Risk Managers' Stock Is Rising

As the financial world reels from massive writedowns, risk managers are moving out of the back office and reporting directly to the C-suite

The lowly risk manager was once a mere compliance functionary, relegated to back rooms, far from the money of the trading floor. No longer. Like Cinderella transformed for the ball, risk managers are now the new belles of Wall Street, which is struggling to flush hundreds of billions in suspect loans through the financial system.

Risk has again assumed the headlines after a young trader in Paris cost Société Générale (SOGN.PA) $7.2 billion by betting fraudulently on European stock index futures and using his knowledge of the bank's risk controls to conceal the trading. On Jan. 27, Société Générale said the trader's positions had totaled $73.5 billion (BusinessWeek.com, 1/28/08)—exceeding even the bank's market value.

Who's Watching?

Risk management failures have managed to unseat CEOs at the top of the banking industry. October saw the resignation of Stan O'Neal from Merrill Lynch (MER) after he presided over $8.4 billion in writedowns from subprime mortgages, asset-backed bonds, and soured loans. A month later, Charles Prince quit Citibank (C), following an $8 billion hit to the company's balance sheet.

Coming fresh off the global fallout from the subprime lending crisis, the SocGen scandal raises stark questions about risk management systems and how critical-risk information is shared across an organization. That, in turn, is elevating the role of those who oversee risk.

"We've seen a surge in demand for qualified risk managers; they are becoming much more in vogue," says Alan Hilliker, a partner at Egon Zehnder International, a talent search firm. "Risk officers used to get a lot less compensation than front-office traders, but now with the billions lost, it's suddenly a good idea to find someone who can model risk well, and pay them nicely for it."

Giving Risk Managers Clout

Traditionally risk managers have been assigned a more advisory role, essentially functioning as referees rather than as players in the game of wealth creation. "It's very difficult to be the voice that says 'stop' when a strategy is making money," says Paul Glasserman, a professor who studies risk management at Columbia University's Business School. He notes that in the latest subprime crisis, the risks were apparent to many across the industry, but investment managers ignored warnings because of the massive profits being generated. "In the subprime contest, a lot of the risk was widely understood, but as long as the trades were profitable there was a strong temptation to keep going," he says.

Now the staggering writedowns have sobered banks, which are scrambling to assess and curtail risk. Enter the risk managers. John Thain, the new CEO of Merrill Lynch, which reported a $9.8 billion loss, established two risk management positions. Since both managers, Noel Donohoe and Edmond Moriarty, will report directly to Thain, it's clear that risk management will receive a greater audience at Merrill.

Some of the banks posting the biggest losses have become the most visible advocates of an emboldened risk manager. Morgan Stanley (MS), which posted $9.4 billion in writedowns, has said that Chief Risk Officer Thomas Daula will report to the chief financial officer, instead of to the head of trading. And after reporting a $9.8 billion loss in the fourth quarter, new Citigroup CEO Vikram Pandit pledged to be a "hands-on participant" in risk management. "That you are seeing new compliance and risk offers being appointed across the banking and financial-services industry is a good indication that they are aware that there are lots of risks out there," says Don Ogilvie, independent chair for the Deloitte Center for Banking Solutions, a consultancy that is part of Deloitte & Touche USA.

A Companywide View

In recent years, banks have spent billions to comply with new international banking accords, the Sarbanes-Oxley Act, and tightened money laundering rules, such as those in the U.S. Patriot Act. According to Deloitte, compliance costs have grown faster than profits for nearly half of the top 50 U.S. banks. From 2002 to 2006, compliance costs grew 159%, on average, according to Deloitte. Still, those efforts failed to stave off the tens of billions lost in the mortgage meltdown.

Why? Analysts say that's because at most banks risk management operations remain segregated by department—say, at the investment bank, or at the retail bank. There's often no holistic view of the institution's risk across the entire firm, and whether the potential reward of a certain esoteric investment simply can't overcome its risks.

"Banks have historically been designed into organizational structures that group risk in silos," says David Rogers, a marketing manager in the risk products division of SAS Institute, a Cary (N.C.)-based company that makes risk management software. Moreover, in a Jan. 24 report about the state of the industry, analysts from Oliver Wyman (MMC), a financial-services consultant, noted that risk management has not kept pace with financial innovation on Wall Street.

"Banks need to embrace risk as a debate vs. a reporting function," says Alan McIntyre, managing director in financial services for Oliver Wyman. "They see it as an industrial process where you have the machine, you have the data, and then you crank the handle. There's been a big focus on volume with no judgment involved." Successful risk management necessitates a genuine partnership between traders and risk managers where information is traded candidly and acted on. Risk managers depend on accurate information from traders in order to build models that predict losses and potentially curtail trading.

Real Authority Is Required

Joseph Mason, a finance professor at Drexel University, compares the risk manager to a kind of police officer of the trading floor, who has the unenviable position of stopping a trade. "They have to be cops and have the authority to arrest," Mason says. "You want to see them have full control of trading operations so that if they cut some highly lucrative arm of the trading floor, they won't be overruled." Columbia's Glasserman notes the recipe for successful risk management involves equality between risk managers and traders. "The best organizations create a healthy tension of checks and balances between traders and risk managers," he says.

That's what appears to have happened at Goldman Sachs Group (GS), which has emerged relatively unscathed from the mortgage mess. Goldman rotates employees between jobs on the trading floor and managing risk. "Goldman has emerged on top, in part because of its insistence on emboldened risk managers," says Mason.

Still, only time will tell whether, in this new era, risk managers are given the real power they need—or if their titles and authority turn to pumpkins at midnight.