FINRA's Grace Vogel Urges Firms to Re-examine Risk Assessment Functions

FINRA's Executive Vice President of Member Firm Regulation, Grace Vogel, addressed the New York Regulation and Compliance Conference on September 9 urging firms to seriously reexamine their processes for assessing risk. Ms. Vogel stressed that the nature of firms' risks have changed dramatically, and warned that part of the failure of firms in recent years to foresee and mitigate the current market distress was that their risk management programs were focused on outdated models and missed the perils presented by a quickly shifting market landscape.

While all this was happening, the firm’s risk managers made faulty assumptions—which they would pay dearly for.

They believed that all mark-to-market positions would receive immediate attention when losses occurred. And they assumed that if the market took a hit they could liquidate their positions quickly, especially triple-A rated securities. The risk group thought they were correctly focusing on the noninvestment grade paper and didn’t pay enough attention to the ever growing highly rated assets that were becoming illiquid. They had not fully appreciated that 20 percent of a very large number could cause much greater losses than 80 percent of a small number.

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Today we face a different world—and we need to prepare ourselves to fight a new war against risk—operating under new assumptions and using innovative tactics.

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It became clear to us that, in many cases, risk management systems simply broke down. There was an over-reliance on internal models, teaching us again the painful lesson that models only work within a certain confidence interval and management needs to supplement models with robust stress testing.

Ms. Vogel also impressed upon her audience that the very nature of market risk itself has changed, and that these risks can be extraordinarily widespread and instantaneous.

But it isn’t just FINRA—every regulator is figuring out how a change in its approach can increase market stability. Because if we’ve learned one thing from this crisis, it’s that the structural risks inherent in our modern financial system no longer impact one institution or sector at a time.

Risk now reverberates throughout the entire marketplace in an instant, threatening firms and exposing investors to harm.

Vogel further observed that, though the regulatory structure of the financial markets is being reassessed, there are limits to functional regulation, and effective and robust risk assessement at each regulated firm is vitally important to restoring confidence in the markets.

We regulators can write rules, conduct examinations, and bring cases, but it’s you, in the firms, on the front lines, who carry an important share of the regulation of the industry.

You see what goes on day to day and can spot small problems before they become large ones. You’re the ones who develop specific practices and policies from our rules and guidance, to make regulation work in concert with your business, not against it.

The full text of Ms. Vogel's address is available at: http://www.finra.org/Newsroom/Speeches/Vogel/P116960