Our Early Warning System for Financial Crises Is at Risk

After the loss of nearly one quarter of a million lives in the 2004 Indian Ocean earthquake, the international community rushed to establish a tsumani warning system for that region in 2006. 

While the financial crisis of 2008-2009 may not have claimed any lives (at least not directly), the financial consequences have been devastating. The Office of Financial Research is our financial tsunami early warning system.

Yet a significant groundswell of opposition in Congress would like to abolish the agency altogether. Coming off a tough set of Capitol Hil hearings in April, the Office of Financial Research's first Annual Report to Congress, due out soon, will likely spark further calls to repeal this agency. 

A creature of the Dodd-Frank Act, the OFR and its mission have become ensnared in a political maelstrom bent on eliminating our only real ability to be ready for the next financial calamity. Unfortunately, the potential for another systemic risk event is real and yet two years from enactment of Dodd-Frank we still do not have a systemic risk monitoring capability in place to warn us of impending problems. 

Part of the concern regarding the OFR simply comes from the unknown.  The subpoena powers bestowed on it by Dodd-Frank have been an unfortunate distraction for an agency whose mission is absolutely critical to the financial security of this country.  Likewise, the breadth of scope in the OFR's data collection mandate has sparked controversy regarding the potential for the agency to request sensitive consumer information and the vulnerability of that data to various security threats.  While these issues merit close scrutiny, they draw attention away from the critical data and research activities that the agency should be putting in place. 

Lost on most non-economists is the fact that the data necessary to detect systemic risks simply was unavailable to financial regulators before or after the crisis, although important headway has now been made to develop a new legal entity identifier standard for tracking financial transactions.  Despite efforts to begin gathering some information on a timelier basis and at a more granular level, the regulators are still highly dependent today on quarterly data from banks aggregated at such a level that it makes it virtually impossible to provide forward-looking analysis of emerging systemic risks.  Never mind trying to pry open the activities of the so-called shadow banking sector where little data is provided to understand how this segment of  financial markets contributes to systemic risk. 

With the data that is currently available today, we could encounter another crisis as we did in 2008 and not know it until it hits. 

Similarly, measurement of systemic risk has largely been confined to academia.  A dizzying array of metrics exists focused on individual sectors and institution types, but a reliable comprehensive forward-looking metric of systemic risk remains elusive. Development of a set of metrics to provide early warning of excessive risk concentrations is imperative for the OFR to do its primary job of identifying and monitoring systemic risks. The agency has been actively engaged with the academic community to develop and report various metrics on systemic risk. However, these efforts are still not sufficiently evolved to provide advanced warning of impending systemic risk events. 

While the OFR's subpoena powers create the potential for overreach by the agency at some point, the enforceability of data requests is crucial for it to be able to collect the information needed to assess systemic risk.  The fragmented regulatory structure and outmoded regulatory data infrastructure in place still to this day puts the U.S. financial system at risk to unforeseen financial threats.  Unlike supervisory agencies such as the Office of the Comptroller of the Currency or the FDIC, OFR would be severely handicapped in its ability to request critical data without some enforceability mechanism. 

Rather than slow its progress or repeal it as some in Congress would prefer, it is essential, even in a time of fiscal belt-tightening, to invest federal dollars in efforts to identify and detect systemic risk.  But OFR has a long way to go to accomplish its mission, judging from the progress report released last week by the Treasury's Office of Inspector General.  

By comparison, the OFR's sister agency, the Consumer Financial Protection Bureau is acknowledged by the inspector general to have gotten off to a much faster start than OFR. This is partly because the bureau consolidated consumer protection activities that were already in place, while OFR was a true start-up.

The OFR's Annual Report will be a critical milestone for establishing this new agency's credibility among legislators wary of its powers and limited progress. It's an opportunity to provide greater clarity on how the OFR will execute its plan and allay some lawmakers' concerns regarding the office's intentions and authority.  Recent events in Europe only underscore the need to accelerate OFR's critical work.

Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.