Operational risk is classified as a form of loss caused by a company’s internal processes, which can be failures in a financial services company’s systems and people. In addition, operational risk can include legal actions or environmental events that serve as potential threats to a firm’s survival.
Unlike market risk, operational risk is caused by human error. More specifically, while market risk and credit risk are generally calculated to help a firm predict or generate profit, operational risk management is geared toward protecting a company from internal failure.
One of the most common ways to measure operational risk is the “matrix approach” in which a company’s losses are categorized by the type of loss and the location in which the event occurred. This method involves defining risk as either high frequency, low impact (HFLI) risks or low frequency, high impact (LFHI) risks. The matrix approach is particularly useful for banks when they attempt to identify risks with the greatest impact. Once the extent of an operational risk can be measured, a company can use several methods to mitigate it.