[Senate Hearing 111-766]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-766
 
  EQUIPPING FINANCIAL REGULATORS WITH THE TOOLS NECESSARY TO MONITOR 
                             SYSTEMIC RISK

=======================================================================



                                HEARING

                               before the

                            SUBCOMMITTEE ON
              SECURITY AND INTERNATIONAL TRADE AND FINANCE

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                                   ON

 EXAMINING THE SYSTEMIC RISK ASPECT OF REGULATORY REFORM, FOCUSING ON 
   REGULATORS' CURRENT CAPABILITIES TO COLLECT AND ANALYZE FINANCIAL 
  MARKET DATA, AND ASSESSING WHAT ADDITIONAL TOOLS AND RESOURCES ARE 
            NECESSARY TO MONITOR AND IDENTIFY SYSTEMIC RISK

                               __________

                           FEBRUARY 12, 2010

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html




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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

        William D. Duhnke, Republican Staff Director and Counsel

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                     Levon Bagramian, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

      Subcommittee on Security and International Trade and Finance

                      EVAN BAYH, Indiana, Chairman

            BOB CORKER, Tennessee, Ranking Republican Member

HERB KOHL, Wisconsin                 ROBERT F. BENNETT, Utah
MARK R. WARNER, Virginia
MICHAEL F. BENNET, Colorado
CHRISTOPHER J. DODD, Connecticut

                      Ellen Chube, Staff Director

              Courtney Geduldig, Republican Staff Director

                 Kara Stein, Professional Staff Member

                                  (ii)


                            C O N T E N T S

                              ----------                              

                       FRIDAY, FEBRUARY 12, 2010

                                                                   Page

Opening statement of Chairman Bayh...............................     1
    Prepared statement...........................................    35
Opening statements, comments, or prepared statement of:
    Senator Reed.................................................     2
    Senator Corker...............................................     2

                               WITNESSES

Daniel K. Tarullo, Member, Board of Governors of the Federal 
  Reserve System.................................................     3
    Prepared statement...........................................    36
Allan I. Mendelowitz, Founding Member, Committee to Establish the 
  National Institute of Finance..................................    14
    Prepared statement...........................................    43
John C. Liechty, Associate Professor of Marketing and Statistics, 
  Smeal College of Business, Penn State University, and Founding 
  Member, the Committee to Establish the National Institute of 
  Finance........................................................    16
    Prepared statement...........................................    43
Robert Engle, Professor of Finance, Stern School of Business, New 
  York University................................................    18
    Prepared statement...........................................    50
Stephen C. Horne, Vice President, Master Data Management and 
  Integration Services, Dow Jones & Company......................    20
    Prepared statement...........................................    78

                                 (iii)


  EQUIPPING FINANCIAL REGULATORS WITH THE TOOLS NECESSARY TO MONITOR 
                             SYSTEMIC RISK

                              ----------                              


                       FRIDAY, FEBRUARY 12, 2010

                                       U.S. Senate,
                 Subcommittee on Security and International
                                         Trade and Finance,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 2:37 p.m. in room SD-538, Dirksen 
Senate Office Building, Senator Evan Bayh, Chairman of the 
Subcommittee, residing.

            OPENING STATEMENT OF CHAIRMAN EVAN BAYH

    Senator Bayh. Good afternoon, everyone. I am pleased to 
call to order this Subcommittee for the hearing entitled 
``Equipping Financial Regulators with the Tools Necessary to 
Monitor Systemic Risk.'' I want to thank my Ranking Member, 
Senator Corker, and Senator Reed, my friend and colleague, and 
their hard-working staff for requesting this hearing on an 
issue that may seem technical to some, but will prove critical 
as we work to reform and modernize our regulatory structure for 
the future.
    I would also like to welcome and thank our able witnesses 
who are here today and thank our staff who have been 
instrumental with regard to technical aspects of this analysis. 
I am so happy to continue the dialog that we have already begun 
on how to equip our regulators to move beyond examining 
individual institutions and toward monitoring and managing 
systemic risk across our financial system.
    To our witnesses that will appear on two separate panels, 
welcome and thank you for appearing before the Subcommittee to 
give an outline on regulators' current capabilities to collect 
and analyze financial market data and, most importantly, what 
additional resources and capabilities are necessary to provide 
effective systemic risk regulation. I understand very well that 
the weather in Washington the last few days has not been ideal. 
As a matter of fact, some of our witnesses have been stranded 
here for several days. So I appreciate the dedication you have 
shown in making it here today, and we promise to be, 
accordingly, most merciful in our questioning.
    Before I turn to Governor Tarullo--and, Dan, thank you 
again for appearing before the Subcommittee; you have been here 
very ably on other occasions--I would like to submit a few 
comments for the record. I have a somewhat lengthy statement 
given the technical nature of the subject matter. I would like 
to submit that for the record, but will not read it. Is that 
all right with you, gentlemen? Very good. Hearing no objection, 
I will go ahead and do that.
    Senator Bayh. Before introducing Governor Tarullo, first, 
Senator Reed, perhaps you would have some comments you would 
like to share.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Very briefly, Mr. Chairman. I would like my 
statement submitted to the record also. I want to welcome 
Governor Tarullo also. I want to thank you for holding this 
hearing at the suggestion of Senator Corker, and this is a 
vital area and could, I think, be overlooked. But it is 
incredibly important.
    What we all witnessed over the last several years is not 
only great market turmoil but great market uncertainty. My 
impression of a lot of the problems with Lehman, with Bear 
Stearns, with AIG is the fact that regulators and other banking 
institutions had no idea where their liabilities, their risks, 
their counterparty exposure lay, and there was no systemic way 
to calculate or aggregate that information. And as a result, I 
think the regulators were flying blind, essentially, doing the 
best they could, trying to work things out, but a lot of it was 
just sort of flying with instruments that were not working in 
bad weather. It was more seat-of-the-pants than systemic 
regulation.
    So one of the things I think we have to do is create a 
repository of information available to regulators, available to 
the public with appropriate delays, so that the system is much 
more understandable and that, when there is a shock to the 
system, markets do not react out of fear, they react with some 
knowledge.
    Thank you, Mr. Chairman.
    Senator Bayh. Thank you, Senator Reed.
    Now, we have on this Committee become accustomed to 
something we call the Corker rule, where violating--or not 
violating, actually a breathtaking, refreshing difference from 
senatorial custom, Senator Corker is known for his brevity in 
opening statements. But since you request the hearing today and 
I know this is a major priority of yours, perhaps you would 
have some opening comments you would like to share.

                STATEMENT OF SENATOR BOB CORKER

    Senator Corker. I will be very, very brief.
    Number one, thank you for having this hearing. I know it is 
Friday afternoon. It has been snowing, and a lot of us are 
trying----
    Senator Bayh. We have been trying since Tuesday to have 
this hearing.
    Senator Corker. Right, but I thank you so much, and I want 
to thank Governor Tarullo for always being available and 
helping us think through these complex issues.
    Our second panel especially, Governor Tarullo, has, I know, 
been holed up on hotels and hanging around for several days to 
cause this testimony to actually occur prior to recess. I think 
everybody knows we are hopefully working toward a regulatory 
reform bill. It is important to get this testimony into the 
public record so we can potentially act upon it. So we thank 
you all for being here, for your ideas, and with that, Mr. 
Chairman, as you walk out the door, thank you so much for 
having this hearing. I appreciate it.
    Senator Reed. [Presiding.] Thank you, and on behalf of 
Senator Bayh and Senator Corker, let me introduce our first 
witness, Daniel K. Tarullo, who is a Governor of the Federal 
Reserve Board. He is an expert in international finance. He 
received his education beginning at Roxbury Latin School, and 
then he went on to Georgetown University, Duke University, and 
graduated with his law degree from Michigan. Prior to assuming 
his responsibilities at the Federal Reserve, he was a faculty 
member at the Georgetown Law School and prior to that served in 
the Clinton administration as Assistant Secretary of State for 
Economic and Business Affairs and other important 
responsibilities.
    Again, Governor, thank you for your presence, and we look 
forward to your statement.

 STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF GOVERNORS OF 
                   THE FEDERAL RESERVE SYSTEM

    Mr. Tarullo. Thank you, Senator Reed and Senator Corker, 
and thank you both for your attention to a subject whose 
importance to financial stability is, as Senator Reed said a 
moment ago, often overlooked in the broader debates about 
reform.
    Good information is crucial to the success of any form of 
regulation as it is to the success of any form of market 
activity. But many features of financial activity make the 
quality and timeliness of information flows even more 
significant for effective regulation. Most important, perhaps, 
is the interconnectedness of financial services firms. In few 
other industries do major players deal so regularly with one 
another, as a result of which major problems at one firm can 
quickly spread throughout the system.
    The financial crisis revealed gaps in the data available to 
both Government regulators and to private analysts. It also 
revealed the relatively undeveloped nature of systemic or 
macroprudential oversight of the financial system. With this 
experience in mind, I believe there are two goals toward which 
agency and congressional action to improve data collection and 
analysis should be directed.
    First, to ensure that supervisory agencies have access to 
high-quality and timely data that are organized and 
standardized so as to enhance their regulatory missions, 
including containment of systemic risk;
    And, second, to make sure such data available to other 
Government agencies, to private analysts, to academics, in 
appropriately usable form so that the Congress and the public 
will have the benefit of multiple perspectives on potential 
threats to financial stability.
    My written testimony details some of the initiatives at the 
Federal Reserve to enhance the type and quality of information 
available to us in support of our exercise of consolidated 
supervision over the Nation's largest financial holding 
companies. I would stress also, though, the importance of using 
that information to regulate more effectively.
    The Special Capital Assessment we conducted last year of 
the Nation's 19 largest financial firms demonstrated how 
quantitative, horizontal methodologies built on consistent data 
across firms could complement traditional supervision. It also 
showed the importance of having supervisory needs and knowledge 
determine data requirements. We are building on that experience 
and adding a more explicitly macro prudential dimension and 
developing a quantitative surveillance mechanism as a permanent 
part of large-firm oversight. While there is much that the 
Federal Reserve--and other agencies such as the SEC--can do and 
are doing under existing authority, I do believe we will need 
congressional action to achieve fully the two goals I stated a 
moment ago.
    There are a number of specific areas in which legislative 
changes would be helpful. Let me briefly mention three.
    First, it is very important that Government agencies have 
the authority to collect information from firms not subject to 
prudential supervision, but which may nonetheless have the 
potential to contribute to systemic risk. Without this ability, 
regulators will have a picture of the financial system that is 
incomplete, perhaps dangerously so.
    Second, it appears to me that greater standardization of 
important data streams will only be achieved with a 
congressional prod. This objective of standardization has for 
years proved elusive, even though most observers agree that it 
is critical to identifying risks in the financial system.
    Third, there will need to be some modifications to some of 
the constraints on information colleague by Government 
agencies, such as authority to share that information with 
foreign regulators or to release it in usable form to the 
public. Since privacy, proprietary information, intellectual 
property, reporting burden, and other important interests will 
be implicated in any such modifications, it is most appropriate 
that Congress provide guidance as to how these interests should 
be accommodated in a more effective system of financial data 
collection.
    Finally, as you consider possible legislative changes in 
this area, I would encourage you to consider the relationship 
between the authorities and responsibilities associated with 
data collection and the substantive regulatory authorities and 
responsibilities entrusted to our financial agencies.
    Generally speaking, regulators have the best perspective on 
the kind of data that will effectively advance their statutory 
missions. Indeed, without the authority to shape information 
requirements, their effectiveness in achieving these missions 
can be compromised. This is all the more important given the 
current state of knowledge of systemic risk in which there are 
as many questions as answers.
    In these circumstances in particular, the insights gained 
by supervisors through their ongoing examination of large firms 
and of markets should be the key, though not the exclusive 
determinant, of new data collection efforts. This does not mean 
that agencies should collect only the information they believe 
they need.
    The aim of providing independent perspectives on financial 
stability means that other data may be important to collect for 
the use of private analysts, academics, and the public. The 
agencies can certainly be asked to collect other forms of 
information that are important for independent assessments of 
financial stability risks. But I think this relationship does 
counsel considerable symmetry between regulatory responsibility 
and data collection.
    Thank you for your attention and, again, for having this 
hearing. I would be pleased to try to answer any questions you 
might have.
    Senator Reed. Well, thank you very much, Governor Tarullo.
    Let me first ask the question that this need for better 
information is not exclusive to the United States. Could you 
comment on how other G-20 countries are trying to deal with 
this and the need for not just a national approach but an 
international approach?
    Mr. Tarullo. Certainly, Senator. A number of other 
regulators and overseers around the world have already begun to 
address the issue of information, among them the various organs 
of the European Union and the United Kingdom, the Bank of 
England. The G-20 itself has issued a couple of recommendations 
that are particularly salient to this question on developing a 
template for reporting of information of the large 
internationally active financial firms.
    Now, this is, of course, not an easy undertaking for any 
one nation much less for the world as a whole, but it is 
something which the Financial Stability Board has taken on as a 
task. There have been some preliminary discussions on how to 
organize the work of trying to see if we can come to agreement 
on a template for reporting of the largest, most globally 
active financial institutions. It is far too early to report 
progress there, Senator, but I can say that the effort has been 
launched.
    Senator Reed. Well, thank you, Governor. As you know, as we 
are proceeding down, and I think appropriately so, a 
legislative path which we hope will incorporate this systemic 
collection of information, I have got legislation in--and, in 
fact, I want to thank Dr. Mendelowitz and Professor Liechty for 
their assistance and help. But this is going to have to be an 
effort that goes beyond the United States to understand that, 
but I think it is important that we begin here.
    Another aspect of this international question is the issue 
of sovereign behavior. The Greek Government now is in a very 
serious crisis which is rattling the markets. There also is 
some indication that another one of our favorite topics, 
derivatives and credit default swaps, have come into it. 
Apparently, there are reports that investment banking firms 
have helped them legally avoid treaty obligations under 
Maastricht, et cetera. But the long and the short of it is, do 
we also have to include sort of sovereign entities in terms of 
data collection?
    Mr. Tarullo. Well, Senator, I think that one of the lessons 
that the international community drew from some of the 
sovereign debt crises of the late 1990s and the very early 
years of this century was that there needed to be more 
transparency associated with a lot of sovereign debt issuance. 
And the International Monetary Fund undertook to create special 
data dissemination standards which would provide more such 
information.
    Generally speaking, I would distinguish between the 
sovereign information and private financial system firm 
information since we as regulators obviously have a mandate 
over private firms rather than certainly over sovereigns. It is 
relevant, though, for us in thinking about systemic risk 
because, to the degree that our large institutions have 
significant exposures to sovereigns which may conceivably have 
difficulty in servicing their debt, that becomes a matter of 
concern for the private financial regulators as well.
    Senator Reed. One of the issues that repeatedly is made--
points, rather than issues--is that, you know, too big to fail 
is the first chapter, but the second chapter is too 
interconnected to fail. And that raises the issue of a focal 
point on large institutions might miss small institutions that 
could cause systemic risk. In fact, you know, there is the 
possibility that multiple failures in small institutions could 
have a systemic problem.
    So how do we sort of deal with that in terms of these 
interconnections? I mean, traditionally, it is easy for us to 
go to a big financial institution and say report X, Y, and Z.
    Mr. Tarullo. Right.
    Senator Reed. How do we capture everybody, not in a 
pejorative sense but in a data sense?
    Mr. Tarullo. Sure. So let me distinguish while trying to 
address both the data collection and the regulatory supervisory 
side.
    I think with respect to data collection, there is little 
question, in our minds, at least, that the data collection 
authorities of U.S. Government agencies need to extend beyond 
the universe of firms which are subject to prudential or even 
market regulation. For the very reasons you suggest, a large 
number of intermediate size firms can themselves have a 
substantial amount of financial activity, which, although not 
necessarily associated with systemic risk in any one firm, in 
the aggregate can define an important phenomenon or trend or 
development in the economy as a whole. So we do think there 
needs to be that kind of authority in our financial regulators 
to gather the necessary information to round out the picture.
    When it comes to supervisory or regulatory authority, the 
three of us, at least, have been in this room on a number of 
occasions talking about the choices that we have in front of 
us, and one of those choices is going to be how broadly to cast 
or to draw the perimeter of regulation. Will it be only firms 
that own banks? Will it be firms beyond that which are thought 
to be themselves systemically important? Or will it be some 
broader set of firms above a certain size? And I think those 
issues are probably going to be more difficult to resolve than 
the data issues, where I personally, at least, think there is 
little argument against the proposition that you need to gather 
this information.
    Senator Reed. Thank you.
    Senator Corker.
    Senator Corker. Thank you. And, Senator, I want to thank 
you for raising this up. I do not think we would have met with 
our next panel without you having brought this forward, and I 
think you are actually responsible for all of this being 
brought to our attention. So thank you very much.
    Senator Reed. Thank you, Senator.
    Senator Corker. I appreciate that.
    Governor, I think you are probably familiar with the 
National Institute of Finance, as it has been proposed, and 
they have discussed certainly it being done in an independent 
way. I think you maybe would allude more to that happening at 
the Fed itself. But I am wondering if you could talk to us a 
little bit about the pros and cons of what you know their 
proposal to be from the Fed's standpoint.
    Mr. Tarullo. Certainly, Senator. So this will not surprise 
you to hear that I think there are some advantages and 
disadvantages to each of the different organizational options 
that you would face. One such option would be the creation of a 
single, free-standing agency that would have overall 
responsibility for all the financial data collection and a good 
bit of the analysis.
    On the other end of the spectrum would be presumably just 
giving more authority to a single U.S. Government--existing 
U.S. Government agency and saying why don't you fill in the 
gaps?
    As I suggested in my written testimony, there is probably 
an option in between as well, particularly as you go forward 
with thinking about overall reg reform.
    To the degree that a council emerges, as I think it might, 
as an important center for coordinating the oversight of 
systemic risk in the United States among all the various U.S. 
Government agencies, we may want to lodge some of the data 
responsibilities in the council as well.
    The basic advantage, I think, of the single agency is what 
one would infer, which is you have a single group. They can 
take an overview. They can say let us try to prioritize, let us 
try to figure out where the most important unknowns are, and we 
will devote our activities in that direction, and we will do so 
in a way that we are not always stumbling over one another 
because we are just one agency.
    Some of the costs associated with the single agency--quite 
apart from out-of-pocket costs, which are nontrivial, but costs 
in the sense of non-immediate monetary costs--would include, I 
think, some risk that you detach data collection from the 
process of supervision, the process of regulation. And I do 
think it is important and I think our experience over the last 
couple of years has borne out the importance of having those 
with the line responsibility for supervising and regulating 
being able to shape the kinds of data collection that they feel 
are necessary in order effectively to regulate or to supervise.
    In the middle of the crisis, for example, it became 
apparent to some of the people at the Fed that getting 
information on the kinds of haircuts that were being applied to 
some securities repurchase agreements was a very important 
near-term piece of information in trying to assess where the 
system was at that moment.
    If that capacity had been lodged in an independent agency, 
with some of its own priorities perhaps and having to go 
through a bit more of a process, there may--and I emphasize 
``may''--have been some delays in getting to that end.
    So I think that, as with everything, there are going to be 
pluses and minuses. It will not surprise you to know that from 
a somewhat--from the perspective of 20th and Constitution, 
there would be concerns about losing the capacity to shape and 
act quickly on informational needs. But I hasten to add that 
here, as with systemic risk generally, I do not think anybody 
at the Fed believes that the Fed should be the sole or even the 
principal collector and analyzer of data. This has got to be a 
governmentwide priority.
    Senator Corker. The information that you receive now, the 
data, how realtime is it? And I would assume during a crisis it 
is very important that it is daily. And then how granular is it 
today?
    Mr. Tarullo. So that varies considerably, Senator, from 
data stream to data stream, and I think the subject--let me be 
clear just that when some people say ``realtime,'' some people 
mean ``immediate'' by that; that as a trade happens, the data, 
the information about the trade is immediately available to 
regulators and possibly the public.
    For most of our supervisory purposes, that kind of 
literally realtime data is not critical to achieving those 
supervisory purposes. And, of course, as you all know, true 
realtime data is a very expensive thing to put together. But 
timely, meaning in many instances daily or end-of-the-day 
trading, is very important for making an assessment on a 
regular basis as to the stability of a firm that may be under 
stress.
    One of the things that became clear, I think, during the 
crisis--and for me became particularly evident during the 
stress tests last spring--was the substantial divergence in the 
capacities of firms to amass, to get a hold of their own data, 
to know what their own trades were, to know what their own 
counterparty risk exposures were.
    So one of the things that we have actually been doing in 
the wake of the Special Capital Assessment Program is placing 
particular emphasis on the management information systems of 
the firms, requiring that they themselves be able to get a hold 
of the data on trades or counterparty exposures or certain 
kinds of instrument--certain kinds of involvement with certain 
kinds of instruments, because if they can get a hold of it for 
their own internal purposes, we will be able to get a hold of 
it pretty quickly.
    So right now it is actually not so much a question of our 
telling them, ``Send us something you have on a daily basis.'' 
It is in many instances as much a matter of making sure they 
have the capacity to derive that information from their raw 
computer records and then to send it to us.
    Senator Corker. May I ask another question, Mr. Chairman?
    Senator Reed. Yes, sure.
    Senator Corker. You know, of course, we all tend to try to 
find a solution that is unique and maybe alleviates a lot of 
just the daily work it takes to be good regulators, right? And 
a lot of what happened this last time could have been prevented 
with the tools we had if we just maybe had been a little more 
effective in regulating the way that we should have and 
Congress overseeing the way that it should have. But there were 
certainly lots of issues that caused this last crisis, if you 
will, to unfold.
