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SectionsDecember 23 2009

Lloyd Blankfein - Comment

Heavy-handed regulatory reform in response to the financial crisis runs the risk of damaging the economy further. A measured response that accepts a certain level of risk makes good fiscal sense and will be a more sensible outcome.
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In the wake of the financial crisis, there has been no shortage of approaches to regulatory reform, both in Europe and the US. In a relatively brief period, we have witnessed a number of proposed changes to the rules and regulations that govern our industry and markets more broadly. Driving these are several common themes, but two seem particularly prevalent: a backlash against complexity in financial products and markets, and the need for macro-prudential regulation to address systemic risk.

Setting a standard

First, the sector allowed the growth and complexity in new instruments to outstrip their economic and social utility as well as 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. That is one reason why Goldman Sachs supports the broad move to central clearing houses and exchange trading of standardised derivatives. There is general agreement on the necessity of central clearing for derivatives. A central clearing house with strong operational and financial integrity will reduce bilateral credit risk, increase liquidity and enhance the level of transparency through enforced margin requirements and verified and recorded trades. This will do more to enhance price discovery and reduce systemic risk than perhaps any specific rule or regulation.

The debate gets harder when defining what should be traded on or off an exchange. We believe all liquid over-the-counter derivatives should be centrally cleared and that where trading volumes are high enough and price discovery mechanisms can be established, regulators should strongly encourage exchange trading. In less liquid markets, prompt reporting of aggregated pricing and clearing is necessary to improve transparency. More generally, it is incumbent upon financial institutions to recognise that we have a responsibility to the financial system that demands we should not favour non-standard products when a client’s objective and the market’s interests can be met through a standardised product traded on an exchange.

However, we should also recognise that underlying the development of the derivatives markets was client demand for individually tailored solutions. During the financial crisis, credit default swaps, many of them customised, actually worked as intended. They increased the ability of market participants to diversify their credit exposure in companies – some that were financially strained or ultimately went bankrupt – by swapping default risk with others. In that vein, these instruments represent an important economic and social purpose. If we simply ban customised derivatives to satisfy the perception that everything associated with these markets is bad, we run the risk of limiting risk capital, ultimately reducing capital expenditures, business investment and, in the long run, economic growth.

I believe the public policy goal is to retain the economically valuable attributes of these markets while mitigating the systemic risk they pose through the right infrastructure and incentives to manage it. The right incentives should be at the heart of reform, and this is particularly true with respect to how non-standard derivatives are managed. Customised derivatives should entail more rigorous capital requirements, for instance. The pros and cons of buying and selling derivatives on or off an exchange should be immediate and clear to all market participants.

Managing risk

The second theme attracting a lot of focus is macro-­prudential oversight. But while many are focusing on who in Europe and the US may ultimately be tasked as the systemic regulator, the more important question is how they will systemically manage risk. Regulators need to be able to identify risk concentrations early and prevent them from growing so large as to threaten the system. If systemic problems arise, they need to act quickly to limit the impact, protecting the safety of the whole.

To do this, the systemic regulator must be able to see all the risks to which an institution is exposed and require that all exposures be clearly recognised. Consider off-balance sheet vehicles, such as structured investments, which represented big sources of funding for a large number of institutions. Many risk models ignored these activities, even though their sponsors had exposure to them. If existing and contingent liabilities, credit commitments and other exposures are not transparent, how can risk managers and regulators see all the risks an institution is exposed to?

It is not enough even that all exposures be identified. An organisation’s assets must also be valued at their fair market value – the price at which willing buyers and sellers transact – not at the (frequently irrelevant) historic value. Some argue that fair value accounting exacerbated the credit crisis. I see it differently. If institutions had been required to recognise their exposures promptly and value them appropriately, they would have been likely to curtail the worst risks. Instead, positions were not monitored, so changes in value were often ignored until losses grew to a point when solvency became an issue.

At Goldman Sachs, we calculate the fair value of our positions every day because we would not know how to assess or manage risk if market prices were not reflected on our books. This approach provides an early warning system that is crucial for risk managers and regulators. The importance of fair value accounting to responsible systemic risk management is hard to overstate. We also believe regulators should avoid implementing a more comprehensive fair value regime in the midst of a fragile market. In extreme circumstances of systemic illiquidity, an institution is not required to use a distressed price – it is only required to use reasonable judgements and estimates to determine an asset’s fair market value. We feel the broader aspiration, however, is a guiding one: markets, and ultimately investors, are better served with information that more closely reflects the judgement of the market rather than the historical price.

There has been much discussion about the concept of ‘too big to fail’. There is consensus that a clear resolution authority – the mechanism to oversee and execute an orderly liquidation of a failing firm – is necessary. But when systemic problems surface, regulators need the tools to be able to limit their impact and minimise the need for public capital. For instance, regulators need the authority of a fast trigger to force any big shortfalls in capital to be swiftly addressed by reducing risk, raising capital, or both. The quality, not just quantity, of a bank’s capital matters. Hybrid securities, such as preferred equity, combine elements of debt and equity. They are a key part of a capital structure but, in a crisis, can feel more debt-like; they do not absorb losses and failure to pay dividends may compound a crisis of confidence.

Liquidity reserve

Raising capital requirements will certainly reduce systemic risk. However, we should not overlook liquidity concerns. An institution can have a very low leverage ratio, but that tells you nothing about its liquidity. If a significant portion of an organisation’s assets are impaired and illiquid, and its funding is reliant on short-term borrowing, low leverage will not be much comfort. Problems within financial institutions nearly always become life-threatening as liquidity begins to dry up. That is why systemic regulators should lay out standards that emphasise prudence and the need for longer-term maturities depending on the assets being funded.

Institutions should also be required to carry a significant liquidity reserve at all times, insuring against extreme events. Because of the interconnected nature of finance, one institution’s liquidity crisis can swiftly be transmitted around the system. In determining a robust level of liquidity, regulators should insist on recurring stress tests that include government-supplied (ie: tougher) assumptions.

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. We know from economic history that innovation – and the new industries and jobs that result from it – require risk-taking.

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.

Lloyd Blankfein is chairman and chief executive officer of Goldman Sachs

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