Here is an interesting extract from Lloyd Blankfein’s testimony to the Financial Crisis Inquiry Commission on Goldman’s risk management practices. I would not want to add much by way of editorial comment here, except that Lloyd Blankfein gets to the heart of risk management – which isn’t about fancy math or regulation alone.
The complete testimony can be found at http://www.fcic.gov/hearings/pdfs/2010-0113-Blankfein.pdf
“Our approach to risk management is rooted in accountability, escalation and communication. A large part of this discipline is reflected in the marking process, which assigns current values to financial assets and liabilities. We believe that rigorous fair value accounting for financial instruments is fundamental to prudent management because it facilitates a clear view of risk. It allows us to manage market risk limits, monitor exposure to credit risk and manage our liquidity requirements.
For Goldman Sachs, the daily marking of positions to their fair value was a key contributor to our decision to reduce risk relatively early in markets and in positions that were deteriorating. This process can be difficult, and sometimes painful, but we believe it is a discipline that should define financial institutions. We fair value our positions, not only because we are required to, but because we wouldn’t know how to assess or manage risk if market prices were not reflected on our books.
As I look back prior to the beginning and throughout the course of the crisis, we never knew at any moment if asset prices would deteriorate further, or had declined too much and would snap back. Having to fair value our assets on a daily basis and see the results of that marking in our P&L forced us to cut risk regardless of market or individual views, estimates or expectations.
After the fact, it is easy to be convinced that the signs were visible and compelling. In hindsight, events not only look predictable, but look like they were obvious or known. But none of us know what is going to happen. Risk management begins by admitting this fundamental reality and planning with that mindset as the dominant one running through all of our processes.
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More broadly, we place great importance on communication between revenue and control areas. This translates into a constant flow of risk reports, and the end result is a better understanding of the risks we are taking.
At the same time, risk and control functions are completely independent from the businesses. Independent verification of prices is frequent and thorough. And, risk managers 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 prevails.
Closely related to communication and escalation is accountability. People have to feel responsible for the decisions they make, and for the decisions their subordinates make. If we suffer a credit loss, the relevant business is not absolved of the consequences simply because the risk was approved by the credit department. All flow into one another: Communication encourages escalation and escalation reinforces accountability.”