    So we have had this wonderful presentation that we are 
going to hear next, and, you know, we envision having all this, 
at the end of the day, realtime type of data so we know 
positions throughout our country, so that regulators have the 
ability to know if something that is putting our country in 
systemic risk is occurring.
    What should we be concerned about there from the standpoint 
of having this thing that sounds really neat and costs money, 
how do we prevent it from being something that really is not 
that useful but is collecting a lot of data that I imagine 
takes place throughout this city that is not utilized?
    And then, second, I would imagine that data like that 
collected in one place could be used for pretty nefarious 
purposes if it got into the wrong hands. If we actually have it 
and collect it, what should be our concerns in that regard?
    Mr. Tarullo. OK, so with respect to your first question, I 
mean, I do think that the efforts of the group of academics and 
others who have been promoting the NIF and certainly the 
efforts of the National Academy of Sciences in convening that 
workshop have been very valuable in drawing attention to and 
moving the debate forward on the data needs that we really do 
have. And I think, Senator, just to underscore something I said 
earlier, the absence of data from the shadow banking system was 
certainly problematic in retrospect. I think that the degree to 
which the tightly wound, very rapid shadow banking system was 
channeling liquidity around the financial system and, thus, the 
rapidity with which it came to a screeching halt once things 
began to break down, is something that was at least 
underappreciated by even those who foresaw problems ahead.
    So I do think that there is--and I do not think it is a 
coincidence, by the way, that some of the names I saw on the 
list of participants in that workshop that the NAS held were 
the names of scholars who have written, quite insightfully, I 
think, on the substantive causes of the crisis and of the way 
in which adverse feedback loops began when things moved into 
reverse. So I do think we need additional data sources.
    Now, how to make sure that every dollar of governmental 
funds spent on this are spent most wisely and how to make sure 
that we do not demand a lot of private expenditures that are 
not going to useful purposes is the kind of question that I 
think we all confront all the time in any Government regulatory 
or data collection effort.
    And I guess I would say that that is where some of the 
principles that we suggested in my written testimony I hope 
will be of some help. Keeping the regulator and supervisory 
agencies closely involved and, I would hope, the prime movers 
of these data collection efforts I think will help because 
whether it is the SEC or us or the CFTC, we are going to be 
most concerned in the first instance with achieving our 
statutory missions. And so for us that would be the 
consolidated supervision of the largest financial holding 
companies and also, obviously, our monetary policy and 
financial stability functions. That I think is one way to do 
it.
    I think a second way would be to make sure that there is 
some thought about new requirements coming forward. This is why 
OMB has the rules they have. And as you know, we think maybe 
some of the Paperwork Reduction Act features need to be changed 
around the edges. But there is a good reason why that act 
exists because you do want to put the brakes on people just 
willy nilly saying we would like new data sources.
    I think actually the council, if a council of regulators 
were created or the President's working group could formalize 
such an effort, I think it would be useful to have different 
agencies actually thinking about what new data sources may be 
important and having a debate precisely to guard against any 
one maybe going a bit too far afield from its own regulatory 
mission.
    On the protection issue, obviously there are, as I 
mentioned, these important interests, proprietary interests, IP 
interests in some cases where vendors are involved, privacy 
interests where individuals are involved, a little bit less, 
obviously, with some of the things we are talking about. We 
ought to continue to have those protections. But it is also the 
case that our country I think wants to be protected from 
financial instability, and my conclusion at least is that the 
efforts to identify potential sources of financial stress and 
risk throughout the economy is not something that one or even a 
whole group of Government agencies should be the sole actors 
in. I think we do need to enable analysts, private analysts, 
finance professors, people who have expertise but are not in 
the Government, to look at what is going on in the economy to 
offer their views to you, to us, to the American people, and 
let us all filter through how much of that may be well grounded 
and where we might disagree.
    If we are going to do that, we have to figure out how to 
get this data into a sufficiently aggregated form so as to 
protect proprietary information, but to make sure that it is 
really useful to somebody out there who is trying to do an 
analysis and have some insight into what is going on in the 
subprime mortgage market or over-the-counter derivatives or 
anywhere else.
    Senator Reed. Well, thank you, Governor Tarullo, and you 
have reminded me, I have to thank also the National Academy of 
Sciences because we asked them to convene that meeting and I am 
pleased that it produced positive results in your view and 
other people's view, but thank you very much.
    Senator Corker. I thought maybe you were going to ask 
another round. If I could just ask one more question----
    Senator Reed. Yes, and I might have one, but go ahead. You 
go first.
    Senator Corker. No, go ahead. Absolutely.
    Senator Reed. Well, it sort of--no, why don't you go, 
because this is not Abbott and Costello, but you are ready.
    Senator Corker. So a number of us have been looking at 
speed bumps, ways for us not to be faced with resolution. We 
obviously, if we have resolution, want to ensure that this 
whole notion of too big to fail is not part of the American 
vocabulary. But we have had numbers of entities in recently--
today, yesterday, the day before--talking about contingent 
capital and the ability to take unsecured debt in an 
institution that is moving into problem areas and converting 
that immediately to common equity.
    I know that is a little bit off topic, but there is a lot 
happening. We are going on recess next week. I just wondered if 
you might have some comments regarding that. It is something 
that I think is gaining more and more attention.
    Mr. Tarullo. Sure. Actually, Senator, we have been paying a 
good bit of attention to that in the Federal Reserve. I got 
together a group of Board staff and staff from some of the 
Reserve Banks to try to think through some of the potential 
options here.
    So let me first begin with a little taxonomy because 
different people mean different things when they talk about 
contingent capital. There are at least a couple of concepts 
here. One is a concept under which a firm would issue a 
specific kind of instrument which would have debt-like 
characteristics under normal circumstances, but by the terms of 
the instrument would itself have a conversion to equity when 
some trigger event happened.
    The concept behind that tends to be the following. There is 
a period during which a firm may still be somewhat healthy, but 
is beginning to deteriorate, and if capital levels go down to a 
certain level there will be a loss of confidence within the 
markets and counterparties with respect to that firm. So if at 
that point the trigger means that all of a sudden there are X-
billion dollars more of common equity in the firm, that might 
provide a reassurance and stop a slide downward, and I will 
come back to that in a moment.
    A second concept is really one which is as much about the 
potential insolvency of the firm as it is stopping the slide. 
So some have proposed, for example, that all subordinated 
debtor all forms of debt other than specified senior tranches 
of debt would, at some moment, which would probably be the 
equivalent of when you are on the verge of insolvency, convert 
to equity, thereby, in effect, helping to move forward what 
would be a resolution process under another name, because now 
you have way less debt on the liability side of your balance 
sheet and more equity.
    The first is, I think, the concept that has intrigued some 
academics, some regulators, and, I must say, some investment 
bankers who probably see the opportunity to create some new 
forms of investment. The big issue there--there are a number of 
technical issues, but I think probably the biggest is what is 
the trigger going to be. If the trigger is supervisory 
discretion, you probably have an issue because everybody is 
going to be wondering whether the supervisor is going to pull 
the trigger for exogenous reasons, or when the supervisor would 
pull the trigger. It would create a good bit of uncertainty in 
the markets.
    A second option is that you have the trigger tied to the 
capital levels of the firm. Now, that still involves some 
supervisory discretion, but it is within the context of an 
ongoing regulatory system. The problem there has been that, as 
you know, capital tends to be a lagging indicator of the health 
of a firm. Many firms, 2 months before their insolvency, looked 
like they were adequately capitalized, and so unless we get a 
quicker adjustment of capital levels, that probably wouldn't do 
the trick.
    A third proposal is to have a market-based trigger, a 
trigger that might, for example, be the relationship between 
common equity and assets or something of the sort, or the 
market price of the--a lag market price of the firm related to 
assets, something that gets the market in as the trigger so 
that nobody can manipulate it in any way. The concern that one 
hears from a lot of people about that approach is that it can 
induce a kind of death spiral in the firm, whereby people begin 
trading against--when they see the price go to a certain level, 
they begin trading against it.
    So my personal--and this is really personal, this is not 
the Board--my personal view is that all three of these 
approaches have significant problems. I personally just have 
excluded full supervisory discretion as a real option. But I 
think it is worth pursuing the technical challenges around both 
the market-based trigger and the capital trigger and that is 
what we have asked our staffs to do within the Reserve Banks 
and the Board, to see if there is something here which can be--
and this is important--which can be a less expensive form of 
capital for the banks. I don't want to create anything that 
costs more than common equity for the banks. That is kind of a 
feckless undertaking. But if we can figure out a way to have a 
capital instrument which is there in the exigent circumstances 
but which costs less than common equity on a normal basis for 
the firms, I think that is something worth pursuing.
    I am sorry I was long-winded, but as you can tell, we have 
actually been analyzing this.
    Senator Reed. Thank you. It did give me time to think of a 
question.
    [Laughter.]
    Senator Reed. No, just a comment, because I think Senator 
Corker, as always, has raised a very interesting point, and 
this is a comment. When push came to shove, all the varieties 
of capital, risk-based capital, were essentially disregarded, 
the stress test, the tangible capital, or am I overstating or 
misstating?
    Mr. Tarullo. So our focus--so here is what happened, what I 
found so interesting during the crisis itself. During the 
crisis itself, private analysts, who are operating on the basis 
of less than full information, of course, and regulators both 
found themselves focused on common equity. Now, some of the 
market guys called it tangible common equity, but basically, it 
was common equity. And I think that what all of us, if we 
didn't already believe it, and some of us did, but if we didn't 
already believe it, what all of us concluded from this exercise 
was that common equity needed to be an even more important 
component of the equity of financial firms going forward.
    The stress tests, the SCAP, were conducted with the 
assumption that--or under a set of standards that looked to the 
common equity levels as well as the traditional tier one 
levels, and I think, Senator, that regulators around the world 
whom we talk to in the Financial Stability Board, market 
analysts, and the financial institutions themselves have all 
converged around the proposition that common equity really and 
truly is far and away the most important--not the only, but the 
most important component of regulatory capital.
    Why? Because if it is adequate, it allows the firm to 
continue as an ongoing institution. There are some forms of 
equity, tier two--excuse me, capital--tier two capital, which 
will be available to protect the Deposit Insurance Fund or 
senior creditors, but not to keep the firm going on an ongoing 
basis. And since I don't think any of us relish the thought of 
another go-around of major challenges to major financial 
institutions, I think we are all focused on finding the best 
way to maintain higher levels of common equity--when I say all 
of us, I don't just mean regulators. I think that is a market 
imperative, as well.
    Senator Reed. Thank you. We had a sidebar which we don't 
need to continue about Basel II. I think we do have to spend 
some time thinking hard about the rules of capital going 
forward. But just two quick comments about the issue at hand.
    I don't want to trivialize this, but essentially, this 
center would be on patrol for bubbles in the economy, things 
that could cause, you know, not in one forum but throughout the 
economy, real problems. Is that too simple, or is that----
    Mr. Tarullo. No, I don't think it is too simple, and if I--
so if I can hearken back to a sidebar we had in a different 
hearing where you and I were talking about--I mentioned several 
times in the written and oral testimony the need for 
independent views of things, and this is something which I have 
always believed, but my conversations with you have reinforced 
it in this context, that no matter how good a job I think the 
Fed can and will do, or no matter how good a job in market 
regulation I think the SEC can and will do, the uncertainties 
around financial stability are always going to be significant 
because stresses and problems arise in new ways.
    And so I think it is important for us to foster within the 
government but also outside of the government the ability of 
multiple agents to make a judgment on this.
    Now, I guess I think that this is something which is best--
within the government is best pursued in a collegial fashion, 
which is why the council occurred to me. I think if we are 
doing our analyses and the SEC is doing its and Treasury is 
doing its, bringing those together in council discussions and 
determining whether there needs to be a different kind of 
analysis or initiative seems to me to make a lot of sense. It 
may also make sense--again, responding to something you 
suggested to me a while ago--it may also make sense to have a 
council have at least a smallish staff of people who themselves 
are dedicated to looking at all of this and maybe doing some 
heterodox analyses.
    So I think I am all in favor of that, and actually not all 
in favor of it in the sense of we wouldn't oppose it. I 
personally think it is an affirmative good.
    Senator Reed. Thank you very much.
    Senator Corker. I know we need to move on with the subject 
at hand. I would like for you to, in writing, maybe respond, 
just so we can get something on the public record, regarding 
how--going back to the collateral or the capital we were 
talking about a little while ago, using maybe a quarterly 
stress test that was made public, thinking through how 
something like that might help us. But I know we don't have 
time for that today.
    Mr. Tarullo. OK.
    Senator Corker. We again thank you so much----
    Mr. Tarullo. Happy to do it.
    Senator Corker. If you could do that in the next few days, 
that would be wonderful.
    Mr. Tarullo. OK, Senator.
    Senator Corker. Thank you. Thank you very much, Mr. 
Chairman.
    Senator Reed. Thank you, and I will call the second panel 
forward. Thank you all, gentlemen. Let me introduce the second 
panel.
    First, Dr. Allan I. Mendelowitz. Dr. Mendelowitz is a 
Washington-based economist and housing finance expert. He is 
the co-founder of the Committee to Establish the National 
Institute of Finance and the former Chairman and member of the 
Board of Directors at the Federal Housing Finance Board, where 
he served two terms. Thank you for your assistance on this 
issue, Doctor. Thank you very much.
    Our next witness is Professor John C. Liechty. Professor 
Liechty is the Associate Professor of Marketing and Statistics 
at the Smeal College of Business at Pennsylvania State 
University. He is also the co-founder of the Committee to 
Establish the National Institute of Finance. Thank you very 
much, Professor.
    We are also joined by Professor Robert Engle. Professor 
Engle is the Michael R. Merlino Professor of Finance at the New 
York University's Stern School of Business. Professor Engle was 
awarded a Nobel Prize for Economics in 2003, along with his 
colleague at the time, I presume, Dr. Granger at the University 
of California at San Diego.
    Our final witness is Stephen C. Horne. Mr. Horne is 
currently the Vice President for Master Data Management and 
Integration Services for Dow Jones Business and Relationship 
Intelligence. He specializes in data integration and analysis 
of large quantities of disparate data from thousands of sources 
and the improvement of marketing productivity from the 
resulting information. Thank you very much, Steve, for 
returning.
    Dr. Mendelowitz, please.

