By Heather Landy
Special to The Washington Post
Thursday, August 7, 2008
NEW YORK, Aug. 6 -- A Wall Street consortium led by Goldman Sachs managing director E. Gerald Corrigan recommended new standards Wednesday for monitoring and managing risk, saying the financial industry must be better equipped to contain the type of widespread damage wrought by the credit crunch.
The group's report, addressed to Treasury Secretary Henry M. Paulson Jr. and Mario Draghi, chairman of the international Financial Stability Forum, suggested that big investment houses regularly perform "liquidity stress tests" to measure their expected flexibility in the face of a crisis. It also urged firms to make sure they have accurate snapshots of their exposures to institutional trading partners, with the ability to compile detailed reports within hours.
In the current crisis, "some of the worst failures were in risk monitoring, which was before you even got to risk management," Corrigan, a former chief executive of the Federal Reserve Bank of New York, said in an interview.
Corrigan convened the task force, called the Counterparty Risk Management Policy Group III, in April, bringing together chief risk officers and other high-ranking executives from firms including Citigroup, J.P. Morgan Chase and Lehman Brothers.
In dissecting the causes of the credit crisis, the panel pointed to what it called a "false sense of security" stemming from the comparatively easy mop-ups of other financial messes of the past decade and faulted a Wall Street compensation mind-set that may encourage too much risk-taking by executives.
The panel also argued that a buildup of cash from the fast-growing economies of China and energy-producing countries, combined with relatively low interest rates, spurred demand for riskier securities that could provide higher rates of return.
Amid the growing complexity of securities and their potential impact on various corners of the market, "all of us failed to anticipate the way in which contagion forces would work their way through the financial system," Corrigan said.
The Counterparty Risk Management Policy Group previously convened in 1998, during the market crisis marked by the failure of the Long-Term Capital Management hedge fund, and in 2005, when Corrigan wanted to address what he viewed as risky activities in the burgeoning market for derivatives known as credit default swaps.
The latest policy group issued a new list of suggested reforms for the credit-default-swap market, in which investors can buy or sell protection in the case of a default by a bond issuer. Among the recommendations: the establishment of a government-regulated clearinghouse for these trades.
The policy group also argued for an increase in funding for regulatory authorities that monitor markets. And it said the support of government institutions, in particular the New York Fed, will be vital if the industry is to carry out the group's recommendations in a timely manner.
As a result of the fallout from the latest market crisis, "the existing arrangement of very, very close cooperation between the industry and the Fed is going to get new momentum," Corrigan said.