Euromoney 40th anniversary special: Lloyd Blankfein, chairman and CEO, Goldman Sachs

To begin with an obvious point, much of the past year has been deeply humbling for our industry. We held ourselves up as the experts, and the loss of public confidence from failing to live up to the expectations that we created will take years to repair.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well-functioning system, but we collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public’s long-term interests.

As policymakers and regulators begin to consider the regulatory actions to be taken to address the failings, I believe it is useful to reflect on some of the lessons from this crisis.

The first is that risk management should not be entirely predicated on historical data. If events that were calculated to occur once in 20 years in fact occurred much more regularly, it doesn’t take a mathematician to figure out that risk management assumptions did not reflect the distribution of the actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress-testing.

Second, 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. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.

Third, size matters. For example, whether you owned $5 billion or $50 billion of supposedly low-risk super-senior debt in a CDO, the likelihood of losses was, proportionally, the same. But the consequences of a miscalculation were obviously much bigger if you had a $50 billion exposure.

Fourth, many risk models incorrectly assumed that positions could be fully hedged. After LTCM and the crisis in emerging markets in 1998, new products like basket indices and credit default swaps were created to help offset risks. However, we didn’t, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.

Fifth, risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles (SIVs). It seems clear now that managers of companies with large off-balance sheet exposure didn’t 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.

Sixth, 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.

Last, and perhaps most importantly, financial institutions didn’t account for asset values accurately enough. I’ve heard some argue that fair-value accounting – which assigns current values to financial assets and liabilities – is one of the major factors exacerbating the credit crisis. I 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.

Through these lessons, and others that will emerge from this crisis, we should consider important principles for our industry, for policymakers and for regulators.

For the industry, we can’t let our ability to innovate exceed our 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.

Clarity is crucial

Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report to is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts in producing divisions. If there is a question about a mark or a disagreement about a risk limit, the risk manager’s view should prevail.

In addition, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire and equity delivery schedules should continue to apply after the individual has left the firm.

For policymakers and regulators, it should be clear that self-regulation has its limits. Fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Capital, credit and underwriting standards should be subject to more "dynamic regulation". Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated.

To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair-value accounting gives investors more clarity with respect to balance-sheet risk.

The level of global supervisory coordination and communication should reflect the global interconnectedness of markets. Regulators should implement more robust information-sharing and harmonized disclosure, coupled with a more systemic, effective reporting regime for institutions and major market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

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, like securitization 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.

Over the last several months, there have also been a number of broader policy lessons. We have seen actions that, for all intents and purposes, are protectionist and self-defeating. For instance, recent legislation in the US constrains the ability of financial institutions to hire employees through the H-1B visa programme. This and other short-term salves, such as the ‘Buy America’ provision or mandating a certain level of domestic lending, will only end up harming the process of economic growth.

All along, we have known that market events and economic trends are interwoven on a global basis. But the events of the past year have shown that the connections are more direct and immediate than perhaps we previously appreciated.

In times of economic distress, the relationships between creditor and debtor countries take on even more complex dynamics – especially as the US is the largest debtor. We have learned that when a financial institution fails in a debtor country, a creditor country is likely to pull back from its financing relationship in one way or another, and maybe in every way.

We have much to do to repair our financial system and reinvigorate our regulatory structure. At the same time, our financial system, rooted in the belief of putting risk capital to work on behalf of ideas and innovation, has helped produce a long-term record of economic growth and stability that is unparalleled in history.

We have to safeguard the value of risk capital, which is at the heart of market capitalism, while enhancing investor confidence through meaningful transparency, effective oversight and strong governance. But there should be no doubt: markets simply cannot thrive without confidence.