Financial Risk Management 101

What lessons can the financial services industry learn from the 2008 global financial crisis. Lloyd Blankfein, CEO of Goldman Sachs gave his views in a recent article published in the Financial Times. Hopefully the industry will take Blankfein's advice seriously; they are (were) after all the custodians of our hard-earned savings!

1. Risk management should not be entirely based on historical data and reliance on statistical distributions. The events of 2008 have been dubbed “multiple standard deviation events”, yet if an event, for example, were calculated to occur once in 20 years but in fact occurred much more regularly, it is clear the statistical distribution assumption does not reflect accurately the actual outcome. Hence, the industry must do much more to enhance and improve scenario analysis and stress testing.
2. Too many financial institutions and investors outsourced their risk management. Rather than doing their own analysis, they relied on the rating agencies to do the risk analysis for them. At the same time rating agencies diluted the significance of the triple A rating. In January 2008, there were only 12 triple A-rated companies in the world, but there were 64,000 structured finance instruments, rated triple A!
   In hindsight it is easy and appropriate to blame the rating agencies for their poor credit judgment. Yet, every institution that participated and acted on the credit ratings has to accept its share of the responsibility.
3. Size matters. Whether an institution owned $5bn or $50bn of (supposedly) low-risk debt in structured finance instruments, 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. While a host of new products such as various basket indices and credit default swaps were created to help offset a number of risks, 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. Financial institutions did not account for asset values accurately enough. Lately, arguments were made that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. Blankfein, however, see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

Lloyd Blankfein, 2009. “Do not destroy the essential catalyst of risk”, Financial Times, FT.com, February 8.