Goldman Sachs 2007 Annual Report Download - page 45

Management’s Discussion and Analysis
we provide to clients, often must adhere to client-specific
guidelines, as well as legal and regulatory standards. Despite
the contingency plans and facilities we have in place, our
ability to conduct business may be adversely impacted by a
disruption in the infrastructure that supports our businesses
and the communities in which we are located. This may include
a disruption involving electrical, communications, transportation
or other services used by us or third parties with which we
conduct business.
LEGAL AND REGULATORY RISK. We are subject to extensive and
evolving regulation in jurisdictions around the world. Several of
our subsidiaries are subject to regulatory capital requirements
and, as a Consolidated Supervised Entity (CSE), we are subject
to minimum capital standards on a consolidated basis.
Substantial legal liability or a significant regulatory action
against us could have material adverse financial effects or cause
significant reputational harm to us, which in turn could seriously
harm our business prospects. Firms in the financial services
industry have been operating in a difficult regulatory environment.
We face significant legal risks in our businesses, and the volume
of claims and amount of damages and penalties claimed in
litigation and regulatory proceedings against financial institutions
remain high. For a discussion of how we account for our legal
and regulatory exposures, see “ — Use of Estimates” below.
Critical Accounting Policies
Fair Value
The use of fair value to measure financial instruments, with
related unrealized gains or losses generally recognized in
“Trading and principal investments” in our consolidated
statements of earnings, is fundamental to our financial statements
and our risk management processes and is our most critical
accounting policy. The fair value of a financial instrument is
the amount that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market
participants at the measurement date (the exit price).
Instruments that we own (long positions) are marked to bid
prices, and instruments that we have sold, but not yet purchased
(short positions) are marked to offer prices.
We adopted Statement of Financial Accounting Standards
(SFAS) No. 157, “Fair Value Measurements,” as of the beginning
of 2007. See Notes 2 and 3 to the consolidated financial
statements for further information on SFAS No. 157.
CREDIT RISK. The amount and duration of our credit exposures
have been increasing over the past several years, as has the
breadth and size of the entities to which we have credit exposures.
We are exposed to the risk that third parties that owe us money,
securities or other assets will not perform their obligations.
These parties may default on their obligations to us due to
bankruptcy, lack of liquidity, operational failure or other reasons.
We are also subject to the risk that our rights against third
parties may not be enforceable in all circumstances. In addition,
deterioration in the credit quality of third parties whose securities
or obligations we hold could result in losses and/or adversely
affect our ability to rehypothecate or otherwise use those
securities or obligations for liquidity purposes. A significant
downgrade in the credit ratings of our counterparties could also
have a negative impact on our results. While in many cases we
are permitted to require additional collateral for counterparties
that experience financial difficulty, disputes may arise as to the
amount of collateral we are entitled to receive and the value of
pledged assets.
In addition, as part of our clearing business, we finance our client
positions, and we could be held responsible for the defaults or
misconduct of our clients. Although we regularly review credit
exposures to specific clients and counterparties and to specific
industries, countries and regions that we believe may
present credit concerns, default risk may arise from events or
circumstances that are difficult to detect or foresee, particularly
as new business initiatives lead us to transact with a broader
array of clients and expose us to new asset classes and new
markets. In addition, concerns about, or a default by, one
institution could lead to significant liquidity problems, losses
or defaults by other institutions, which in turn could adversely
affect us.
We have experienced, due to competitive factors, pressure to
extend and price credit at levels that may not always fully
compensate us for the risks we take. In particular, corporate
clients sometimes seek to require credit commitments from us
in connection with investment banking and other assignments.
OPERATIONAL RISK. Shortcomings or failures in our internal
processes, people or systems, or external events could lead
to impairment of our liquidity, financial loss, disruption of
our businesses, liability to clients, regulatory intervention or
reputational damage. Our businesses are highly dependent on
our ability to process and monitor, on a daily basis, a large
number of transactions, many of which are highly complex,
across numerous and diverse markets in many currencies.
These transactions, as well as information technology services
43Goldman Sachs 2007 Annual Report