Porretta 2018, pp. 27).

Although operational impact may apply to any business organisation, the risk management model is of particular importance for the banking system, where supervisory and regulatory authorities are responsible for establishing safeguards to protect against disruptions to the banking system and economic turmoil (P. Leone, P. Porretta, 2018, pp. 28). In banking, the notion of operational impact is most often associated with the management of programme risk of financial institutions, which is reflected in the New Capital Accord, known as Basel II.

The Basel II standard, which defines operational impact, defines it as effects resulting from the inadequacy or unreliability of internal processes, people and technical systems or from external events (P. Leone, P. Porretta 2018, pp. 29). The definition of operational impact of Basel II does not include, for example, strategic effects, i.e. losses resulting from e.g. a failed strategic business decision, or reputation risk (damage to an organisation consisting in the loss of its reputation), which may arise from operational failures, as well as from other events.

Operational impact may also be understood as the risk of errors in transactions, the risk of losses resulting from inadequacy or unreliability of internal processes, people and technical systems or from external events (P. Leone, P. Porretta 2018, pp. 30). However, operational risk is not directly related to market volatility or counterparty creditworthiness. It is often argued that this risk includes everything that is not classified as other risks. The growing importance of operational risk is related to the progressive globalization and rapid development of the information society and social issues - the increasing number of acts of terrorism and racial, ethnic and religious conflicts.

One of the basic objectives of any company is to maximize value. This value is significantly influenced by, inter alia, an appropriate policy on risk reduction in the activity (P. Leone, P. Porretta 2018, pp. 30).

Main factors of operational impact

The main factors influencing the overall condition of an organisation should be included (A. Demir 2019, pp. 25-27):

  • people - losses caused by intentional actions of employees, human factors are associated with abuse such as theft by employees, falsification of documents, errors in data entry, incomplete legal documentation and conflicts, business practices: use of confidential customer data, money laundering, sale of unauthorized products, but also low tolerance of stress, discrimination and adaptation of changing working conditions may be a factor,
  • processes - mistakes in procedures, which may involve the need to adapt to customer requirements,
  • systems - including device failures, hardware, connectivity and software problems,
  • external events - losses resulting from natural activities such as earthquakes, floods, hurricanes, but also criminal activities such as terrorism, assault, theft, vandalism, physical and computer intrusion (A. Demir 2019, pp. 25-27).

Classification of operational impact events

The official list of events related to operational risk defined by the Basel II standard lists the following situations with a negative impact on the condition of the organization (A. Nazeri 2012, pp. 18-19):

  • internal fraud - activities of bank employees aimed at intentional fraud, misappropriation of property, circumvention of bank law or policy, e.g. credit fraud, cheque fraud, bribery, falsification of internal reporting, intentional destruction of assets,
  • external fraud - activities of third parties aiming at, inter alia, theft, robbery, physical intrusion, computer intrusion, information theft, forgery,
  • human resources practice and safety in the workplace - discrimination against employees, compensation, violation by the bank of occupational health and safety regulations and health and safety regulations, employee claims on account of wages, working conditions threatening health and safety,
  • customers, products and business practices - actions leading to a breach of trust and guidelines in the area of customer service, disclosure of customer information, aggressive commercial strategy to maximize commissions, unauthorized transactions in customers' bank accounts, misjudgment of the customer profile, as well as incorrectly constructed banking products (wrongly drafted templates, contracts, regulations),
  • damage to tangible assets - lost or destroyed physical assets as a result of force majeure (natural disasters), acts of vandalism or terrorism,
  • disruption of business activity and systems errors - manifested, inter alia, in malfunction of equipment, software errors, telecommunication and power supply problems,
  • transaction execution, delivery and operational process management - errors during data entry into the system, execution, settlement and handling of transactions,
  • negligence in monitoring and reporting, improperly maintained documentation concerning bank customers, improper management of customer accounts, unfavourable relations with counterparties and bank suppliers.

In terms of the discipline of Management Science, the classification is different and includes 28 categories (A. Nazeri 2012, pp. 18-19).

Methods of limiting operational impact

Operational impact can be minimized, through (S. Rahman, et all., 2010, pp. 839-842):

  • well-prepared and well-functioning internal control,
  • independent and objective bank audit,
  • effective banking supervision, which can identify many of the bank's internal problems during inspections.

Operational impact management

In order to manage it effectively, it is necessary to quickly identify, measure, analyse, monitor and report risks and keep them under constant control. The probability of an undertaking being exposed to a difficult financial situation and the resulting costs can be reduced by risk management, the basic objectives of which are to control operational impact and risk (N. Akhter 2018, pp. 12-14):

  • hedging the cash flow exposed to the risk of changes in interest rate, exchange rate, commodity prices, stock prices,
  • hedging the value of the portfolio of assets exposed to interest rate risk (in cases where it is a portfolio of debt instruments) and equity prices. This type of risk can be defined as the uncertainty of meeting the customer's expectations.

Measures of variability

The operational impact measures can be broken down into (H.K.S. Lam 2016, pp. 28-34):

  • Volatility measures - reflect changes in financial prices or yields. This risk is understood as a mismatch with expected return. The bigger the difference, the higher the risk. With the increase in changes in the rates or prices of income of financial instruments, the investment risk increases.
  • Sensitivity measures - reflect the impact of variables on financial prices. The purpose of sensitivity measures is not to measure the effect of an existing risk, but to consider the relationship between the financial value and the risk factors that directly affect the value of the instrument. The more sensitive the price is to the influence of the factors influencing the price, the higher the risk. Sensitivity measures for option price risk are called Greek coefficients and are denoted by Greek letters. The Greek factor indicates how much the option price will change approximately when the value of the factor changes by the entity, while other factors remain unchanged.
  • Hazard measures - determine the maximum amount of loss that can be incurred (H.K.S. Lam 2016, pp. 28-34).

References

Author: Karolina Szlachtun