Data Agency Cites Top Risks to System

WASHINGTON — The Office of Financial Research released a report Tuesday that cited continued risks from a reliance on short-term wholesale funding and unveiled an early prototype for how it plans to track threats to the financial system.

In the 150-page report, the data and research arm of the Financial Stability Oversight Council reiterated concerns about the repo markets, given their vulnerabilities to runs and asset fire sales. It also highlighted new worries such as interest rate risk and credit risks given rising leverage on investment-grade and high-yield corporate balance sheets.

Additionally, the report detailed areas where the agency plans to bulk up its data collection, including obtaining more information tied to the asset management industry and repo markets.

"Our focus in 2014 will be to improve data measuring the sources and uses of short-term funding; collect data gauging the activities and terms of securities financing transactions, such as in the three segments of U.S. repo markets; and, if requested by the Council, address data gaps in asset management activities," the report said.

Regulators have been increasingly focused over the past year in addressing supervisory gaps when it comes to triparty repo markets and short-term wholesale funding to prevent potential fire sales from ever again crippling the financial system.

"We will also prioritize our work with international partners on ways to address the risks from short-term wholesale funding markets and shadow banking, complementing our domestic efforts," Treasury Secretary Jack Lew said in a speech earlier this month detailing regulators' 2014 priorities.

Not surprisingly, the research office's second annual report to Congress echoed several risks and vulnerabilities cited in the FSOC's report released in April.

"This report documents our recent efforts to analyze and monitor the financial system and the forces that can disrupt its functioning," Richard Berner, director of the research office, said in a statement.

While the agency said many threats to financial stability have mostly "abated" since last year's assessment, it cited ongoing vulnerabilities in markets for securities financing transactions and credit, concerns stemming from an increase in interest rates and uncertainty about the U.S. fiscal policy outlook.

As a result, the OFR said its priority next year will be to fill data gaps with regard to repo markets and asset management.

Data collection of repo markets is complicated by the fact that there are three different markets: bilateral, triparty and general collateral finance. While there is substantial information available, it falls short of what is necessary, according to the report.

"Without detailed, institution-specific information about all three components of the repo market, supervisors are handicapped in identifying potential sources of instability originating in this market, or originating with institutions that regularly fund themselves in this market," the report said.

In regard to asset management, the OFR outlined specific information that would be helpful to regulators in evaluating risks tied to the industry. In September the research office released a report to the FSOC noting there were significant gaps in data to comprehensively review asset managers.

"Collecting transaction-level data and position data about securities lending between large international financial institutions, including the composition of the underlying cash collateral reinvestment assets, would give regulators a clearer view of market activities," the report said.

Additionally, the report pointed to the lack of data tied to securities lending transactions and reinvestment of cash collateral limits, which ultimately makes monitoring of such activities less effective. Currently available market data does not provide information on the beneficial lenders and borrowers behind the transactions.

"It is consequently difficult to know the depth of securities lending in a particular issue at any given time, the extent of the counterparty exposures, or the number of times that an issue has been re-lent," according to the report.

The agency also warned that duration risk is at recent historical highs given long periods of low yield, low volatility and investors' search for yield.

The report noted that fixed-income instruments held in portfolios are also at a historical high, increasing the likelihood that losses from a given change in interest rates would be larger than in the past.

"Investment portfolios now facing growing duration risk - the risk that investors will incur outsized losses in the event of an unexpected rise in interest rates as a result of exposure to long-dated, fixed-rate bonds," the report said.

The data collection agency also released new details on a tool it has created that regulators can use to "track threats and the interplay among them."

The tool, called a Financial Stability Monitor, would track five separate pieces of data: macroeconomic, market, credit, funding and liquidity and contagion.

"This is Version 1.0; the monitor will continue to evolve as we develop and test its performance, evaluate new indicators, and respond to the ways innovation may change intermediation, asset allocation, and risk management," according to the report.