What is Operational Risk?
Operational risk encompasses losses caused by breakdowns in internal processes, human errors, technology failures, or external disruptions such as natural disasters and fraud. The Basel II framework formally categorized it alongside market and credit risk, requiring banks to hold capital reserves against it. Industry estimates suggest operational losses cost the global banking sector over $80 billion annually, with individual incidents sometimes exceeding $1 billion.
Sources and Measurement
Common sources include trade-processing errors, cybersecurity breaches, compliance failures, and rogue trading. Banks typically measure operational risk using one of three Basel approaches: the Basic Indicator Approach (allocating 15% of gross income), the Standardized Approach (varying by business line from 12% to 18%), or the Advanced Measurement Approach using internal loss data and scenario analysis. For individual investors, operational risk manifests as brokerage outages during volatile markets or errors in automated order execution.
Key Considerations
Operational risk is harder to quantify than market risk because loss events are infrequent but potentially catastrophic. Diversifying across brokerages and custodians reduces single-point-of-failure exposure. Investors should verify that their financial institutions carry adequate insurance and maintain robust disaster recovery plans before entrusting significant assets.