In the complex and ever changing world of business, it is important to understand he different types of risks for effective management. Two of the most common and significant risks business face are legal risk and operational risk. While both risks can cause serious damage to a business, they both come from different sources and require different strategies to mitigate the impact.
Is Legal Risk and Operational Risk the Same?
Legal risk and operational risk are not the same. Legal risk refers to financial losses because the business did not comply with relevant laws whereas operational risk refers to breakdowns in internal processes. However, operational risk also includes legal risk.
What is Legal Risk?
Legal risk refers to the potential for reputational or financial loss from a company’s business operations not being operated in compliance with relevant laws, rules, or contract obligations. These risks manifest in many ways and can differ widely depending on the nature of the business, the jurisdiction it operates within, and the applicable laws.
What is Operational Risk?
Operational risk is the uncertainties and hazards a company can face when it attempts to do its daily business activities within a specific field or industry. It can result in breakdowns in internal procedures, people and systems instead of problems incurred from external forces like political or economic events.
What is the Difference Between Legal Risk and Operational Risk?
Legal risk and operational risk are two critical concerns for businesses, each with unique characteristics. Below, we outline the key differences between them to help you understand how they impact organizations.
Source of the Risk
Legal risk comes from external sources like changes in regulations and laws or contracts imposed by external parties. On the other hand, operational risk comes from internal factors which can include failure in processes, systems, or an employee’s action within the business or company.
Impact
The impact legal risk has on a business differs from the impact of operational risk. The impact of legal risk involves fines, penalties, or in some cases legal action which can have a direct impact on a business’s reputation and finances. The impact of operational risk can lead to direct financial loss due to operational failures like systems going offline or trading errors which directly affect the bottom line.
Timeframe
Legal risks often happen over a long period of time with the potential for legal disputes or investigations whereas operational risks are immediate, with disruptions or system failures occurring quickly requiring fast action to minimise loss.
Consequences
The consequences legal risk has on a business or company is different then that of operational risk. Legal risks can hurt the business’s reputation if they are seen as unethical or non-compliant which can affect their standing in the market. The consequences of operational risk is that it leads to direct financial loss due to system failure or human error.
Risk Triggers
Things that can trigger legal risk include a breach of law, regulation, or contract which can end in potential legal action. This can harm a business’s reputation and finances since a legal battle can get pricey. Operational risk triggers include system malfunctions, human errors, trading errors, or any other internal failures that can disrupt operations.
Preventative Measures
Preventing legal risk involves regular legal audits and compliance checks to make sure the business adheres to all laws and regulations. Also, it’s important to stay up to date with any changes in the laws or regulations. To prevent operational risks businesses should review and optimise processes regularly, implement robust systems, and train employees to minimise the risk of human error.
Response
When legal risk materialises, the response usually includes legal action like litigation or settlements whereas operational risk requires an operational response. This includes things like system repairs, process adjustments, or retraining employees to address the issue immediately.
What are the Common Legal Risks?
Businesses face a variety of common legal risks that require careful management. Here are some areas where legal risks typically originate:
- Regulatory Compliance: Businesses must comply with various laws and regulations related to their industry. Failure to do so can result in enforcement actions, fines, and operational restrictions.
- Contractual Disputes: Contracts are fundamental to business operations as it governs relationships with suppliers, customers, and partners. Disputes over contract terms or breaches of contract can lead to costly litigation and strained business relationships.
- Intellectual Property Infringement: Protecting intellectual property (IP) is critical for businesses that rely on innovation. Unauthorised use of a company’s patents, trademarks, or copyrights can lead to legal battles and significant financial losses.
- Employment Law Violations: Issues such as wrongful termination, workplace harassment, and discrimination can result in lawsuits and damage the company’s reputation.
- Data Privacy Breaches: Businesses must ensure compliance with data protection and privacy laws. Data breaches can not only result in severe fines but also shake up customer trust and confidence.
What are the Common Operational Risks?
The goal of the operational risk management function is to focus on the risks with the most impact on the organization and to hold employees who manage operational risk accountable. The most common operational risks include:
- Human Error: When an employee makes a mistake that can materialise operational risk due to lack of training.
- Cyber Attacks: In today’s world keeping client or customer data safe is a number one priority. A breach of private data resulting from cyber-attacks can shake the trust clients have in the company.
- Flawed Process: The process can’t correctly address its intended use. For example, if a company has a procedure for data entry without proofreading, there’s a high risk of failure.
- Technological Failure: Dealing with technological failures is likely already part of the business continuity plan. But it’s also a critical operational risk in an increasingly digital world. Consider the technology the company needs to run.
Legal Risk vs Operational Risk
There are a lot of differences between legal risk and operational risk. However, it’s important to remember that operational risk also includes legal risk. By making sure that the business adheres to the regulations and laws and that the systems are updated and reviewed regularly, neither one of these will materialise within the business.