    STATEMENT OF ALLAN I. MENDELOWITZ, FOUNDING MEMBER, THE 
    COMMITTEE TO ESTABLISH THE NATIONAL INSTITUTE OF FINANCE

    Mr. Mendelowitz. Thank you, Mr. Chairman. Thank you, 
Senator Corker. I am really very pleased to be here today as a 
representative of the Committee to establish the National 
Institute of Finance and to bring the recommendations and 
findings of that committee.
    The Committee to Establish the National Institute of 
Finance is an extraordinarily unique group, based on my three-
and-a-half decades of experience in Washington. I have actually 
never seen anything like it. It is a committee that has raised 
no money. It is a committee that represents no vested 
interests. It is a committee where no single member has any 
personal financial interest in the outcome of our 
recommendations. It is a committee where we have covered our 
expenses, what they are, out of our own pockets, and because we 
never organized as a 501(c)(3), we don't even get the tax 
benefits associated with those expenditures.
    What it is, is it is a group of extraordinarily talented 
and, in many cases, very distinguished members, all brought 
together by the commonly shared view that the Federal 
Government and the regulatory communities lack the data and 
lack the research capability to effectively monitor and 
regulate systemic risk, and for that matter, to effectively 
monitor and regulate financial institutions and markets.
    We have come together to propose a solution to that 
inadequacy in the Federal Government's capability and that 
solution is the National Institute of Finance. And we view the 
National Institute of Finance as addressing the weaknesses, 
both respect to data and research and analytical capability, 
and I can't stress the importance of the research and 
analytical capability enough. A lot of time was spent with the 
earlier panel discussing data and there was far less mention of 
the analytical capability.
    The reality is, we do not have a particularly good 
understanding of how financial markets work because we have 
never had the kind of sustained research effort that would 
yield those insights. Despite the fact that there are research 
departments at large financial institutions, there is a lot of 
good research being done by very talented people in academia, 
there are research departments in the regulatory agencies, but 
at the end of the day, the research efforts never had access to 
the appropriate data or to the sustained funding to do the kind 
of work that would provide the analytical tools needed by 
regulators given the challenges that we face today.
    And that is why in our proposal for the National Institute 
of Finance we would have two key components: One, the Federal 
Financial Data Center; and the second, a Federal Financial 
Research and Analysis Center. We think the structure of the 
institute should be set up in a way that ensures that it can, 
in fact, play its key role.
    It would be, as we indicated, an independent agency, 
ideally. It would be an independent voice on issues of 
financial risk, regulation, and policy. It would be independent 
for several reasons. One, it hopefully would be free from 
political influence.
    Second, it would be free from having to investigate its own 
decisions and actions. As long as the institute is not a 
regulatory agency, it is untainted by the fact that if it were 
investigating itself, it would be given an impossible challenge 
and an impossible task if you are looking for really truly 
independent, high-quality assessments of what is going on.
    Third, the institute would be self-funded, and it would be 
self-funded for a couple of important reasons. One, fairness. 
It is our understanding, based upon the research that we have 
seen and the discussions we have held that adapting the common 
data standards associated with the Federal Financial Data 
Center would produce a significant reduction in operating costs 
on the part of financial institutions. Because it would get 
this benefit, it is only fair that some small share of those 
savings would be used to fund the operations of the institute.
    Second, given the burdens placed on the taxpayer and the 
taxpayers in this most recent crisis, it is not appropriate 
that taxpayers should be asked to pay for the monitoring of an 
industry which has already imposed a tremendous burden on the 
taxpayers.
    And third, there are certain benefits in the ability to 
compensate staff and attract folks that go with being funded 
with non-appropriated funds that would make it more 
competitive.
    All of this is critical and it, of course, would yield 
multiple benefits. It would yield substantial benefits in terms 
of improving the efficiency and effectiveness of financial 
regulation. It would reduce the likelihood of a future systemic 
event. It would make U.S. markets safer and more competitive. 
It would reduce the operating expenses of financial 
institutions. And the kind of standardized data that would be 
required would go a long way toward addressing one of the 
problems that Governor Tarullo mentioned when he commented on 
how he was surprised to find out that financial institutions 
actually didn't have a good handle on what their own exposures 
were and they didn't have ready access to that kind of data.
    Last, I just want to say how pleased we are that we learned 
last week that Senator Reed introduced S. 3005, the National 
Institute of Finance Act of 2010. That Act is structured in a 
way that creates a National Institute of Finance along the 
lines that we think would be essential to making it effective 
and we were really very appreciative to see that legislative 
measure.
    That concludes my oral comments and I will be happy to 
answer any questions you or the Committee may have.
    Senator Reed. Thank you very much, Doctor.
    Professor Liechty, please.

STATEMENT OF JOHN C. LIECHTY, ASSOCIATE PROFESSOR OF MARKETING 
     AND STATISTICS, SMEAL COLLEGE OF BUSINESS, PENN STATE 
UNIVERSITY, AND FOUNDING MEMBER, THE COMMITTEE TO ESTABLISH THE 
                 NATIONAL INSTITUTE OF FINANCE

    Mr. Liechty. Thank you, Mr. Chairman, Senator Corker. I 
appreciate the opportunity to be here and to again also speak 
about or on behalf of the Committee to Establish the National 
Institute of Finance.
    I would like to just give a little history. The Committee 
to Establish the National Institute of Finance started a little 
over a year ago at a workshop that was jointly sponsored by the 
Office of the Comptroller of the Currency and the National 
Institute of Statistical Sciences. As an academic and a 
professional statistician, I was really interested in the topic 
of the workshop, which is exploring statistical issues in 
financial risk and in bank regulation. I consult with some of 
the big investment banks, specifically helping them with issues 
related to modeling and valuing many of these complicated 
credit derivative securities that played a part in the recent 
crisis and I was hoping that the workshop would focus on 
systemic risk. But it was primarily focused on Basel I and 
Basel II and assessing the safety and soundness of individual 
institutions.
    And focusing on the safety and soundness of individual 
institutions is important, but that in and of itself will not 
ensure the safety and soundness of our financial system. In 
some ways, this approach is similar to ensuring that a group of 
cars going on a freeway or around a racetrack are all 
individually safe and sound, but then ignoring the larger 
dynamics of the traffic, for example, whether the cars are 
bunched together, they are observing safe stopping rules, or 
going too fast as a collective group.
    Now, because there was a broad collection of regulators, 
academics, and practitioners at this workshop, I asked a very 
simple question in my mind. Does anybody have the data 
necessary to monitor and measure systemic risk? And the 
informal consensus I got from that workshop is the same 
consensus I have heard over and over again as we have gone 
forward with this effort. The regulators do not have the 
correct data, and in addition, to get the data they need, it 
will probably require additional legislation.
    Now, I spent the bulk of my professional career developing 
methods and systems to go from data to information and I know 
that just collecting data is not enough. We have to have the 
appropriate analytic tools if we are going to turn that data 
into the useful information to be able to really monitor and 
measure systemic risk, and it will not only take more than data 
collection, it will take more than just building the models 
itself. In my view, in some sense, it is a fundamental 
scientific problem, that we have to put forward fundamental 
research efforts in order to be able to understand the 
frameworks, be able to frame the metrics, be able to get the 
models in place and then know what data we need.
    In some sense, I echo the finding that came from the 
National Academy of Sciences workshop which was that we really 
don't actually know all the data and we are not going to know 
until we have an iterative process, which is the fundamental 
part of the research process.
    Let me illustrate with an analogy from the weather, which 
is very appropriate given our last couple of days. This focuses 
on hurricanes. When the financial crisis of 2008 hit, the 
regulators and policymakers charged with keeping our financial 
system safe were taken by surprise. Although there were some 
indications of uncertainty, this financial storm hit with the 
same unexpected suddenness as the New England Hurricane of 
1938. The Martha's Vineyard Gazette noted at that time, this 
tragedy was not the loss of nearly 10,000 homes and businesses 
along that shore. It was the psychic destruction of summer for 
an entire generation.
    Earlier hurricanes had brought structural responses from 
the U.S. Government. The Weather Bureau was formed in 1870 
under President Ulysses S. Grant with a mandate to gather data 
on the weather and provide warnings of approaching storms. Even 
though the Weather Bureau was in place, it was not able to 
offer any warnings for the Category 4 hurricane that hit 
Galveston, Texas, September 8, 1900, and it only offered a few 
hours of warning for the hurricane that hit Miami September 18, 
1929.
    By 1938, the Weather Bureau had better models, it had 
better data, but as the New York Times observed regarding that 
hurricane, the Weather Bureau experts and the general public 
never saw it coming. I would ask, are our regulators and 
policymakers any better equipped today than the Weather Bureau 
of 1938?
    In 1970, President Richard Nixon created the National 
Oceanic and Atmospheric Administration, NOAA, with the mandate 
to do three things. One, collect data to document natural 
variability and support predictive models. Two, to develop new 
analytic and forecasting tools. And three, to conduct essential 
long-term research to underlie these models.
    Now, NOAA's current real-time data collection and analysis 
infrastructure is very impressive. It is significant. It 
continues to bring substantial benefits to our society. But 
they were made possible mainly through and largely through the 
research efforts of NOAA.
    At this point, I would like to offer an observation and a 
question. Clearly, I put forward to you that our financial 
markets are at least as important and as complicated as the 
weather. If that is the case, why don't we have the equivalent 
of NOAA for the financial markets?
    When it comes to safeguarding our system, our goal should 
be bold, our expectations realistic, and our dedication to the 
task substantial. Although it will take time, the benefits will 
far outweigh the cost, just as they have done for hurricanes.
    This concludes my oral remarks. I would be open to any 
questions you might have. Thank you.
    Senator Reed. Thank you very much, Professor.
    Professor Engle, please.

