"Do Not Destroy the Essential Catalyst of Risk"

I recently read the article "Do Not Destroy the Essential Catalyst of Risk" by Lloyd Blankfein, which seemed to tie in with many themes of risk management we have discussed in class so far this semester.

The article explained that the deterioration of risk management and finance practices was a large portion of this global economic crisis we are currently undergoing. One of the main points made in the article was that we cannot base risk management decisions on just historical data. I thought this was quite interesting insight, as it is exactly what we talked about in class this past week. Given the current state of our economy, there isn't really a "normal" historical time period that we can relate it to. These times of low stocks, failing companies, and layoffs are certainly the norm for this time period, but no time periods of the past had the same circumstances occurring. Therefore, to look back and base our risk management decisions on how things used to be, or how things nowadays were predicted to be 20 years ago, is certainly not a beneficial thing to be doing.

The article also discussed the problems with over-dependence on credit rating agencies. We have discussed the significance of these credit ratings many times in class. An AAA rating is the best, with investment quality going all the way down until BBB. Where BB down to CCC is considered high yield or "junk." During this time period the problems faced by risk management officials were more severe because they outsourced so much of their risk and depended too much on these credit rating agencies - many of which were over inflating ratings. For example, the article states that at this time there were over 64,000 structured finance instruments rated AAA. Clearly, the companies should have seen the problems with the credit agencies ratings and tried to evaluate some of the risk on their own, rather than completely relying on others. Therefore, personally I feel like a lot of the blame should be put on the credit agencies, but also some blame does belong to those financial institutions that did nothing to take on any responsibility for their own risk.

Another interesting thing this article brought up was the idea that "many risk models incorrectly assumed that positions could be fully hedged." Many new products to hedge had been created, such as basket indices and credit default swaps. However, they did not properly think through the fact that "liquidity would dry up, making it difficult to apply effective hedges." I think this is an interesting point, because we have talked a great deal about hedging in class, from examples we have seen in class it does sometimes seem that companies depend a great deal upon hedging to protect themselves from any risk possible. I think this brings up a good point, that though hedging is a great risk management tool, it isn't something that should be used in all instances for every risk management problem a company of institution faces.

And lastly, the article brought up the problem of risks in off-balance sheet activities. The management for these companies with huge risk off their balance sheet did not take necessary precautions and even worry about the great risks they faced. I think this also seems to relate to things we have talked about in class. This is one of those things that as investors, ordinary people can look through every financial document available, but some things, such as these huge off balance-sheet risks will still not be able to be seen. This is why reliable, responsible management, that won't get tied up with greed is a huge thing for a company. Management has great control over the risks of a company, and sometimes all these risks aren't as evident to lower level employees or the public as we would like them to be.

Overall, I think this article brought up a lot of great points about the economic problems institutions and companies currently face, and some risk management errors that are tied to these problems. It was really intersting to see how these tie to many things we have discussed in class already this semester. I think by realizing where these problems stem from is the first major step towards fixing them. However, it is evident that it is going to take time to "mend our financial system to restore stability and vitality."

Financial Times - "Do Not Destroy the Essential Catalyst of Risk"