Delboy
02-10-2009, 02:34 PM
Financial institutions have an obligation to the broader financial system. We all depend on a healthy, well-functioning system but this very system failed to raise enough questions about whether some of the trends and practices that had become commonplace really served the public’s long-term interests. As a result people are angry, the industry is deeply humbling but it has to account for its role in what has transpired and react.
As policymakers and regulators begin to consider the regulatory actions to be taken to address the failings, the chief executive of Goldman Sachs insightfully reflects on some of the lessons from this crisis:
1. Risk management should not be entirely predicated on historical data.
2. Too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. But the blame result is not the agencies alone. Every financial institution that participated in the process has to accept its share of the responsibility.
3. Size matters. For example, whether you owned $5bn or $50bn of (supposedly) low-risk investments, the likelihood of losses was, proportionally, the same. But the consequences of a miscalculation were obviously much bigger if you had a $50bn exposure.
4. Many risk models incorrectly assumed that positions could be fully hedged. However, the industry did not consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.
5. Risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles. It seems clear now that managers of companies with large off-balance sheet exposure did not appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business.
6. Complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.
7 And perhaps most important, financial institutions did not account for asset values accurately enough.
As a result of these lessons and others that will emerge from this financial crisis, the industry should consider important principles for the industry, for policymakers and for regulators. For the industry, we cannot let an ability to innovate exceed the capacity to manage. Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.
So what lessons:
- Risk and control functions need to be completely independent from the business units.
- We should apply basic standards to how we compensate people in our industry.
- For policymakers and regulators, it should be clear that self-regulation has its limits.
- Capital, credit and underwriting standards should be subject to more “dynamic regulation”.
- The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets.
- In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.
After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.
Most of the past century was defined by markets and instruments that fund innovation, reward entrepreneurial risk-taking and act as an important catalyst for economic growth. History has shown that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy.
The industry collectively has a lot to do to regain the public’s trust and help mend the financial system to restore stability and vitality.
As policymakers and regulators begin to consider the regulatory actions to be taken to address the failings, the chief executive of Goldman Sachs insightfully reflects on some of the lessons from this crisis:
1. Risk management should not be entirely predicated on historical data.
2. Too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. But the blame result is not the agencies alone. Every financial institution that participated in the process has to accept its share of the responsibility.
3. Size matters. For example, whether you owned $5bn or $50bn of (supposedly) low-risk investments, the likelihood of losses was, proportionally, the same. But the consequences of a miscalculation were obviously much bigger if you had a $50bn exposure.
4. Many risk models incorrectly assumed that positions could be fully hedged. However, the industry did not consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.
5. Risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles. It seems clear now that managers of companies with large off-balance sheet exposure did not appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business.
6. Complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.
7 And perhaps most important, financial institutions did not account for asset values accurately enough.
As a result of these lessons and others that will emerge from this financial crisis, the industry should consider important principles for the industry, for policymakers and for regulators. For the industry, we cannot let an ability to innovate exceed the capacity to manage. Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.
So what lessons:
- Risk and control functions need to be completely independent from the business units.
- We should apply basic standards to how we compensate people in our industry.
- For policymakers and regulators, it should be clear that self-regulation has its limits.
- Capital, credit and underwriting standards should be subject to more “dynamic regulation”.
- The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets.
- In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.
After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.
Most of the past century was defined by markets and instruments that fund innovation, reward entrepreneurial risk-taking and act as an important catalyst for economic growth. History has shown that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy.
The industry collectively has a lot to do to regain the public’s trust and help mend the financial system to restore stability and vitality.