CHICAGO - It often takes an economic crisis before firms really start thinking about risk management.

Theoretically, if risk management teams had done their homework, current market fluctuations and the subsequent ramifications wouldn't have come as a complete surprise. Unfortunately, even the best-prepared companies couldn't have predicted the depth of the current situation, what many are calling the worst since the Great Depression.

"Risk management is all about limiting surprises and meeting the changing needs of investors," said James Mikolaichik, director of risk management for Old Mutual, at the Investment Company Institute's annual Tax and Accounting Conference recently held here. "Risks are inherent in our business. Our goal is not to eliminate risk, but to identify, assess and manage our risks."

Obviously, the best time to plan for risk is before the crisis happens, Mikolaichik said. While it's impossible to change the past, the current financial crisis could turn out to be a positive catalyst for building better risk management in the future, he said. As the old saying goes: the higher the risk, the greater the reward. But in their greedy hunt for alpha over the past few years, some managers clearly took too great a gamble.

Risk managers attending the conference got to see how well they predicted the future as they watched the economy take one sharp dive after another before the stock market's eventual recovery a few days later.

"Some people were taking risks based on the expectation of a government bailout," said Jerry Webman, chief economist for OppenheimerFunds. "Now the Treasury's calling our bluff."

Because all risks can never be fully avoided, companies have to accept some level of residual risk. That means planning for the worst, hoping for the best and trying to predict everything in between. Financial companies can create economic value by managing their exposure to risk, particularly credit and market risk.

Many financial companies failed to predict the depth of the fallout from their investments in incredibly risky mortgages repackaged as AAA securities. When Lehman Brothers realized that it was hopelessly stuck with billions of dollars of triple-A junk, it had no choice but to file for bankruptcy.

"What is Lehman's portfolio really worth?" Webman asked on Sept. 15, just after the bankruptcy was announced.

"There is a lot of hypocrisy in our industry. For the last 20 years, the way to accelerate the economy was to extend leveraging. Instead of saving first, everybody was borrowing to buy a car or a house," Webman said.

With everyone leveraged against everyone else, nobody was really sure who owned what.

"We need to come back to the economic fundamentals," he said. "We're all going to have to pull in risk. It will be a drag on economic growth, but if the consumer is weak, so is the rest of the economy."

"If you want to do risk management right, you need to get into the top of the organization where most the risks are being taken," Mikolaichik said.

"Obviously, the people taking the greatest risks at mutual fund companies are the senior executives and portfolio managers. But many portfolio managers are artists at what they do, and clamping down on them with too many limitations and restrictions can encourage them to apply their talents elsewhere," Mikolaichik said.

"A good risk manager tries to understand the process portfolio managers take," said Joseph Carrier, director of strategic initiatives at Legg Mason. "Risk management is not here to replace portfolio manager judgment. It's about respecting their expertise, understanding what they do and why they're good at it."

The fund industry has taken a beating recently, and part of risk management includes controlling a company's public image and reputation. Several executives were reluctant to go into any specific details on the record, but most companies in the U.S. and around the world seem to be using the current economic crisis as a perfect excuse to revisit their risk management protocols.

Finding the right balance can be tricky, and there is no one-size-fits-all answer.

Firms that continue to let their freewheeling portfolio managers do as they please will have to explain their actions to paranoid shareholders. On the other extreme, firms that lock up managers with the iron cuffs of rigorous, firm-wide restrictions could see their talent revolt. Most firms will choose something in between.

"It's important to develop a culture of risk management within your organization," said Charles Rizzo, chief financial officer at John Hancock Financial Services. "Firms need to ensure that key reconciliations are being done, so that total exposures are understood and the accounting and valuations are handled appropriately from a fund pricing standpoint," Rizzo added. "Part of risk management is knowing when to periodically look under the hood."

Many portfolio managers are already reviewed by their peers. Adding a second set of eyes to a manager's work through extra data aggregation can provide a second line of defense without making the managers feel like they are being watched like a hawk by their superiors.

In some cases, however, it may be necessary or prudent to hire a third party to be that hawk. In those cases, firms should establish a robust, clear process for managing third-party service providers to ensure that all parties understand their roles and responsibilities.

Portfolio managers still want to have the final say for their funds, but most risk managers agree that an extra set of eyes can't hurt, particularly during times like these when so much is at stake.

"Risk management should focus on what the business is trying to accomplish," Mikolaichik said. "It helps you make better decisions. Risk should be managed by everybody in the business."

If they don't have one already, he said firms should put a policy structure in place, but keep it flexible and adaptable.

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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