Holly H. Miller and Philip Lawton, Stone House Consulting LLC, New York
Operational risk is a serious concern, not only to traditional and alternative investment managers, but also to their clients and the organisations that regulate buy-side firms. In worst-case scenarios, an investment firm’s failure to identify and mitigate operational risk can result in significant direct costs and a devastating loss of reputation. It may take years to reassure investors, regulators, and trading partners that the firm is well-managed.
So what exactly is operational risk? Castle Hall Alternatives calls it ‘risk without reward’. The Basel Committee on Banking Supervision (Basel II) defines operational risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events’, and states that the definition is intended to include legal risk, but exclude reputational risk, and lists as examples events ranging from data entry errors to earthquakes.¹ But operational risk is not something that can be easily identified by a generic checklist, nor is there a single, universally applicable approach to mitigating the operational risks to which a given firm is exposed. Different organisations will have different exposures (depending, for instance, upon their investment strategies, the markets in which they operate, and the instruments they employ), as well as varying tolerance levels for operational risk, just as they have with regard to investment risk.
Nonetheless, there are key areas to look for risk within an investment management organisation. In addition, there are some straightforward approaches to mitigating operational risk that can be deployed by large and small organisations alike. Many of these approaches will address several key risk areas at once.
In this article, Stone House Consulting will be covering the first of our ‘top 10’ areas of operational risk. The article includes suggestions for identifying whether these risks exist within your organisation and steps to mitigate them. Although there is no one-size-fits-all solution for operational risk management, we hope this article will help many organisations reduce their operational risk profile.
The following ‘top 10’ list summarises the areas where we most often see operational risk — which is not necessarily where the greatest risks lie for any given manager. Despite significant media attention to some of these areas, they keep popping up in operational reviews. Please note these areas are not presented in any particular order, and include:
• the ‘blind leading the blind’;
• novices, apprentices and soloists;
• dropped batons;
• naïve reliance on technology;
• amalgamated assignments;
• reconciliation gaps;
• reading the fine print; and
• poor planning and slow response times.
We remarked that operational risk may be seen as ‘risk without reward.’ In this view, there is no upside for the firm, and operations managers are compensated on the pinball model: if they do very well, they get to play again. We’d like to suggest another perspective. Operational excellence, which starts with risk management, can create value by reducing costs, increasing client satisfaction, and maintaining sound business relationships with trading partners.