 STATEMENT OF ROBERT ENGLE, PROFESSOR OF FINANCE, STERN SCHOOL 
                OF BUSINESS, NEW YORK UNIVERSITY

    Mr. Engle. Thank you. It is a great pleasure to be here 
today. I appreciate the invitation from the Committee. Mr. 
Chairman, Mr. Corker, Mr. Reed, it is a pleasure to be here.
    I am here because I recently co-authored a report of the 
National Research Council that summarized a workshop on 
Technical Capabilities Needed for the Regulation of Systemic 
Risk. The Research Council is the operating arm of the National 
Academy of Sciences, the National Academy of Engineering, and 
the Institute of Medicine, all chartered by Congress to advise 
the Government on matters of science and technology. The 
workshop and its report were sponsored by the Sloan Foundation 
and were actually in response to a letter from Senator Reed. 
After I summarize our report, I would like to give you some 
personal opinions on the National Institute of Finance and the 
questions that were in the call.
    Our 1-day workshop, summarized, came to the following set 
of conclusions, I think.
    First of all, we were all convinced that with better data 
and better analytical tools, the problems of reducing systemic 
risk were actually solvable. Research necessary to accomplish 
this goal is already underway in both academic and regulatory 
settings, but it is now being carried out with purely market-
based data and, therefore, does not have access to the full 
range of information that would be needed to make these models 
as accurate as possible.
    Additional data collection across asset classes with 
counterparty, position, collateral, and valuation information 
would be extremely helpful. Nevertheless, it was clear at the 
meeting that many participants were unsure exactly how great 
this--what data would ultimately be needed. There is an 
important question that keeps coming up: whether the total 
range of everything that you can think of is required or there 
is a subset that could be required, and how would you select 
the subset of data that is really needed.
    The first step in this process would be the standardization 
and classification particularly of the OTC contracts, and this 
would be, I think, a substantial benefit to the industry as 
well as to the regulators if this could be accomplished, and it 
is one of the goals of the NIF.
    But even more important, as Allan said just a moment ago, 
than the data are the models, because data alone will not tell 
us about risk, it will not tell us about liquidity, it will not 
tell us about bubbles and other features which are necessary in 
order to understand the risks that face our financial system. 
And so the analysis is extremely important as well.
    So that concludes my brief summary of the meeting the 
National Research Council had. The full summary I would ask be 
attached to the record.
    Senator Reed. Without objection.
    Mr. Engle. Now let me say a few other things in my 
remaining time. Data gathered by supervisory agencies is 
already being used in attempts to try to calculate and evaluate 
systemic risk. This data, however, is often available on an as-
asked basis. In other words, it does not flow regularly to the 
agencies. They need to request it from the agencies they 
supervise, and this gives them only a partial picture, in any 
case.
    There is additional data within clearinghouses that is 
available to regulators, but, again, regulators cannot get this 
on a regular basis, and there is difficulty with sharing it 
across regulators.
    The same thing is true of risk reports. Risk reports are 
reported by financial institutions on a daily basis, but these, 
of course, discuss the risks of the firm, not the risks of the 
system, and do not have important kinds of counterparty 
information that we would really want to us the networks of 
risks across the system.
    So, in summary, regulators do have a substantial amount of 
information available, but it is not on a systematic basis, and 
it cannot easily be shared across regulatory agencies.
    Let me make just a couple more points on more general 
topics.
    It seems to me there is a question of the independence of 
the National Institute of Finance. I am a supporter of the 
proposal for the National Institute of Finance. The idea that 
it is an independent organization is important because it needs 
to be insulated from pressures from corporations and from 
Government. However, this independence could also be achieved 
if it were housed, I believe, within regulatory agencies who 
were already independent in that same sense. There could be 
substantial cost savings from such a location of NIF.
    The international effects of this are extremely important, 
and the location of the National Institute of Finance would 
necessarily--it would be very important that it be able to 
collaborate and share data and analytical tools with sister 
agencies around the globe; otherwise, we only see a partial 
picture of this financial system.
    Then one final comment. The security of the data is 
extremely important to preserve, but I think--and I think that 
an ultimate goal would be to make as much of this data in a 
delayed and aggregated form available to the public as 
possible. Transparency in financial markets is a great 
supplement to regulation. It is cheaper, and it may be more 
effective in many ways than much of the regulation we consider, 
and so an ultimate goal, I think of the National Institute of 
Finance would be to disseminate as much of this information as 
possible, and that would require congressional guidance.
    Thank you.
    Senator Reed. Thank you very much, Professor Engle.
    Mr. Horne, please.

