In Congress, corporate treasuries and regulatory agencies, smart people are trying to resolve the paradox of risk management. The economic crisis certainly exposed excessive risk taking and the need for better risk management, yet it was ostensibly more sophisticated risk management strategies and tools that increased risk and brought on the crisis.

In theory, sophisticated models reveal and can reduce risk. In practice, we now know that such models engendered false confidence that risk was being micromeasured and micromanaged, making it safe to take on more risk, explains Dan Borge, a director in the New York office of consultancy LECG and formerly the main designer of the first bank enterprise risk management system.

Borge built the computerized risk-adjusted return on capital (RAROC) model while working at Bankers Trust in the 1980s. In hindsight, he says bank risk models had two flaws. Some of the banks' products became more complex than the models were able to measure. More significantly, the models relied on historical risk data, and what happened in 2008 fell well outside historical norms.

As banks improved their models and derivatives flourished, much risk management in the mid-2000s was based on the principle that risk distributed is risk mitigated. Securitizing subprime mortgages was the most conspicuous example, but financial institutions, noting concentrations of risk, would often use derivatives to spread that risk among other financial institutions. For example, Goldman bought credit insurance and credit default swaps from AIG. Corporate treasurers would mitigate concentrations of risk by passing them to hedging counterparties.

Creating a complex risk-sharing supply chain among financial players can reduce the apparent risk of an individual corporate or bank, but increase systemic risk. AIG alone may not have been too big to fail, but the AIG supply chain–the other financial institutions that would fall if AIG did–clearly was. “Financial supply chains grew long, and each participant didn't necessarily know or care what the others were doing,” Borge notes.

At the heart of the debate over risk management is the future of over-the-counter derivatives, the preferred antidote to risk among corporate treasurers and the cause of much of the risk build-up that led to disaster. Treasurers are understandably defensive. Tom Deas, treasurer and vice president at FMC, a $3 billion chemical company in Philadelphia, and executive vice president of the National Association of Corporate Treasurers (NACT), favors derivatives transparency, but says that can be accomplished by having trades reported to data repositories. “The details can be reported to repositories and analyzed there,” Deas says. He also favors proposals to provide a government framework around swap execution facilities.

Deas notes that traditional investment banks like Goldman Sachs and Morgan Stanley are now regulated by the Federal Reserve and are subject to the capital requirements and supervision that apply to commercial banks. “That in itself means a drastic reduction in leverage for these firms,” he points out.

Others favor going further. Derivatives trading must be reformed, insists John McLaughlin, managing director and risk practice leader at LECG Smart Consulting in Philadelphia. “The crisis was created by complex derivatives,” McLaughlin says. “Keeping OTC derivatives outside of effective visibility and regulation would mean ignoring a principal cause of the crisis. We need to effectively regulate derivatives and then adapt to whatever that means.”

McLaughlin draws a parallel to automobile air bags. When they were first required, Chrysler CEO Lee Iacocca was adamant that air bags were a bad idea and waste of money, McLaughlin recalls, and auto manufacturers had to redesign their dashboards. But air bags work and have saved a lot of lives. “We adapted, and today almost everyone agrees that they are a good idea,” he says.

Carrick Pierce, president of Derivix, a New York City company that makes derivatives trading software, observes that “forcing all derivative trades onto public exchanges and having them all cleared by licensed clearing agencies will make it easier to value, aggregate, see and manage the risk. We're looking forward to it.” He concedes that such a move would be good for his business.

Exchange trading won't make derivatives more expensive for end-users in the long run, Pierce argues. “We'll see a familiar evolution. Any new product going into exchange trading starts with low volumes, an illiquid market and wide spreads. As the market grows, the costs come down.”

But corporate treasurers have been fighting hard to preserve their right to use customized OTC derivatives to hedge their exact exposures over exact time frames. Rick Moss, treasurer at Hanesbrands in Winston-Salem, N.C., expresses the typical treasurer's focus on protecting economical access to OTC derivatives. “I think we need a solution that brings more regulation to the admittedly hard-to-understand derivatives market without making those markets less efficient,” he says. “That market provides important value to corporate treasuries. We shouldn't throw out the baby with the bath water.”

Moss doesn't want all derivatives forced into the boxes that can trade on exchanges. And he's suspicious of government intervention into complex financial markets. “Historically, the government rushes in to fix perceived problems that it doesn't adequately understand and comes up with a solution that is politically expedient but doesn't necessarily fix anything and adds layers of bureaucracy,” Moss says, citing Enron and Sarbanes-Oxley as a case in point. He favors a middle ground between doing nothing and passing the bills that were pending in Congress at press time.

The regulatory reform bill that the House passed in December provided a broad exemption for corporate end users of OTC derivatives.

In April, when the Senate Agriculture Committee passed a bill sponsored by chairman Blanche Lincoln (D-Ark.) that took an even stronger position, banning banks with FDIC insurance from trading in derivatives.

The Ag bill includes an exemption for end users, but defines them as non-financial institutions and leaves it up to the Securities and Exchange Commission and Commodity Futures Trading Commission to determine what a financial institution is.

The Lincoln measure on derivatives was included in the legislation proposed by Sen. Chris Dodd (D-Conn.) that eventually passed the Senate. Now the differences between the House and Senate measures must be ironed out.

