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Turning On the Risk Management Switch

As market conditions change, investors tune their strategies to risk on or risk off. In risk management, however, off is not an option. Five to seven years ago, the financial risk management switch was turned off in too many places, and we know how that turned out.

Risk management has certainly been turned on since the depths of the 2008–’09 crisis, but is it everything it needs to be to deal with whatever twist, turn or turmoil comes next? Recent events do not instill great confidence.

“Consider the failures of MF Global and Peregrine Financial, the risk management failures at J.P. Morgan, the abuses surrounding Libor or the financial threats from Europe,” U.S. Treasury Secretary Timothy Geithner said in July. “The work is not done. We still have unfinished business.”

Geithner made those remarks at a meeting of the Financial Stability Oversight Council, the superregulator created by the Dodd-Frank Wall Street Reform and Consumer Protection Act to look out for systemic risks. Two weeks later a software glitch at market maker Knight Capital Group touched off 45 minutes of stock market chaos. It was the latest of several incidents pointing to potentially devastating operational and financial vulnerabilities related to high frequency trading.

There will always be new risks to mitigate and adverse events to react to. But if the current risk management system looks too much like a game of Whac-a-Mole, there is, as Geithner suggested, much hard work to be done.

To be sure, risk management has come a long way. Financial institutions have raised the stature of risk executives and given them authority they previously lacked to sound alarms or veto initiatives deemed dangerous to long-term safety or profitability. Risk, compliance and audit responsibilities have been more precisely defined and better orchestrated.

Risk management and related control functions within a financial institution and regulatory supervision from outside are seen as two sides of the same coin. Risk managers talk to regulators, and both have lines of communication to boards of directors. The Securities and Exchange Commission has adopted “a policy to proactively engage senior management and boards to discuss critical business, risk and regulatory issues and support effective regulatory compliance and risk management,” Carlo di Florio, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), said at an agency compliance forum in Washington in January.

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