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The financial services industry has been marked by volatility over the past 10 years and
will likely continue to experience the same volatility over the next 10 years. This is the
character of the financial markets, and it has been made more severe by electronic
trading. The challenge is the diagnosis. Government advocates a diet of regulations like
Basel II, Solvency II for insurers, UCITS 3 for asset managers and Sarbanes Oxley
(SOX) for everything else. Now AIG, Bernard Madoff and the loss of Lehman Brothers
are spurring a new set of regulations; risk managers in the financial sector can already
feel the new treatment. This article will provide a brief history of risk management in the
financial sector and explain why the term has become synonymous with financial
control, compliance and governance. It will also discuss its relevance in today's
environment, current issues in the field and recent developments.
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1. It is not possible to understand or discuss risk management without understanding the roles
financial catastrophe and regulation have played in the development of the field. Until 1863,
regulation was governed at the state level. Efforts to centralize a national bank failed, twice.
The Civil War created the need to raise national capital, so U.S. Treasury bonds were
created--along with a regulatory body to govern them. Each new capital markets product or
catastrophe introduced the need for greater financial regulation at the federal level. From
the Great Depression and the Banking Act of 1933 (the second Glass-Steagall Act) to SOX,
the history of financial regulation has clearly shaped risk management for the financial
sector.

 
  

2. In finance, much time is spent defining what something is and what it should be. Risk
management should be a measure of overall risk in the organization. However,
client/product-side risk, including franchise risk, new product risk, human capital risk and
market risk, have all been overshadowed by regulatory risk. Failure to plan for regulatory
risk can put senior management in federal prison and end the going concern of a company.
This is why it has become synonymous with governance and compliance rather than
corporate strategy, new product development, operations or human resources.





3. There are benefits to a risk management culture defined by regulation. A study conducted
by PriceWaterhouseCoopers (PWC) in 2007 found that key management in the financial
services sector believed a focus on compliance has produced better relationships with
 regulators, a better relationship among customers, better and timelier data on internal
performance and improved returns relative to risks taken.


  


4. While the benefits are numerous, concentrating on risk management in the financial sector
can also lower profitability and reduce efficiency. Risk management in financial institutions
must figure out a way to concentrate on all major business-related risks. The same PWC
study noted above found that managers believed community relationships, attracting and
retaining talent, the cost of risk management, and competitive pricing have all suffered as a
consequence of an increased focus on regulatory risk.

 
   

5. There are many theories about the direction of risk management in the financial sector.
Perhaps financial engineering will become the degree path for investment banking analysts
as companies figure out ways to keep up with the risks associated with electronic
transactions. Incorporating risk management at the front, middle and back offices of
financial service organizations is the only way to balance the risk of maximizing profits while
staying legal. This is the controller's or chief risk officer's constant conundrum, and the
recent call to change the over-the-counter derivatives reporting framework will continue to
absorb more risk management resources.

   

6. Those divisions within the organization of a financial institution that lack a centralized risk
management process due to less regulation tend to focus more on the risk of losing
profitability and/or shareholder value. However, as profitability grows, so do the number of
entrants and the need for increased regulation. Those achieving higher profitability in
industries or product groups that are not highly regulated by the government must maintain
a low risk environment by embedding intelligent, automated controls within the
infrastructure. They should be organic and easy to change. They should also aim to improve
transparency and check for excursions. Key performance indicators (KPIs) should be set up
around improvements and tied to compensation. Goals and achievements

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