  STATEMENT OF STEPHEN C. HORNE, VICE PRESIDENT, MASTER DATA 
    MANAGEMENT AND INTEGRATION SERVICES, DOW JONES & COMPANY

    Mr. Horne. Thank you. Thank you, Senator Reed, Senator 
Corker. Thank you this afternoon for spending time with us. My 
name is Steve Horne. I am Vice President of Master Data 
Management for Dow Jones, as Senator Reed introduced me 
earlier. I have spent over 30 years building very complex 
databases and transforming highly complicated data into usable 
information.
    I have testified many times over the last year on the 
impact of the financial meltdown and the need for comprehensive 
analytic databases designed to capture the appropriate realtime 
information necessary to prevent waste, fraud, and abuse of the 
IPSA Act--and ``realtime'' I think was discussed earlier--
including those of the TARP program to ensure that the American 
taxpayer's money is being used as intended.
    Legislation that would create such a database has been 
introduced by Senator Warner--it is S. 910--with a companion 
bill that has already passed the House, H.R. 1242, by a vote of 
421-0. These bills have been strongly endorsed by organizations 
such as the U.S. Chamber of Commerce, OMB Watch, and the Center 
for Democracy in Technology.
    Using the same basic infrastructure of the database that 
would be created under the legislation that I have described, 
we at Dow Jones have identified over 400 leading indicators 
that, when used together, can identify potential systemic risk 
within the financial system, but also, I want to add, many 
other parts of the economy, which expands upon what our 
esteemed presenters have presented today. And the challenge is 
to combine this disparate data into a structured database to be 
able to make informed decisions and judgments about the risks 
that are inherent to the system.
    Systemic breakdowns that impact individual geographic 
markets in this country are caused by a combination of factors, 
including unemployment, bankruptcy, foreclosures, commercial 
real estate failure, and other factors. For example, in Las 
Vegas, a huge influx of different socioeconomic groups moved 
into this market in the past 10 years. One of these groups is 
retirees. And when the financial meltdown occurred, these 
Americans were mostly living on fixed incomes: savings, 
retirement investments, and their Social Security. They bought 
retirement homes either with cash or with mortgages that were 
smaller than many, but they still incurred new debt. Over the 
last 3 years, the income from their retirement accounts went 
negative. They have had to dip into principal as the only way 
for them to gain cash.
    As the foreclosures generally grew around them, the 
retirees saw the value of their homes decrease in half as well. 
Those who had mortgages were now upside down, those who did not 
saw the major investment they had spent a lifetime building 
dwindle in value.
    Now, these senior citizens face a much more difficult 
situation. With a major portion of their principal gone, they 
cannot afford to live on their fixed income and now may have to 
go back to work. In Las Vegas, 16-percent unemployment does not 
bode well for anybody looking for a job. If they own their 
home, new mortgages are very difficult to get. Reverse 
mortgages are not an option because of the reduced availability 
of these programs. And the combination of these factors shows 
the market for retirees in Las Vegas is in systemic failure 
right now. So I am expanding upon the concept of systemic 
failure to talk about the markets as well as the financial 
systems that support those markets.
    The example of this process is known in statistical 
terminology as the ``Compounding Effects of Multiple Indices.'' 
If we can integrate this data into an actionable database, 
regulators can quickly implement surgical solutions that will 
apply the appropriate programs and/or funds to the most serious 
problems.
    The database can be applied for potential systemic failure 
of the commercial real estate market that has been highlighted 
by the Congressional Oversight Board report that was issued 
just 2 days ago. And, in addition, we are currently observing 
markets in North Carolina and Tennessee that are at risk of 
systemic failure. If the proposed database were in place, the 
Government would be in a better position to confirm, quantify, 
and tackle these problems proactively.
    Unfortunately, the data is in disparate systems that cannot 
talk to each other. The value of the database that is proposed 
in S. 910 is in its ability to combine and analyze this data to 
predict and prevent systemic risk. The transformation of this 
data into actionable information is neither easy nor 
inexpensive. However, the implementation of the proposed 
database will save significant taxpayer dollars in three ways: 
first, through more efficient targeting of resources and 
serving the areas of greatest need; second, by enabling the 
Government to ensure that the appropriate actions are taken 
before systemic failure occurs; and, third, by helping prevent 
waste, fraud, and abuse of taxpayer's money.
    The database proposed should not create additional security 
concerns. The security methodologies under the IPSA Act and the 
contractual controls for the use of commercial data are 
sufficient to protect this information. In addition, language 
included in H.R. 1242 that passed the House provides for even 
greater protections for non-public data.
    The system being proposed is designed to expand to cover 
global data. Although some of the data from overseas may not be 
accessible due to laws of specific countries, other 
international data is in better shape than our own and can be 
built into accurate analytic systems because of the early 
adoption of XBRL technology by many countries.
    In summary, the data and technology exist today to equip 
financial regulators with the tools necessary to monitor 
systemic risk. The only thing lacking is Government action to 
make it happen.
    I want to thank you again, Senator Reed and Senator Corker, 
for your time and attention, and I am happy to answer any 
questions you may have.
    Senator Reed. Thank you very much, Mr. Horne. Thank you 
all, gentlemen, for excellent testimony, and let me begin with 
the comments you made, Dr. Mendelowitz.
    It is very difficult to review objectively your own 
decisions and actions. I think that is a very strong rule in 
every type of human endeavor, and particularly in these 
endeavors. And that argues, I think, strenuously for some type 
of independent agency. You can also factor in that there are 
particular cultures in agencies that obscure--illuminate and 
obscure analysis of data.
    Again, I wonder if you might comment on this issue of 
independence, and I would ask all you gentlemen to do so. Could 
you please turn your microphone on?
    Mr. Mendelowitz. Yes. I have got it. I am a little rusty on 
this. It has been a while since I have been in this hearing 
room as a witness.
    Senator, you have highlighted--there are handfuls of 
critical things associated with the NIF proposal, and 
independence is one of those absolutely essential ones. If 
someone has the control over the purse of the NIF, they are not 
independent. If the NIF were to have to investigate its own 
actions, it certainly could not be unbiased. And so we feel 
very strongly that this is absolutely an essential component, 
and no matter how and where the institute is placed or 
structured, unless it has those absolutely essential 
independent safeguards, it cannot be effective.
    It is one of the reasons why we proposed that the Director 
of the NIF be a Presidential appointee, Senate confirmation, 
with a fixed term so that he or she would not serve at the 
pleasure of the President.
    And it is interesting because not only is this independence 
critical with respect to backward-looking on past decisions, it 
is actually also critical sort of going forward. One of the 
reasons why our proposal includes the fact that the NIF would 
not have any regulatory authority, except to set data standards 
and compel the provision of data, is the fact that if the NIF 
not only had to do the analysis and then act on the analysis, 
its ability to report clearly its findings would be 
compromised.
    The example I like to give is a provision in law that I was 
involved with a number of years ago which requires the Treasury 
Department to make an annual report to the Congress on foreign 
countries that manipulate their exchange rates for trade 
advantage. Now, those of us who at one time or another have 
followed this issue know that over the years a number of 
different countries have clearly manipulated their currencies 
for trade advantage. There is ample evidence. The most obvious 
example currently is the value of the Chinese RMB. And despite 
all the evidence that has been there, I do not believe the 
Treasury Department has ever been able to conclude in a report 
to Congress that any country was manipulating its exchange rate 
for foreign currency advantage.
    With the case of systemic regulation, I have to say that if 
a systemic regulator took the data and analysis and used it 
correctly and acted appropriately, that regulator would only be 
subject to criticism, because if he is successful, if she is 
successful, we would never see the next systemic event because 
it would have been prevented. But the actions of the regulator 
definitely will have taken some profits away from someone and 
slowed down the good times.
    If a systemic regulator--if the NIF had regulatory 
responsibilities, they would reach conclusions, the time would 
come to present the conclusions publicly, and I could just hear 
the sort of wheels turning in the minds of the Director, and he 
or she might say, ``Gee, I do not know. If we release this, I 
act on it, I am going to get a lot of criticism. Let us wait a 
little while and see what happens.''
    So the answer is whether you are looking backward, whether 
you are looking forward, whether you are looking at budget 
issues, whether you are looking at the position of the Director 
of the institute, this issue of independence is central and 
critical to the ability of the institute to do its job.
    Senator Reed. Thank you. Your comments sort of--there is a 
relationship with CBO that has a degree of independence from us 
that sometimes we appreciate and sometimes we disparage.
    [Laughter.]
    Senator Reed. But I believe that Director is appointed for 
a term of 5 years.
    Mr. Mendelowitz. Five years.
    Senator Reed. And serves independent of us. They have 
proven that the last few months rather aggressively.
    I wonder if anyone else has a comment on independence. 
Professor?
    Mr. Liechty. I would be happy to. I will echo what Allan 
has said, what Dr. Mendelowitz has said, about in the 
importance in terms of political pressures that the institute 
is able to act in a way that it feels is in the best interest 
for the country. I have five reasons for being here: Joseph, 
Jacob, Sam, Matt, and Tom, my five boys. I want them to have a 
safe, secure financial system that gives them the same 
opportunity as I had when they grow up and get into the real 
world and start providing for a family.
    I think you need to have somebody who has the ability to 
speak the truth in the middle of a crisis or in the buildup to 
a crisis and can have the protection. There are really two 
roles that you think about in terms of systemic regulation. One 
is advisory, seeing and understanding the risks, and then 
speaking about them. The second one is the actual regulatory 
implementation, the different actions you might take in terms 
of how capital requirements--or how the institutions themselves 
are regulated. And I think it is very important to separate 
those two, and making the National Institute of Finance 
independent would do that.
    A second point that you want to consider in terms of why 
you want to keep the National Institute of Finance independent 
and why you want to also have somebody of high stature involved 
who is a Presidential appointee, who is going to be able to 
serve not at the will of the President but for a fixed term, is 
that if there is a crisis, again, that does happen and the 
National Institute of Finance is in place, all eyes will turn 
to the National Institute of Finance. And it needs to have 
absolute credibility. It needs in some sense to be like the 
National Oceanic and Atmospheric Administration. When it 
speaks, it is not speaking because it has some political agenda 
or because it has to worry about whether its budget is going to 
be cut or not cut. It is speaking because it is trying to serve 
the best interests of the Nation.
    Senator Reed. I want to invite the other panelists to 
comment also, but one other factor that I think strikes me is 
that it goes to your point about surprise, and I thought the 
analogy with the hurricane of 1938 was--I will borrow it. It 
seems very compelling. But part of this was this was never 
seriously discussed at a national level--``this'' meaning the 
growing housing bubble, the national characteristics of it, the 
growing derivatives trade from a notional value of X to 200X. 
And as a result, it sort of got lost in the shuffle, and I 
think one of the purposes of having an agency like this is to 
get critical topics on the agenda of Congress and the 
regulators. Then it is our responsibility. But if you do not 
have an authoritative institution supported by data doing that, 
then the problem I think you will have is that the next time it 
will be something different. It will not be a housing bubble 
and subprime mortgages. It will be something we are not even 
thinking about, and it will come up. Regulators will talk about 
it. I am sure the Fed debated internally about the housing 
bubble. I am sure that the OCC and everybody did. But it never 
broke through because there was no one tasked with saying this 
is a serious systemic risk or should be considered at least at 
this juncture as such. So that is my two bits on the point.
    Dr. Engle, please, and then Mr. Horne.
    Mr. Engle. Well, I was just going to say I think an 
independent NIF would be very effective, but I think it could 
also be effective if it is within a systemic regulator, housed 
within a systemic regulator, because a systemic regulator has 
exactly the same target, has the same goals that you have both 
phrased, and it would, therefore, give more of a tool for 
understanding which data series need to be examined, which 
institutions can be ignored for the moment and would have to be 
studied later. Without having that being decided by the NIF 
itself, who would not--since it is responding to multiple 
regulatory inputs but no authority, would not actually be able 
to coordinate those decisions.
    Senator Reed. Thank you.
    Dr. Horne?
    Mr. Horne. Thank you, Senator.
    Senator Reed. Go ahead.
    Mr. Horne. I appreciate it. Well, I think the words come to 
my mind, and it is probably words you have been hearing often 
over the past few months in particular, and those are the words 
``moral dilemma.'' And I think this is what it is all about, 
and, again, my esteemed panelists here have brought up the 
concept of what I think is a moral dilemma.
    You know, if you are inside of an agency whose job is both 
to support the financial markets in terms of being directly 
involved in assisting them in growing and expanding and at the 
same time regulate them, there is a moral dilemma. If you are 
inside of an institution whose goal is to make as much profit 
as possible and at the same time you want to stick within 
regulatory bounds, you have a moral dilemma.
    So the issue that we have--and I can only speak for my 
company--is our goal is if we do not get the data right, we are 
dead in the water because people will stop buying our data. So 
our moral dilemma is getting the facts correct, and there is no 
dilemma. We either get it right or we get it wrong. And if we 
get it wrong, we are not in business very long.
    So part of the issue that I have is that I do believe that 
there is a need for an independent agency inside of the 
Government to deal with these issues without having to face the 
moral dilemma. I believe that there are issues that have to be 
faced by Congress, and it is going to take a little while for 
that to gel and come together. In the meanwhile, I do not think 
you can go and continue moving forward with the state of the 
economy as it is and the current what I call systemic bubbles 
that are occurring all across the country to continue to occur 
without having the information necessary to at least in the 
short term provide information above where you currently are 
today. And you are in very many cases at a point of stone 
chisels and knives, I might say, from a data standpoint, 
turning it into information in comparison to where the 
commercial market is and the commercial sector is in terms of 
managing their own information, although I have to say many of 
these companies, as was mentioned earlier, that I know of 
personally--because I worked with them in building some of 
these systems or trying to build some of these systems--are now 
all of a sudden spending hundreds of million dollars revamping 
their own internal risk management and analytic systems, 
including probably all of the top 20 banking and investment 
firm organizations, have incredible plans moving forward for 
building their own infrastructures, which in the long run the 
Government actions relative to what should be done in terms of 
capturing this data will probably improve their capabilities 
and, therefore, improve the trade of information and exchange 
between the two parties.
    But, again, I think you have a long-run situation where you 
need to get away from the moral dilemma. I think you have a 
short-run situation which is you have got to get the 
information in the hands of the people who can do something 
about it sooner rather than later, because there are other 
bubbles on the horizon that could pop, and unless you know that 
they are happening, unless you understand them, unless you 
address them, and unless you spend less money than just 
throwing it at the whole market, you spend it at the 
appropriate places, you are going to have greater pushback from 
