Operational risk and financial risk often sit side by side on a bank’s risk heat map, but they arise from very different sources and behave very differently when things go wrong. In the Indian context, the Reserve Bank of India (RBI) has sharpened this distinction through detailed guidance on operational risk and operational resilience, while continuing to treat financial risks such as credit, market, and liquidity risk as core pillars of prudential regulation.
How operational risk is defined (RBI/Basel context)
In line with the Basel Committee on Banking Supervision principles (BCBS principles), RBI defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events, including legal risk. This means that if a bank loses money because of a system outage, a process breakdown, a cyberattack, employee fraud, a documentation lapse, or a disaster that disrupts operations, that is operational risk, not financial risk in the narrow sense.
RBI’s guidance on Operational Risk Management and Operational Resilience expects regulated entities to:
- Conduct risk identification across all business lines, products, services, processes and systems to uncover operational risks.
- Put in place tools such as loss data collection, risk and control self-assessments, scenario analysis and key operational risk indicators.
- Hold capital specifically for operational risk under the minimum capital requirement framework.
So, operational risk in this sense is about how the institution runs – the quality of its plumbing, safeguards, people and resilience.
What counts as financial risk?
Financial risk is an umbrella term for risks that arise directly from a bank’s financial positions and exposures. The classic categories are:
- Credit risk: the risk that borrowers or counterparties will fail to meet their obligations, leading to defaults and losses.
- Market risk: the risk of losses due to movements in market prices such as interest rates, foreign exchange rates, equity prices or commodity prices.
- Liquidity risk: the risk that the bank cannot meet its obligations as they fall due or cannot liquidate assets without significant loss.
These risks come from what positions the bank holds and with whom it deals. They are typically measured in terms of exposures, probabilities of default, loss-given-default, value-at-risk, duration gaps, liquidity coverage ratios and so on.
In simple terms: financial risk is about the riskiness of the bank’s balance sheet and off-balance sheet exposures; operational risk is about the riskiness of its operations and infrastructure.
Source, Transmission and Visibility of Losses
Where the risks come from
- Operational risk sources
Internal process failures, human errors, system breakdowns, cyber incidents, fraud risk (internal or external), rogue trading, model errors, legal and compliance failures, outsourcing breakdowns, physical disasters affecting branches or data centres. - Financial risk sources
Counterparty defaults, credit deterioration, adverse market movements, interest rate shocks, currency volatility, liquidity dry-ups, correlation breakdowns in portfolios.
Both can lead to large losses, but the triggers are different: operational risk often starts with “something went wrong in how we do things”; financial risk starts with “something went wrong in the positions we hold or the markets we are in.”
How they show up
Operational risk events typically show up as:
- One-off or series of loss events (fraud, outages, mis-selling settlements, penalties).
- Fines and enforcement actions for regulatory breaches.
- Reputational damage following service disruptions or scandals.
Financial risk events show up as:
- Non-performing assets (NPAs), write-offs and provisioning spikes (credit risk).
- Trading and investment losses (investment risk), mark-to-market hits (market risk).
- Liquidity squeezes, emergency funding at high cost, fire-sale losses (liquidity risk).
Often, a single real-world incident contains both. For example, a massive IT outage (operational risk) can trigger customer churn and, in extreme cases, reputational and liquidity stress (financial risk). But from a regulatory and management standpoint, they are treated as distinct categories with different toolkits.
Why Operational Risk Feels Different from Financial Risk
Several features make operational risk behave differently from financial risk:
- Fat tails and surprises
Operational risk events often have low frequency but very high severity (a major cyber breach, a huge internal fraud, a catastrophic system failure). Statistical models built only on past data may underestimate these tail events. - Data and modelling challenges
There is no equivalent of a yield curve or PD/LGD curves for many operational risks. Loss data are sparse, heterogeneous and sometimes under-reported. Scenario analysis and expert judgement play a bigger role. - Control-intensive mitigation
Operational risk mitigation leans heavily on internal controls, process redesign, automation, segregation of duties, training, cyber defences against cyber security risks, and risk resilience capabilities. Financial hedging is less straightforward compared with market or credit risk. - Strong link to culture and governance
Many major operational losses (rogue trading, mis-selling, conduct failures) are ultimately failures of culture, incentives, oversight and accountability. Fixing them requires changes in people and governance, not just models.
Financial risks, by contrast, tend to be more quantifiable and more closely tied to measurable exposures. They can often be hedged or rebalanced using financial instruments, though not always perfectly.
RBI’s Elevation of Operational Risk
Historically, operational risk was sometimes seen as a residual bin: “everything that is not credit or market risk.” Basel and RBI have moved away from that vague view to a much sharper, capital-linked treatment.
RBI’s direction now stresses that:
- The board must recognise operational risk as a distinct and critical category of risk that requires a structured risk management framework and explicit oversight.
- Banks should build a comprehensive “risk universe” that includes all material operational risks alongside financial risks.
- Operational risk measurement should draw on internal loss data, external loss data, scenario analysis and assessments of the business environment and internal control factors.
- Minimum capital must be held against operational risk under a standardised methodology, replacing earlier approaches.
In effect, operational risk is not a soft risk – it is capital-relevant, resilience-relevant and board-relevant.
Bringing It Together in an ERM View
For Indian banks and NBFCs, the practical question is not “operational vs financial risk – which matters more?” but “how do we integrate both under one enterprise risk management (ERM) umbrella?”
In risk management in banking, a sound ERM approach will:
- Recognise operational, credit, market and liquidity risks as distinct but interconnected parts of the overall risk universe.
- Align risk appetite and limits across both operational and financial risk categories.
- Ensure capital planning and stress testing incorporate shocks from both sides (for example, a cyber event plus a liquidity squeeze).
- Link operational risk management initiatives (stronger controls, better resilience, improved culture) to financial metrics (capital adequacy, profitability, valuation).
In summary, operational risk – as sharpened by RBI’s guidelines – is about the integrity, reliability and resilience of how a regulated entity functions. Financial risk is about the volatility and vulnerability of its financial exposures. For a modern Indian financial institution, mastering both is non-negotiable: one protects the machinery of the organisation, the other protects its balance sheet.
