The more you hang around large institutional investors – especially those with big in-house operations – the more you realize how important operational risk management has become for them. The new hires in these places will spend their first few days filling out compliance information and listening to speeches on ‘segregation of duties’, ‘accountability’, ‘checks and balances’, ‘fail-safe functions’ and ‘redundant operations’. Why? Two big reasons:
These two factors combined are at the heart of why Norway’s NBIM – and other funds around the world – focus so much attention on operational risk management. And I single out NBIM here because it has been quite transparent about its work to minimize the number of “unwanted events” taking place within the organization. Indeed, NBIM’s annual report discusses the ‘fail-safe-functions’ they have in place and all the redundant organizational components that the fund is building to reduce these errors in the future.
But all this focus on “redundancy” comes with a big health warning: it doesn’t always work, and, in fact, it can make your organization less reliable! In order to understand some of the problems with building ‘fail safe’ institutional investors, I thought I’d direct you to a (really fun) paper by Scott D. Sagan entitled “The Problem of Redundancy Problem: Why More Nuclear Security Forces May Produce Less Nuclear Security”. Here’s a blurb:
“The use of redundancy in its many forms is a common strategy used to make more reliable systems out of inherently imperfect parts. Redundancy theory in engineering demonstrates how even unreliable components, if independent and connected in a parallel manner, can lead to rapid increases in overall system reliability. A large number of social scientists and security analysts have, therefore, called for the widespread use of redundancy as one of the necessary requirements of “high reliability organizations.”
That sounds good, right? Hold on, there’s more...
“The article uncovers the dark side of redundancy by focusing on how efforts to improve nuclear security can inadvertently back fire, increasing the risks they are designed to reduce...”
It’s comforting to think that we can just throw resources at the problem to eliminate it. But, alas, that doesn’t seem to be the case, as Sagan illustrates through some lovely examples and cases. In general, there are three reasons fail-safe organizations, well, fail-to-be-safer:
What to do about it? I think we need to be careful about how far we take redundancy in the design of institutional investors. It’s not clear to me that the benefits outweigh the costs. (And I’d be grateful if you have any data that either confirms or rejects the concepts above.) And the costs are quite high – not only is the safety of the organization not dramatically improved, but it adds a level of bureaucracy and rigidity that will inevitably damage returns over the long-term.