the taxpayer in terms of being able to have the tools in your 
possession to be able to do the things that you want to do.
    Senator Reed. Thank you. Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank each 
of you for outstanding testimony. There is something very 
appealing about the presentation which is--and we thank you for 
spending so much time in our personal office talking about it. 
I know Senator Reed feels the same way, I am sure. And then 
there is a piece of it that is almost kind of an eerie feeling. 
On the other hand, it is sort of the chaos of the market system 
and the companies you are talking about, Mr. Horne, investing 
that money to figure out ways of getting a tenth--just a little 
tenth of a point off, and they are taking advantage of 
anomalies that exist to make money, and I mean that in a 
positive way, OK? And then, on the other hand, we are talking 
about Professor Liechty creating models, if you will. You talk 
a little bit about NOAA, and NOAA is an interesting analogy 
except that NOAA is sort of talking about what is going to 
happen with the weather, and there is nothing you can do about 
it. I mean, it is just going to happen.
    On the other hand, you are talking about setting up models 
to keep anomalies or huge systemic risk occurrences from 
happening, and I guess how do you, when you are designing these 
models, keep yourself from sort of interfering from this chaos 
that can be positive or actually sort of creating self-
fulfilling prophecies in some ways by virtue of the modeling 
that you set up?
    Mr. Liechty. That is an excellent question. It really is, 
because it comes to the heart of--this analogy does break down 
when you start thinking about the financial system because it 
is not a bunch of pressure systems and equations that you can 
model. It is just much more complicated than that. It is a 
game, really, is what you are thinking about, a very large-
scale game.
    And I think if you borrow from the general scientific 
tradition, the first thing that you try to do in science is 
understand and explain. The second thing you try to do is 
predict. And then, finally, you see if you can have any level 
of control. It is kind of this progressive improvement that 
happens in your ability to gain scientific knowledge and 
understanding about a system.
    I am not sure how far we can go in terms of that path. I 
really--I am not certain because we haven't gone down that path 
in the research sense. But I think there are a lot of things 
you can borrow because it is a game, and if we begin to study 
it from a number of different perspectives and build a 
competing set of models.
    I want to just kind of echo what Governor Tarullo said and 
what Professor Engle said, is that you really do want--even to 
have this independent, you do want to have multiple people 
contributing to it. You can take, for example, kind of the 
hurricane modeling approach. There is not one model that is 
used to model hurricanes. When they start looking at 
hurricanes, they use a collection of competing models that then 
give them a multiple set of perspectives about how that 
hurricane is approaching and the impact.
    Now, would we potentially impact--I mean, would the 
National Institute of Finance or a systemic regulator 
potentially impact the path of the economy if they interceded 
in certain ways? That is a very hard question for me to answer. 
I am not sure. But I do believe that we can start to find 
answers to those kind of questions if we set up this kind of 
analysis. And we can at least, if we do no more than we do with 
the weather and begin to understand when there are really 
serious risks, when we learn how to potentially prepare 
ourselves better for those type of events that are occurring, 
then I think we will have made important progress in this 
arena.
    Senator Corker. If you are setting up models, though, to 
try to ensure that a systemic risk does not occur and 
information is being made public, do you not automatically in 
some ways affect the economy or affect at least financial 
markets? I mean, how can you not do that if that information is 
being made public? It seems that is self-evident that that is 
going to occur.
    Mr. Liechty. Well, I think that for the large--when people 
approach the financial markets, they typically approach from 
the statistical perspective. Even though it is a whole bunch of 
individual agents interacting with each other, it is too 
complicated typically to really model effectively. There are 
some folks at Los Alamos and there is a really big simulation 
study over in Tokyo. I know there are IBMs involved with where 
they are trying to do Asian-based modeling. But typically, you 
have to sit back and look at aggregate summaries and model it 
from that perspective.
    Now, we have a lot of information that is already about the 
financial markets that is widely disseminated and we would be 
talking about adding additional information on top of that.
    I think where you start to begin to have problems or people 
begin to influence is if you have people all doing the same 
type of behaviors, so lots of people are making mortgage-backed 
securities and securitizing them and selling them off to 
pension fund, and there are lots of similar behaviors happening 
and then a shock comes through and everybody has to respond in 
a similar fashion. Then, in some sense, the model collapses 
down to a much simpler system because everyone is forced into a 
corner in the way they are going to have to behave.
    For the most part, I think giving more information and 
trying to model it is not going to have an impact, because I 
don't know that anybody is going to really have the ability to 
nudge the system one way or another. But what you hope you will 
find is when the system gets to a point where there, in 
essence, are bubbles that could be collapsing and what might 
trigger those bubbles, how you respond to that is going to be 
very carefully thought about, and is going to have to be very 
carefully thought about by the systemic regulator and the other 
regulators when they have that information. Do they want to 
talk to banks quietly? Do they want to make a public 
announcement? These are things that you are going to have to 
think very carefully about, and I am not prepared to lay the 
guidelines out right now.
    Senator Corker. So you are not really thinking about 
creating a world full of elevator music or anything. We would 
still have some degree of chaos in the marketplace.
    Mr. Liechty. Yes, sir. It would be very complicated.
    Senator Corker. OK. Professor Engle, it sounds like you 
want to respond to this, and you are welcome to do that, but 
you also mentioned about making information available. Just for 
laymen like myself that obviously are at a whole different 
level as far as mathematic modeling and all that, what would 
be--for other Senators who might be tuned in, staffs or 
whatever--what would be the first three pieces of public 
information you think that might come out of an institute like 
this that would be helpful for people to know?
    Mr. Engle. Well, I think what I was going to say before is 
also related to this. The systemic regulator is going to have 
to use the incentives in the marketplace to achieve his goals. 
He is not going to be able to just legislate one thing or 
another, and our use of capital standards, capital controls, 
are ways of trying to nudge the institutions to take less risk 
or change their behavior in one way or another. Systemic taxes 
are very much designed to encourage institutions who have 
systemic risk to avoid the taxes by shedding the systemic risk 
if you can define and devise the systemic tax in exactly that 
way.
    The reason I think that making data public is useful is 
quite easily seen in the OTC derivatives market, where every 
time you enter a contract, you have a counterparty. And this 
counterparty has a risk that they will not perform. If the 
derivative turns out to have the value you want it to, then 
your counterparty may not perform.
    So we have to consider there being these extra risks, and 
it is very hard to assess the risk that your counterparty is 
going to be there if you don't know very much about what the 
counterparty is doing. So if we had more information on the 
health of counterparties, in other words, how much exposure 
they had to these same kinds of contracts, then the prices of 
the same deal with two different counterparties might not be 
the same. There would be a risk premium and you could decide 
whether you wanted to take the weak counterparty or the strong 
counterparty and you would get a different price in those 
contracts.
    That way, you would understand what risks you were taking 
and the weak counterparties would not be able to amass big 
positions. The poster child for this example is AIG, who, of 
course, wrote lots of credit default swaps but didn't have 
enough capital behind it, and investment bankers and final 
users bought a great deal of these contracts and insurance 
products without recognizing that actually they should have 
gotten a big discount on getting them because they weren't 
really so likely to pay off because AIG had such a big 
position.
    So if you could make public information on a basis which 
said, for each counterparty, how exposed is this counterparty--
how many positions does this counterparty have maybe a week ago 
on these kinds of contracts? This would give the market a way 
of evaluating the risk that they were taking with each 
counterparty. I think it would also encourage trades to move 
toward exchanges or centralized counterparty where you might 
not have to produce this information.
    So I think that the transparency has a dual role in this 
case. It would encourage the migration of products to 
centralized clearing, which is something that we think would 
reduce systemic risk, and it would allow investors to 
understand the risks and price the risks they are taking better 
and thereby both of these would reduce systemic risk.
    Senator Corker. Professor Liechty, I have two more 
questions.
    Senator Reed. Go right ahead.
    Senator Corker. Professor Liechty, how long would it take--
you know, we talked a little bit about this in the office, but 
let us say something like this became law in the summer of 
2010. How long would it take before an entity like this was at 
least providing some of the basic information, not data, but 
information that would be useful to someone who is looking at 
systemic risk or other prudential regulators?
    Mr. Liechty. Sure. I am not an expert in this, but I have 
spoken to a number of folks who built up large institutions and 
teams of this nature. It does speak to the fact that you really 
want this institution to be an institution of very high 
stature. You want very high-quality individuals in this. To the 
extent you can build a world-class institution, it works in 
favor, I think, of all of us in the economy.
    The way you would start out, of course, is you would take 
existing data that is in the marketplace that you can find, 
pull together many of the ways that Steve is talking about, and 
augment that potentially with other types of reports you could 
require from the banks that would be fairly straightforward. I 
believe within 18 months to 2 years, you would be able to put 
together some preliminary, rudimentary maps of the entire 
system. You would be able to start seeing things like 
aggregation, some of the really simple low-hanging fruit. 
Everybody is heading in the same way in a trade, or someone has 
got outstanding positions that are really too large for that 
institution, like the AIG example.
    You would then, I believe, move yourself toward integrating 
counterparty information that is in the repositories, DTCC and 
the other clearinghouses, and I would see this being multi-
stage, multi-year. So you would have a focus initially as to 
what can you get from the existing data and what science do we 
need and models do we need to build from that. You might be 
able to borrow from existing models and augment those. And then 
you will have another path, in my view, that would be doing 
longer-term, more sustained research.
    I would imagine that it would probably take somewhere, 6 to 
8 years, in that timeframe, to see yourself walk all the way up 
to the full vision that we would see with a National Institute 
of Finance where you have a very fine-grained view of the 
entire counterparty network and be able to do large-scale 
simulations to understand how different types of shocks to the 
economy might work through that network and where the critical 
points of that network are and how they might have cascading 
failures or where you might see liquidity crises occur.
    But I would envision within 8, potentially 10 years, you 
would see a fully functioning institute, and certainly along 
the line you would see some very valuable information come out 
within shorter timeframes.
    Senator Corker. Thank you very much, and go ahead, Mr. 
Horne.
    Mr. Horne. Yes, Senator, if I may add, I think the 
difference between what we are talking about here is mostly the 
fact that the NIF, I think--and again, this is my opinion, I am 
not going to speak on their behalf--but they are really talking 
about building a very structured approach toward managing risk, 
standing back and building models that can take all different 
sorts of views and all sorts of different looks at this problem 
and over periods of time be able to ascertain how to best 
approach these problems from an academic and regulatory 
approach.
    What we are trying to do, which is a little different, in 
the short-term and hopefully becomes a foundation or platform 
for what eventually the NIF is trying to do, and I don't know 
if the two pieces will ultimately fit together, but I do 
believe that we are extensible where that is a possibility, is 
that the data that is available right now today is capable of 
being integrated into a platform where regulators can start 
looking at the governance rules that are in place today and 
start figuring out, just as compensation analysts do, just as 
people who have to deal with the same problems.
    If you think about a compensation analyst inside of a large 
corporation, you have a huge sales force that is saying, OK, I 
am going to try to break every rule I possibly can so I can 
make the most money I possibly can, and I am not concerned 
about profit because it is not built into my compensation. 
Well, some portion of their compensation ends up having profit 
built into it. Then they say, well, wait a minute. I am not 
responsible for all the mechanisms that drive my product, so 
therefore maybe I shouldn't be responsible for profit. So you 
start getting into all these different types of analogies of 
how you should compensate people and how you should incent 
people to move forward.
    Well, the same issue is true in the financial markets. This 
moral dilemma that I brought up earlier is the same problem. 
You brought up the issue to Professor Engle about the fact, 
well, couldn't you--or to Professor Liechty--couldn't you 
actually influence what these markets do? And what I am 
thinking is it would be better to use the nearer-term, the 
shorter-term data that we are talking about now to try to help 
with some of the governance and regulatory rules to get people 
on the same path and same direction, and possibly those are 
things looking at specific pieces of law today that, you know, 
may be in conflict with systemic risk.
    The uptick law, for example, and I don't know how familiar 
you all are, but with shorting issues out there, you know, that 
could be a major driver of systemic risk. As a weighted value 
in a model, if you were to take that out and put that in, you 
may find that right off the bat, there is a factor there that 
maybe should be reconsidered relative to law.
    And what I am saying is from a governance perspective, if 
you have the information in the short-term to be able to do 
some of these things, then these models become incredibly 
valuable over time because they start really showing the 
dynamics and the interconnections and all the points of 
potential failure that can exist within the market.
    But in the near term, you have got to use some of the 
information that can be converted out of the data to figure out 
how to manage. And I am not talking about big government. I am 
not a big believer in big government. I am a believer in better 
government and better governance. And what I believe we have 
got right now is a lot of broad-stroke rules that don't allow 
for the surgical precision of attacking the problems where they 
exist. And with this information, you would have the ability to 
do so, and that is the difference between what we have today 
and what we could have.
    And by going through this process of cutting out certain 
things that make no sense whatsoever and maybe putting some 
governance back into the process, we could be on the same page 
so that the institutions and the government and the taxpayer 
are not facing the moral dilemma with each other.
    Senator Corker. I noticed Professor Mendelowitz.
    Mr. Mendelowitz. Thank you. I really would like to go back 
to one of the issues you raised a few minutes back about 
interfering in the market. We rely on markets, in this case 
financial markets, to allocate capital because they do it 
efficiently, and we know from history when other societies have 
tried to rely on command and control systems to do those kind 
of functions, they failed miserably.
    But for financial markets or any other kind of market to do 
its job, which is to allocate scarce resources efficiently, 
there have to be a number of conditions met that make it 
possible for the markets to do that, and as you well know, if 
they are not present, the markets can't.
    The challenge in financial markets is that it is clear, and 
this recent crisis is the most glaring example of it, financial 
markets are prone to the financial equivalent of sudden cardiac 
arrest, and I would like to take credit for that, but it wasn't 
my analogy. It was a professor at MIT who came up with it. And 
that government intervention was needed to deal with this 
equivalent of sudden cardiac arrest.
