IAFE Recommends Routine Scrutiny of Operational Ri

NEW YORK (HedgeWorld.com)--The International Association of Financial Engineers released a white paper on operational risk for what it describes as the buy-side community, defined as hedge funds, pension funds, plan sponsors, mutual funds and other asset managers.

The report recommends that funds develop a "lessons learned" culture, intent upon learning from the mistakes of others or (as a poor second best) from one's own.

"There have been a number of widely publicized examples of operational risk within the fund community," the Operational Risk committee of the IAFE observed in its November paper. Included in its examples were the recent case of Merrill Lynch's management of Unilever's pension fund and a lawsuit recently lodged against Alliance Capital Management related to its ownership of Enron shares.

One valuable method of inculcating the employees of fund managers with a proper sense of the importance of risk management is the practice of regularly dissecting the causative triggers and contributory factors in such incidents, the paper states. This will hit senior managers in the gut and inspire them to devote the necessary resources to control, audit and supervise in order to avoid analogous fates for themselves.

Another institutional method of using both fear and greed for the benefit of the organization as a whole, and of the investors to whom it has a fiduciary responsibility, is to allocate losses back to the separate business units whence they came, if the process by which this is done is "transparent and positive." Should that process become opaque and punitive, though, "the losses will simply be driven underground and it will become more difficult to establish an organization's risk profile and manage its operational risk."

Operational risk does not lend itself to such ready quantification as does market or credit risk, but IAFE is confident that funds can learn from the models developed in recent years by banks and insurance companies.

There are at least two obstacles to this salutary imitation, though. One is that in a business climate of retrenchment, risk management departments are tempting targets for budget cutters. The other, related, obstacle is that the mastery of risk management is not seen as a glamorous discipline in the eyes of career-conscious executives.

"Some of these issues are seen as too detail-oriented by senior managers. These concerns are not always seen on the surface as strategic and business-driven."

The report concludes, coming full circle, that what is needed to overcome such reluctance is leadership at the top dedicated to creating an internal "lessons learned" culture.

Reprints Discuss this story
This is where the comments go.