Lloyd Blankfein, chairman and CEO, Goldman Sachs

Thought leadership The leaders of nine of the world’s pre-eminent financial institutions discuss the challenges facing the global banking industry: restoring trust among policymakers and stakeholders; avoiding regulation that will hurt economies as well as banks; bringing compensation back into line; and making money in a radically changed world. Lloyd Blankfein, chairman and CEO, Goldman Sachs: How to safeguard the value of risk capital

Ken Lewis, chief executive and president, Bank of America: Global reach and capital remain king

Bob Diamond, president, Barclays: Banks must work with regulators to shape a prosperous future

Paul Calello, chief executive, Credit Suisse: We must apply the lessons of the crisis

Josef Ackermann, chairman of the management board, Deutsche Bank: Banking industry must regain trust

Stephen Hester, chief executive, RBS Group: Earning our way back to respect

Emilio Botín, president, Banco Santander: The basics don’t change

Mike Rees, chief executive of wholesale banking, Standard Chartered: The world has changed: so must banks

Dieter Rampl, chairman, UniCredit Group: Putting the teeth into corporate governance

Return to main index

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.

Lloyd Blankfein, chairman and CEO, Goldman Sachs

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.