Credit vs Operational Risk Models

In the world of risk management, have you ever noticed that the formulas used to calculate credit risk and operational risk share a conceptual foundation. Both are about anticipating potential losses by combining the likelihood of an unwelcome event with the severity of its impact.

However, I’ve come to notice there are differing attitudes towards credit and operational risks which seem to stem from how they are perceived within a business context.

Credit Risk

Credit Risk usually refers to the risk that a borrower will default on any type of debt by failing to make required payments. The key factors, Probability of Default (PD) and Loss Given Default (LGD), are often quantifiable and can be modelled statistically. Businesses may be more comfortable dealing with credit risk because it is directly linked to financial transactions, which are an integral part of any business operation. Moreover, credit risk has been extensively studied, and there are well-established models and historical data to draw from, providing a sense of familiarity and predictability.

Operational Risk

Operational Risk, on the other hand, encompasses a broader range of uncertainties. It includes risks from loss due to inadequate or failed internal processes, people, systems, or from external events. Here, the Likelihood and Consequence variables are much broader and can sometimes be harder to quantify, especially as they can encompass everything from minor process failures to catastrophic events. The breadth and ambiguity of operational risk can sometimes make it feel more abstract and harder to manage, yet somehow we want these risks to all go away. The reality is it is much easier said than done.

Think of credit risk like a seasoned chess player, where each move is calculated and the number of possible outcomes is vast but finite. The game's rules are clear, the moves are documented, and although the opponent might surprise you, you have strategies based on previous games. Credit risk management, like a chess game, involves a lot of strategising based on known quantities.

Operational risk, however, is more like preparing a city for all possible natural disasters. You know disasters will happen, but predicting when, where, and how severe they will be is far more complex. You must prepare for a range of scenarios, from floods to earthquakes, each requiring different responses.

No wonder it feels so broad, some days you think you are playing a game of chess, and then it suddenly feels like you are holding jelly in your hands.

August Advisory
#HumanCentredRisk #EmbracingAIwithCuriosity

[Image: AI generated image of chess board with hands holding jelly with some creepy looking hand image in the jelly itself. Eww. Note that this is, ironically, operational risk in the image generation.]