The operational realm is one in which a minor oversight or single misstep in daily routines could have major consequences, potentially resulting in significant direct costs and, even worse, devastating reputational damage. With this in mind, mutual fund/ETF managers have every reason to want to understand and reduce their exposures to operational risks.
Operational risk can stem from a variety of sources. The Basel Committee on Banking Supervision defines it as "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."While there is no generic checklist for identifying operational risk, virtually every investment management company can benefit from taking a fresh look at common areas of risk. Here are areas of risk frequently encountered by those who work in or around investment operations.
1. Complacency. This might be summed up as a mindset that fails to ask, "What if..?" It's a passive, laid-back approach to operational risk rather than adopting a proactive one. Think about whether you reward, punish or ignore news of a risk and then work on proactive ways to keep potential problems from happening.
2. The Blind Leading the Blind. Supervision is a major area of operational risk because breakdowns occur so often and in so many different forms. It is one thing to manage our own tasks, but directing the decisions and activities of others is a much greater challenge-and the larger the firm, the more difficult it is.
3. Novices, Apprentices and Soloists. Identify training and cross-training challenges when they aren't needed so that you can start mitigating operational risk in the calm before the storm, not in the eye of the hurricane.
4. Dropped Batons. Competitive runners know that in a relay race, significant time, or even the race itself, can be lost if someone bobbles or, worse still, drops the baton while passing it from one sprinter to the next. System and workflow diagrams can give you a complete inventory of where your operational processes might go wrong.
5. Naïve Reliance on Technology. While automation is a powerful tool for mitigating operational risk, it can create new hazards if systems are not carefully designed and implemented. If you want to reduce operational risk, you need to factor that goal into every aspect of your firm's ongoing automation efforts.
6. Playbooks. Nonexistent, obsolete or incomplete process-and-procedure documentation is frequently a factor in operational breakdowns. Keeping workflow diagrams up-to-date and readily available can help prevent this. Make sure your firm has well-defined issue escalation protocols that take into account both the magnitude and timing of potential impacts.
7. Amalgamated Assignments. When designing organizational structures, policies and procedures for the segregation of duties, it is critical to maintain the distinction between the firm and the fund it manages. Operational reviews can help flag potential conflicts of interest as well as opportunities for theft or fraud. Firms may want to consider whether it is appropriate to institute some degree of shadow accounting, whereby managers maintain their own sets of books and records for comparison.
8. Reconciliation Gaps. Less-than-comprehensive procedures can leave you unknowingly exposed to risks. To reduce that exposure, conduct full reconciliations between your records and those of the custodians and administrators, with provisions for supervisory review and accountability. Full reconciliations include comparisons of cost basis and market value, security identifiers and local-currency cash balances.
9. Reading the Fine Print. Legal documents should be reviewed in detail by attorneys as well as knowledgeable operational managers. When assessing counterparty risk, you need to identify exactly which legal entity is your counterparty, determine who has regulatory jurisdiction, and continuously monitor net exposures and the counterparty's creditworthiness.
10. Poor Planning and Slow Response Times. Investment management companies that fail to anticipate future conditions could find themselves out of business as a result of the sweeping regulatory, marketplace and competitive changes that are transforming the industry. Re-examine your firm's organization structure and develop forward-looking staffing and technology plans. Rapid industry change does have its upside, and the firms that manage and reduce their operational risk will make the most of it.
In light of the complexities and constant change in our industry, virtually every firm has the opportunity to take risk management to the next level. Operations departments function best when mutual fund/ETF managers understand how things are done, provide the resources needed to mitigate risk, recognize that some events are beyond reasonable control and reward operations staff for their successful efforts.
While ETF and mutual fund managers are no strangers to managing risk in order to meet stringent regulatory requirements, virtually every firm has the opportunity to take risk management to the next level. By understanding how things are done, providing the resources needed to mitigate risk, and rewarding operations staff for their successful efforts, these managers can stay competitive, and meet the evolving needs of regulators and their investors.
Holly Miller is managing director of middle office services within SEI's investment manager services division.