Since the spring, and most acutely this autumn, a global contagion of fear and panic has choked off the arteries of finance, compounding a broader deterioration in the global economy.

Financial institutions have an obligation to the broader financial system. 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. In the past several months, we have heard the phrase “multiple standard deviation events” more than a few times. If events that were calculated to occur once in 20 years in fact occurred much more regularly, it does not take a mathematician to figure out that risk management assumptions did not reflect the distribution of the actual outcomes.

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 over-dependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A.

Third, size matters, the likelihood of losses maybe proportionally, the same, but the consequences of a miscalculation aremuch bi gger if you had a bigger exposure.

Fourth, many risk models incorrectly assumed that positions could be fully hedged. After the collapse of Long-Term Capital Management  we did not, 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.

Sixth, complexity got the better of us. The industry let the growth in new instruments outstrip 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.

Last, and perhaps most important, financial institutions did not account for asset values accurately enough.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.

As a result of these lessons and others that will emerge from this financial crisis, we should consider important principles for our industry, for policymakers and for regulators. For the industry, we cannot 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.

Risk and control functions need to be completely independent from the business units.

More generally, 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, while equity delivery schedules should continue to apply after the individual has left the firm.

For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.

The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets. Regulators should implement more robust information sharing and harmonised disclosure, coupled with a more systemic, effective reporting regime for institutions and main market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.

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. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.

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.

We collectively have a lot to do to regain the public’s trust and help mend our financial system to restore stability and vitality.

 

The writer is chief executive of Goldman Sachs, this is is just a paraphrase - if you want to read the whole article go to - http://www.ft.com/cms/s/0/0a0f1132-f600-11dd-a9ed-0000779fd2ac.html?nclick_check=1

Professional Help Stock	Lead Investor(s)
Berkshire Hathaway (BRK-A)	Warren Buffett
White Mountains (WTM)	Ray Barrette
W.R. Berkley (BER)	William R. Berkley
Icahn Enterprises (IEP)	Carl Icahn
Leucadia National (LUK)	Ian Cumming, Joe Steinberg
Sears Holdings (SHLD)	Eddie Lampert
Fairfax Financial Holdings (FFH)	Prem Watsa
Brookfield Asset Management (BAM)	Bruce Flatt
Winthrop Realty Trust (FUR)	Michael Ashner
Vornado Realty Trust (VNO)	Steve Roth
Kimco Realty Trust (KIM)	Milton Cooper, Marty Kimmel

My rss feeds currently keeps me up to date about the world of finance, and investing in general. One thing that I have always find fascinating about high finance is what I call master of the universe mentality. As an analyst or investors, you start with a worldview where everything is of interest, because your goal is to understand the way the world works, to see things for how they are as opposed to how you will like them to be.

There are many other skills and aptitude in high finance, however, this strategic, big picture and analytical thinking are the ones that appeals to me.

 

Philosophy:

The guiding principles of this kind of thinking is economics.Economics and indeed social science is an attempt to put frameworks around how we think about human beings. With everything from REMM - Resourceful, Evaluative, Maximizing Model to Maslow Hierarchy.

However, these models are applicable by thinkers everywhere irrespective of their fields.

Posner and Becker, a legal luminary and an economist defines this mode of thinking for me.

 

Utlimately, the goal of this way of thinking or the reason for developing this worldview is to be able to better predict the future. For the finance folks so as to make a better investment, and for strategists, to help companies chart a better course.

 

Of course, this has to be done in a rigorous way, which is where tools like mathematics and statistics comes in to help us develop a data driven ability to think.

 

Reading the current edition of Jack Welch's article in business week, he talked about how private equity is similar to LBO in the 1980's.

I agree with him, and like those days, I think what is next is that we will have small company's becoming creative again. Doing things that big companies may not quite get more efficiently.

 

A quick glance through news archive shows that some of those LBO Kings are now the Kings of Private Equity. So have they learned from the last time? Is there going to be another RJR Nabisco or LBO hearings in congress.

 

You be the judge.. comment on how to trade this...