Money is like muck, not good except it be spread.
Francis Bacon (1561-1626)
DEFINITION OF RISK
Risk is defined as the uncertainty of expected outcomes.
Within asset management firms there are many types of risk that should concern portfolio managers and senior management, for convenience I’ve chosen to classify risk into four main categories:
• Compliance risk.
• Operational risk.
• Counterparty or credit risk.
• Portfolio risk.
Although a major concern of all asset managers, reputational risk does not warrant a separate category; a risk failure in any category can cause significant damage to a firm’s reputation.
Compliance or regulatory risk is the risk of breaching a regulatory, client or internally imposed limit. I draw no distinction between internal or external limits; the breach of an internal limit indicates a control failure, which could just have easily been a regulatory, or client mandated limit.
Operational risk, often defined as a residual catch-all category to include risks not defined elsewhere, actually includes the risk of human error, fraud, system failure, poor controls, management failure and failed trades. Risks of this type are more common but often less severe. Nevertheless, it is important to continuously monitor errors of all types, even those that don’t result in financial loss. An increase in the frequency of errors regardless of size or sign may indicate a more serious problem that requires further investigation and corrective action.