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RISK DOCTOR

We Need an Interim Systemic Watchdog While OFR Sets Up Shop

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Imagine a nuclear power reactor core meltdown caused by a complete breakdown in multiple parts of its cooling systems that an advanced coolant and pressure monitoring system might have averted.

Yet two years after the incident, reactors across the country remain on line with only minor engineering improvements to coolant systems implemented and no retrofitting of warning gauges has occurred. Instead, a new voluminous nuclear safety manual has been issued to the power industry and its regulators, covering virtually every aspect of nuclear power plant construction. But each day, reactors operate without the new technology.

As you probably guessed, this is a not so veiled reference to the financial system, where there are a number of signs that our ability to detect emerging systemic risks is only marginally better than before the 2008 crisis. The Office of Financial Research is the loss-of-coolant detection system and Dodd-Frank is its safety manual. Financial markets remain highly complex webs subject to major systemic shocks that we are ill-equipped to identify before our financial system melts down.

So far, there have been a number of incidences of small, non-catastrophic failures in the form of MF Global, the JPMorgan trading losses and the Libor probe. The mega-reactor equivalents, namely the U.S. fiscal cliff and the European debt crisis, are exhibiting erratic temperature fluctuations. We would hardly tolerate waiting several years before addressing such a systemic public safety problem.

But while we can't decommission the financial system, we can put the OFR's activities on a parallel two-path track: one focused on the long term, the other on developing a set of stopgap processes designed to improve detection of systemic risk as we build data and measurement capabilities for the future.

Last week the OFR released its first annual report. While significant strides have been made in establishing an infrastructure to support its ongoing mission to analyze threats to financial stability, conduct research on systemic risk and strengthen financial data standards and quality, the need to concentrate efforts on providing near-term early warning capabilities is clear.

The report offers one of the most comprehensive and well-documented assessments of systemic risk drivers, measurement techniques and data developed thus far. It's a must-read for those interested in the subject of systemic risk.

The OFR report provides a detailed account of a number of promising gauges of systemic risk, and in that commentary it becomes clear that none of these metrics at this point can provide a comprehensive and accurate view of systemic risk. We are in a real sense fully operational with limited ability to recognize when the system has gone critical. Partly this is due to poor data available to measure systemic risk, but it also is due to the fact that the metrics themselves are not fully developed to handle the scope and scale of financial market participants and activities.  

It will take OFR and other agencies years before the data and measurement infrastructure for accurate assessment of systemic risk is on line. This may be one reason why no specifics were offered in the report for how the OFR will execute its plan or what the timetable might be for implementation.

In the meantime, the Financial Stability Oversight Council needs to embark on an interim joint initiative to provide reporting and assessment of potential financial threats cobbled together from existing data augmented by other information that can be made readily available within six months. Such an effort could be assigned to a joint interagency taskforce comprised of FSOC member agencies led by OFR. No doubt this would create some redundancy in the process; however, we do not have years to wait for the new capabilities to materialize.

The OFR in its report played out the scenario of what it might have been able to do in 2005 to forestall the crisis. It concluded that its ability to investigate important financial activities and request data on them would have been an ''appropriate role'' for the OFR. Such a role today for the OFR should not be lost on itself or the FSOC as an interim and proactive step in maintaining the safety of the financial system while we await development of reliable advance warning capabilities.

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.

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Comments (3)
Politicians in Europe are in denial about the systemic risk of there own fiscal profligacy, blaming it on "market speculators." Do you really think the warnings will emanate from Washington, DC?
Posted by kvillani | Wednesday, July 25 2012 at 1:17PM ET
Kevin -- You've got a point that the idea of the OFR identifying a key market failure is never going to happen. But wouldn't gathering the data and making it available to relevant parties for analysis help, particularly in the middle of a crisis? So even if Washington doesn't have the answers, couldn't it at least handle a collective need to gather information so that others can sort it out? - Jeff Horwitz, editor
Posted by jhorwitz24 | Wednesday, July 25 2012 at 1:22PM ET
Clifford; Great article- and a wholly valid analogy re Nuclear.
Central to the functioning of any systemic risk management function is a clear and unequivocal system of identity- who did what and when- coupled with a resilient/trusted liability model so there are no "grey areas" re dispute resolution and so on. This is not just identity as a number, it is identity down to the individual person, and it needs to be interoperable/span geographies and conventional silo's etc. Such a systemic risk management function exists today and can be massively leveraged- indeed there are big gains for all concerned in re-inventing the role of "regulated financial institutions" as the "distribution arteries" for such a function. Kind regards from London as we welcome i the XXX Olympiad...John G Bullard
Posted by johnbullard | Wednesday, July 25 2012 at 1:34PM ET
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