Lessons from Merrill Lynch: In prior generations, Merrill Lynch was noteworthy for its recognition of the dangers of pursuing quick profits. It had a long history of being very conservatively managed. Its legal and compliance departments had extraordinary clout, much more so than at other leading Wall Street firms. Executive management empowered these internal watchdogs to stop any business intiatives that were remotely questionable from either a legal or regulatory perspective.


Business unit managers grumbled that these internal regulators persistently stopped initiatives that were common practice elsewhere on "The Street," and which earned rival firms significant profits. Still, the Merrill Lynch of that era preferred long-term safety to short-term gain.

Additionally, in the wake of the 1987 stock market crash, Merrill Lynch created a risk management department with sweeping powers to monitor trading desk activity and dictate rules. Its first director was one of the firm's best and most experienced traders at the time. His first major initiative was reducing securities inventories to the bare minimums necessary for the accommodation of customers' orders. Merrill never liked to take bets on the market, as many of its competitors did. Now it was even more risk-averse.

All this changed under the leadership of E. Stanley O'Neal as CEO (2003-07). He greatly diminished the authority of legal, compliance and risk management, viewing them as hindrances to profitability.

For a while, the new strategy worked. Merrill Lynch's profits hit new highs. Then, in 2007, the new risk-loving (risk-ignoring?) practices blew up, blasting a hole in earnings that wiped out several years of prior profits, and which continued to bleed red ink for years thereafter.

Experience Elsewhere: In August 2008, an anonymous essay appeared in The Economist magazine, written by a risk manager at a large international financial services firm. His company also was in grave difficulty in 2007. The business side was fixated on getting transactions done, uninterested in close study of the risks, and risk managers began abdicating their responsibility to stop flawed deals. The best talent was flowing from risk management to trading and banking, not the other way around. When risk managers thought that rating agencies had been too generous in grading a given security, their attempts to downgrade it internally was resisted. The list went on, in a pattern oddly reminiscent of Merrill Lynch.

Bottom line: Chastened by the crisis of 2007-08, experienced hands in risk management are in demand. The financial industry as a whole, like Merrill Lynch, is realizing that it must re-learn the good risk management practices that it carelessly abandoned in the last bull market cycle.