Reassessing Risk

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When firms did steer clear of what was, in retrospect, excessive risk, the tone typically came from the top. Goldman Sachs, which has a long history of CEO interest in risk management and rotates its traders and risk managers through one another's jobs, pulled back from mortgage-related securities earlier than most after direct orders from the CFO and CEO.

In mid-2005, when the Canadian bank Toronto-Dominion got out of structured products, including CDOs and interest-rate derivatives, CEO Ed Clark was pilloried for leaving profit on the table. Clark, who has a Ph.D. in economics from Harvard, made the decision because he couldn't comprehend, to his satisfaction, the credit and equity products that were being traded at the firm. So he decided to quit the business--a move that kept his bank in the black while others suffered. "I'm an old-school banker," he later said. "I don't think you should do something you don't understand, hoping there's somebody at the bottom of the organization who does."

That is exactly the sort of top-down control financial firms now say they want. Citigroup CEO Vikram Pandit vows to be a "hands-on participant" in risk management. In August, UBS chairman Peter Kurer broke the firm into three separate units partly because the old structure, he said, encouraged "the blurring of the true risk-reward profile of individual businesses." In July, the Institute of International Finance, which counts large banks and insurance companies among its members, put out a 174-page report detailing best practices in the wake of the financial crisis. Among them: developing a corporate culture of risk awareness, integrating analysis of different sorts of risks instead of keeping them in silos, and basing compensation on risk-adjusted performance and long-term, firm-wide profitability.

Sage advice, that. But for how long will it be followed? "Risk gets forgotten in all bubbles," says Peter Bernstein, an investment adviser and the author of Against the Gods: The Remarkable Story of Risk. "We've been down this particular road before." Indeed, we have. After every other trauma--the 1987 stock-market crash, the savings-and-loan crisis, the meltdown of the Long-Term Capital Management hedge fund--boisterous, unchecked risk-taking eventually rushed back in. "In times like this, people do listen to risk managers," says John Hull, professor of derivatives and risk management at the University of Toronto. "The problem is, times will become good again, and then you listen to the trader who is making a big profit."

It is tempting to say that this time is different, that the pain has been so severe and ongoing, the lessons will be remembered. Four exchanges, with encouragement from the Securities and Exchange Commission and the Federal Reserve Bank of New York, have volunteered to create a clearinghouse for the hazily understood concentrations of risk known as credit-default swaps. Investors are also taking more responsibility. Over the past month, the analytics firm RiskMetrics has seen a rush of pension funds, hedge funds and asset managers signing up for tools to analyze counterparty risk. "The only folks who used to ask us about those were banks," says risk-management-practice head Gregg Berman.