The broad exclusion for OTC end users in the House bill brought “a sigh of relief” from corporate treasuries. Now the Senate bill has brought back some anxiety. “It looks like a lot will be left up to the regulators,” observes Dave Robertson, a partner at Treasury Strategies in Chicago. “A lot of treasury practitioners are taking a wait-and-see attitude while things shake out.”

The breakdown in risk management occurred among financial institutions, not corporations, and financial institutions are the target of most regulatory reform proposals. Bank risk pioneer Borge says the primary problemwas not flawed models but flawed judgment. “You have to take into account what is happening in the environment and use the model as a basis for making judgment calls. That judgment was lacking in the recent crisis,” he says. “Management has to understand the models and use them appropriately to make reasonable risk assessments and good decisions about how to manage that risk.

“The people building the models were very smart, but there was a communications gap between the modelers and the decision-makers,” Borge explains. Some of it was cultural: modeling geeks and aggressive business line managers don't always speak the same language. And some of it may have been a deliberate misuse of models to provide cover for whatever business leaders wanted to do. “You could use a model to hide risk from management or shareholders or make the risk seem minimal,” Borge notes.

Flawed incentives were a big part of the problem. Give a motivated executive good tools and bad incentives and you're likely to get bad results. “The wrong incentives were in place, and they rewarded managers for making bad risk decisions,” Borge explains. “People were rewarded by short-term earnings or sales volume, which didn't encourage them to make intelligent use of risk models.” If that's to change, banks will have to be forced by the regulators or possibly by Congress to change their compensation practices, he says.

Bankers are now reworking their models in light of what went wrong. One big reason to hope the revised models work better is that their historical data now include what happened in 2008, so they reflect greater volatility in asset value, Borge reports.

Still, the challenge around models is that they give, at best, a clear view of the landscape through a rearview mirror. “We had just developed interest-rate risk management modeling, based on historical Treasury rates, back around 1980,” Borge recalls, “and then Paul Volcker came along and turned our historical data upside down by using interest rates as a tool of monetary policy. The interest-rate environment changed radically, with much more volatility than we incorporated in the model.”

Whether banks are to be restored or fundamentally reformed is very much in play. “Treasurers should put a high priority on a sounder banking system,” says treasury manager turned consultant Jeff Wallace, who argues that much more is at stake than derivative trading, including the health of the payments system. If the dominos had been allowed to fall and Citigroup, for example, had gone down, a lot of companies would have had real trouble physically paying and collecting the payments on their receivables, he says. “A banking crisis would have quickly become a corporate crisis.”

One reform measure in proposed legislation, Wallace notes, is a “death will,” which would “require financial institutions to provide a step-by-step guide to how everything they hold could be unwound.” But banks are balking at that, he reports. “They have complex structures that are set up to minimize taxes and minimize regulation. A death will would expose their manipulations.

“Banks think they are entitled to extraordinary returns, but they are regulated institutions and should expect to make modest returns,” says Wallace, managing partner of Greenwich Treasury Advisors in Boulder, Colo.

Rather than radical legislative reform, some treasury pros favor tougher regulation. “That would, if properly done, stop the greed-driven risk-taking,” says James Haddad, vice president of finance at Cadence Design Systems in San Jose, Calif. The problem is that there are multiple regulatory agencies, which fragments accountability, he says. Get the best minds from each of the regulatory agencies and bring them together so they can design something better than any agency with its own limitations could come up with, Haddad recommends.

Robertson suggests self-regulation. “We need greater transparency, everyone agrees, but many of us don't have a lot of confidence that the government can provide that transparency,” he says. “The banks may have to be good corporate citizens and provide that transparency voluntarily.”

Alex Pollock, a resident fellow at the American Enterprise Institute in Washington and a former CEO of the Federal Home Loan Bank of Chicago, argues that the solution lies in preventing excessive leverage. “Every speculative bubble coincides with a run-up in leverage, whether it's at banks, households or governments,” Pollock says. “Once leverage gets too high, there's no margin for error, and any negative event can cause a crash. If you let leverage get too high, any system will crash, no matter what else you do.”

Pollock's preferred antidote is to introduce countercyclical elements into the economic cycles that can feed overleveraging. Changing the application of fair value accounting would help, he says. “Fair value accounting works pretty well under normal conditions, but it's terrible in a crisis. It's pro-cyclical and makes the situation much worse.”

And whenever the growth in asset values exceeds a normal trend line, credit availability based on those assets should be reduced, not expanded, Pollock argues. If banks were required to increase their loan-loss reserves in boom times instead of doing stock buybacks, that would help, he says. Accounting standards that prevent banks from over-reserving when profits are high are “stupid,” he says. “FASB and the SEC made an incredible mistake there.”

While much of the attention has focused on derivatives, the reform measures include some sleeper issues that could bite corporate treasurers. Watch out for the consequences of rating agency provisions in the bills, Pollock warns. “They will make the rating agencies super conservative,” he predicts. “They'll be like the accountants after Sarbanes-Oxley.” Treasurers and CFOs of companies that issue rated securities should worry about that, he argues. And any company that offers consumer finance services should be worried about consumer protection provisions, he adds.

Haddad argues that no amount of reform will make the rating agencies reliable. “We'll have to do our own due diligence,” he says. “The more opaque the instrument, the higher it should be priced for risk.”