Operational risk within investment management firms can stem from many sources. Firms also have varying tolerance levels for accepting or handling such risk. SEI believes virtually every firm can benefit from taking a fresh look at common areas of risk and consider the variety of relatively straightforward risk management measures that can readily be deployed. In that spirit, SEI put together a 10-part guide as an effective risk management tool to set the foundation for operational excellence. Below are excerpts from chapters seven and eight, now available for download at www.seic.com/OpsSurvivalGuide.
7 ) AMALGAMATED ASSIGNMENTS: Improper Segregation of Duties
In designing organizational structures, policies and procedures for the assignment of duties, firms need to maintain a clear distinction between the assets of firms and assets of the funds they manage.
Common pitfalls: The failure to properly assign duties can create conflicts of interest, throw up barriers to accountability, and complicate matters of compliance and administration. It can even open the door to fraud and embezzlement.
What can firms do?
Conduct operational reviews – This can help firms flag trouble spots and identify potential remedies; outsourcing is another measure to consider, especially if resources are already stretched.
Draw clear lines between functional activities – For example, portfolio managers and traders should never be allowed to price their own portfolios; nor should they be involved in trade settlement or reconciliation.
Make sure clients are in control when their assets are moved – The authority to transfer funds, for example, should always rest with the client – not the investment team or anyone involved in reconciliation.
Consider whether some level of shadow accounting is appropriate – Some firms maintain their own set of independent books and records for periodic reconciliation with the records of safekeepers and fund administrators. Others consider this to be overly costly and inefficient. In our view each investment manager should consider where on the spectrum of partial to complete shadow accounting they wish to be, given the firm’s specific situation.
Issues relating to segregation of duties are fluid and may result from seemingly innocuous hiring or management decisions. Thus, firms should recognize that due diligence in this regard is not a one-time occurrence, but a critical point of control that should be repeated regularly.
8 ) RECONCILIATION GAPS: A False Sense of Security
Procedures that are less than comprehensive can leave investment managers unknowingly exposed to risks.
Common pitfalls: Too many firms fail to institute or follow through with complete and timely reconciliation procedures. Risks also crop up when reports other than official hard-copy statements are relied upon; many safekeepers will not stand by electronic representations of an account. Another problem is the absence of a management review confirming that each portfolio was reconciled.
What can firms do?
Provide for full reconciliations of records with those of custodians and administrators – Such procedures should include comparisons of cost basis and market value (in local currency terms), security identifiers, and local-currency cash balances.
Be sure to use the right statements for collateral – Managers that trade derivative instruments, or have assets held as collateral or margin for some other reason, should make sure their reconciliations are based on statements from the party holding the margin or collateral.
Properly account for soft-dollar payments – Even though they are not normally included in a firm’s accounting-based reconciliation process, they should nonetheless be periodically reviewed somewhere in the organization, especially where they are addressed by regulation, as in the U.S. and U.K.
Establish consistent procedures and documentation for supervisory reviews – This can be as simple as having the manager who conducted the review initial and date a reconciliation worksheet or checklist of accounts, specifying the date each account was reviewed.
While managers may feel they have already established effective reconciliation processes and systems, hidden gaps and problems are all too common. In our view, this function is worth revisiting.