One lesson from the crisis is the need for more effective systemic regulation. There has been a focus on who should exercise this responsibility. But the most critical question is what the systemic regulator should do, and what responsibilities will make it effective – not who, so much as how?
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, regulators need to take prompt action to limit their impact and protect the safety of the system.
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 Investment Vehicles, which represented big sources of funding for many 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 institution'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 beenlikely 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 essential early warning system that is critical for risk managers and regulators.
Regulators also need to ensure that prices are tested through an independent verification process. It would make sense to compare pricing information for similar positions across firms. Where wide discrepancies exist, so, often, will problems.
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. But, we support the Financial Accounting Standard Board's efforts to begin that process.
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 believe 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.
More generally, we have to build a culture whereby firms are required to share concerns about systemic risks with regulators. I remember being told by my mentors we do not fire people for losses or mistakes that were honestly made. But if anyone conceals or fails to escalate a problem, they must be held accountable immediately. The same principle should inform regulatory oversight.
Regulators could establish a multi-firm business practices committee to examine issues such as underwriting standards. If practices slip, regulators would be among the first to know. They should ask questions such as: “Where are policies being stretched and pressures building? Where are you seeing concentrations in risk, crowded trades or one-way bets?”