    Now, maybe extending the analogy is a bit much, but there 
was a time when if you suffered sudden cardiac arrest, there 
wasn't much the medical profession could do for you. Then we 
moved to a stage where there are some sort of dramatic 
interventions at the point of a heart attack. Until now we are 
at the situation where you stave off sudden cardiac arrest with 
long-term care. You take statins to lower cholesterol and 
vulnerability. You are more careful about what you eat. You 
exercise, a little bit healthier lifestyle. And you, in effect, 
are able to reduce the risk of the sudden cardiac arrest.
    What we are talking about with what the NIF can contribute 
is, in fact, the sort of financial market equivalent of a 
healthier lifestyle, to preserve the efficiencies that you get 
out of the financial markets.
    Senator Corker. Thank you very much. I know I have gone on 
for a long time and I am sure you have a number of questions.
    Senator Reed. I don't. If you have additional questions, 
Bob, go ahead, please.
    Senator Corker. I have lots of questions. We spent a great 
deal of time with each of you and I have gotten a chance to 
know you, and I am sure that Courtney and Michael and Arlene 
and others will be talking with you over the course of the next 
week or so.
    I would ask, Mr. Horne, you mentioned you were looking at 
housing in North Carolina and Tennessee. I don't know for what 
reason. Maybe to purchase, I hope.
    [Laughter.]
    Senator Corker. But I wondered if you would tell me why and 
what you found. I wouldn't be a good Senator from Tennessee if 
I didn't ask.
    Mr. Horne. Well, I appreciate that, and I am sorry that I 
didn't put it into the rest of my speech, but I thought just 
putting it out there would bring a question about it.
    We look at leading indicators, and part of the issue that 
we have is that we have to look at these leading indicators 
today manually because they are in separate pieces of--or 
separate systems. So we look at the housing systems that we 
have access to and we have virtually every parcel of land in 
the country identified. And we know those that are in 
foreclosure. We know those that are underwater relative to the 
mortgages. And we understand those that are delinquent on their 
mortgage payments.
    One of the key ratios in North Carolina and Tennessee that 
are leading indicators to us is the 90-day delinquency rate on 
mortgage payments. Relative to the peers--although across the 
country, if you look at the chart, States like Nevada, Arizona, 
Florida have huge market viability from a--or market problems, 
market viability issues from being upside down in their 
mortgages. In Nevada, for example, seven out of ten homes are 
in negative value relative to the mortgages that exist for 
those properties.
    In Tennessee and in North Carolina, you are right around 
the national average. You are about 33 percent of the homes in 
your State and in North Carolina are right around the national 
average. But relative to your peers, the 90-day delinquency 
rate over the last 3 months has increased dramatically, OK. So 
that shows me that there is a leading indicator out there that 
says that people are not able to pay their mortgages. So I 
start with that one.
    Then I look at plant closings and failures and shifts in 
unemployment. Now, it doesn't mean the unemployment rolls 
immediately go up, but it shows me as a leading indicator that 
there is going to be a possibility that the unemployment rolls 
are going to go up. So I start looking at that as a leading 
indicator to unemployment.
    Then I look at bankruptcy and I start looking in the retail 
sector, in particular. And I think you heard from the 
Congressional Oversight Panel, or at least if you were able to 
read any of the report, that commercial failure particularly in 
the retail sector is up, and that is also a leading indicator 
of the potential of people not having available cash because 
they are either temporarily or potentially for long-term 
unemployed and therefore start becoming delinquent on bills 
such as their mortgages.
    We don't have the database built yet, so I can't just run a 
model and 20 seconds later come up with every county or every 
Congressional district in the State of Tennessee and tell you 
exactly what the combination of those factors in that model 
would tell us in terms of the potential for systemic risk or 
failure of any of those given markets. But I can tell you from 
leading indicators that these are pieces of information that 
are telling me that there are potentials for problems out 
there, and particularly the 90-day delinquency risk factor, 
which is one of the ones that we weight relatively heavily 
relative to some of the other factors, is a leading indicator 
that is telling us people are having a difficult time paying 
their bills.
    And so that is why I bring that up and that is why I say in 
those two States, because relative to other States who are in 
the same range of being underwater on their properties, don't 
have the same delinquency rate problems that those two States 
are currently facing.
    Senator Corker. Well, thank you. I almost wish I didn't 
ask, but thank you.
    [Laughter.]
    Mr. Horne. I am sorry.
    Senator Corker. I will say this, though. That example, I 
think, Senator Reed--first of all, I want to thank you again 
for your leadership on this and trying to figure out a solution 
on the derivatives side. I think, though, that answer, 
irrespective of the not-good news that is relayed there, is an 
indication of some of the kinds of data that one might generate 
and could, in fact, be useful, even though I know you are 
looking at different types of financial instruments. I 
appreciate that explanation and I thank you so much for your 
generosity of time, Senator.
    Senator Reed. Certainly, Senator. Thank you for your 
leadership on this and so many other issues involved in banking 
and other challenges facing the country.
    I don't want to ask any more questions about specific 
localities, Mr. Horne.
    [Laughter.]
    Senator Reed. I don't mean to be disrespectful, but given 
your access to all this data, when did you and your colleagues 
first get the sense that there was a national housing problem?
    Mr. Horne. I have known that there has been a national 
housing problem since the first time that our partners--we have 
over 900 data partners that we work with. One of our largest 
data partners is First American CoreLogic, which is the largest 
collector of deed, tax, and mortgage roll property information 
in the country. So when I started analyzing their data and 
combining it with Dow Jones information about the individual 
market segments and the tremendous volumes--I mean, we collect 
terabytes and terabytes of information--and start looking at 
the various factors that we call trigger events--these are 
things that occur that show an action taking place that is 
either positive or potentially adverse actions--we saw this 
occurring, frankly, before 2007. We actually saw the bubble 
before the bubble and could tell some of these things were 
starting to happen.
    The problem, again, is this is macro data. When they roll 
it up and look at it, they usually look at it within the 
housing market, within the specific segment of the database 
that they have, and we haven't brought it together with our 
unemployment findings, with our bankruptcy findings, with our 
commercial real estate information to separate it from the 
residential real estate information. And this disaggregation of 
information in these individual silos prevent us from being 
able to do, except through very extensive manual efforts, the 
ability to bring this data together in a way so we actually can 
build real models on the symbiosis, the systemic issues that 
are occurring between all these different factors in the 
marketplace.
    The systemic issues that occur within an institution and 
institutions, which I think we are talking about here, between 
the majors, the Citicorps, the JPMorgans, the AIGs, are 
extensive and we understand that they are very complex and the 
counterparty risks there are very difficult to track, 
particularly if you don't have access to all of the other 
pieces of information.
    Now, we have large amounts of information regarding 
derivative data, regarding all sorts of different kinds of 
financial instruments, but it is only segments of the market. 
We don't have all of it because not all of it is available, 
even in public or private data. So part of the issue here is 
the investment that needs to be done to actually build the 
database.
    Senator Reed. Well, I don't--we have taken a great deal of 
your time and it has been extremely valuable, so thank you. But 
I don't sense there is a mutually exclusive sort of agenda 
here. I think we are talking about the same thing, which is 
building in the short term an information gathering and an 
analytical capability that will help us, but in the longer 
term, getting to the point where it is just not prediction, 
there might be even some treatment involved, which is the point 
you made.
    Dr. Mendelowitz, a final point.
    Mr. Mendelowitz. Yes, Senator. This discussion about the 
housing bubble, I think, gives us an insight into what the need 
for the NIF is. While Steve said back in 2007 he saw it, those 
of you--but basically 5 years ago, I started predicting a major 
credit event in the housing sector that was going to push the 
economy into the worst recession since the Second World War, 
and it was really just based upon looking at relatively small 
data sets that went to what was happening to housing prices, 
what was happening to household income, and what was happening 
on the delinquency and default rate on mortgages, all of which 
was readily available data.
    So it was easy to predict a major credit event in housing 
and it was easy to predict, because of the widespread nature of 
home ownership, that this was going to lead to a recession that 
was going to be driven by falling consumption. That was the 
easy piece of it.
    Now we are saying the fact the Fed didn't see it, because 
they were using the standard monetarist model, and if you can't 
see something with the monetarist model, you don't see it.
    But what I didn't see and couldn't see and couldn't 
understand was how what was happening in the housing sector was 
going to lead to the collapse in the financial sector. And it 
is the kind of data that we are talking about the NIF 
collecting that would provide that insight, and there is no 
substitute for that. There is no alternative. There is no 
shortcut. Because at the end of the day, you have to know where 
the concentrations of risks are and you have to know what the 
nature of the intertwined network of financial firms and their 
obligations are, because it is the combination of 
concentrations of risk and the exposure of the network that can 
produce a domino effect of multiple failures that creates a 
systemic risk.
    And so it is one thing to see a macroeconomic crisis tied 
to something like housing. It is something entirely different--
the data needs are entirely different when it comes to 
understanding the systemic risk that flows from those 
concentrations of risk.
    Senator Reed. I want to thank you all for excellent 
testimony, thought provoking, and also for your advancing this 
issue. I think we leave here with, one, we need better data. We 
need better analysis. And if we don't achieve it in the next 
several months, the bubbles that might be out there 
percolating, if that is the right term, will once again catch 
us by surprise and we shouldn't let that happen. But thank you 
all very, very much. Thank you.
    Mr. Mendelowitz. Thank you.
    Mr. Horne. Thank you, Senator.
    Senator Reed. The hearing is adjourned.
    [Whereupon, at 4:33 p.m., the hearing was adjourned.]
                PREPARED STATEMENT OF CHAIRMAN EVAN BAYH
Pre-Opening Remarks
    Good morning. I am pleased to call to order this Subcommittee for a 
hearing entitled ``Equipping Financial Regulators with the Tools 
Necessary to Monitor Systemic Risk.'' I want to thank the Ranking 
Member, Senator Corker, and his staff, for requesting this hearing on 
an issue that may seem technical to some, but will prove critical as we 
work to reform and modernize our regulatory structure for the future.
    I would also like to welcome and thank Senator Jack Reed. He has 
been instrumental on the technical and analytic aspects of systemic 
risk regulation, specifically on the proposal of a National Institute 
of Finance. I am happy to continue the dialog he has already begun on 
how we equip our regulators to move beyond examining individual 
institutions and toward monitoring and managing systemic risk across 
our financial system.
    To our witnesses that will appear on two separate panels, welcome 
and thank you for appearing before the subcommittee to give an outline 
on regulators' current capabilities to collect and analyze financial 
market data; and most importantly, what additional resources and 
capabilities are necessary to provide effective systemic risk 
regulation. I understand that the weather in Washington the last few 
days has not been ideal, so I appreciate the dedication you have all 
show in making it here today.
    Before we turn to Governor Tarullo, I would like to make a few 
remarks on why this issue is essential to the safety and soundness of 
our financial system moving forward.
Opening Statement
    Over a year ago, our country experienced a financial crisis that 
exposed the complexity and interconnectedness of our financial system 
and markets. The globalization of financial services and the increasing 
size and intricacy of major market players enabled the buildup and 
transferring of risk that was not fully recognized or understood by our 
regulators, or, in some cases, by the institutions themselves. These 
vulnerabilities made it clear to policymakers here in Washington that 
our financial system, as whole, needs its own overseer. As a result, 
systemic risk regulation has become a central part of our efforts to 
modernize our financial regulatory system.
    Creating a new regulatory structure to monitor systemic risk is no 
easy task. My colleagues here in the Banking Committee, including 
Chairman Dodd, Senators Corker, Reed and Warner have been working 
diligently to determine what tools and technical capabilities may be 
necessary for the regulation of systemic financial risk. To that end, 
the National Research Council held a workshop in November at the 
request of Senator Reed to identify the major technical challenges to 
building that capacity. While it is clear that our regulatory system 
currently lacks the technical resources to monitor and manage risk with 
sufficient sophistication and comprehensiveness, we should figure out 
what capabilities our regulators currently have. That involves 
assessing what data and analytical tools are currently available to 
regulators to collect real-time, consistent market data. We have 
Governor Tarullo here to discuss what data and analytical methodologies 
prudential regulators currently have in place to see real-time 
financial market data and how our current financial regulators 
collaborate in aggregating and analyzing data.
    Next, we can focus on the biggest challenge of this exercise--
determining what further capabilities are necessary, as well as 
identifying the barriers and challenges to meeting the goals of 
systemic risk regulation. This involves much more than aggregating 
information, but making sure we are filling the information gaps, 
asking the right questions, and putting that information into the 
broader context of the risk dynamics in the system. Currently, risk 
analysis has developed solely to manage firm-specific risks. That 
approach needs to evolve beyond the individual institution, and work to 
include the complex interaction and linkages amongst the system to 
assemble a holistic perspective.
    In debating the capabilities needed, the next obvious question 
centers on developing the right infrastructure for the enhanced data 
aggregation, mathematical modeling and all the other issues that go 
into systemic risk regulation.
    An idea that has the support of six Nobel Laureates, including 
Professor Engle who is on our second panel this afternoon, is the 
creation of a National Institute of Finance. Supported by the Committee 
to Establish the National Institute of Finance, this proposal urges the 
creation of an independent institute to collect and standardize the 
reporting of financial market data, as well as develop tools for 
measuring and monitoring systemic risk. On February 4th, my colleague 
Senator Reed introduced legislation to create such an institute. We 
have some of the founders of that Committee with us today to outline 
what they envision in the creation of an independent NIF.
    I am also open to other ideas, including whether or not a separate 
additional agency is necessary or if these new technical capabilities 
can be housed in an existing independent Federal agency, such as the 
Federal Reserve. I look forward to hearing our witnesses' perspective 
on this issue, as well.
    Lastly, in a discussion on systemic risk and data aggregation, we 
would be remiss to ignore the international implications to our 
domestic systemic risk regulation. As I've said before, we live in an 
interconnected global economy, and as we've seen, that means 
interconnected global problems. Vulnerabilities and gaps in financial 
markets abroad, can impact us here at home. A key element of this 
discussion should focus on how we encourage global financial market 
reporting, aggregating and analytic capabilities, as well as 
identifying any legal or legislative barriers to international data 
sharing.
    Ultimately, all of us here know our country cannot afford another 
financial crisis that will have a devastating impact on household 
wealth, unemployment and our economy, at large. While seemingly 
technical in nature, these issues are critical to our national interest 
and necessary to strengthen and provide credibility to our financial 
system. I look forward to working with my colleagues to ensure these 
issues are addressed in our comprehensive regulatory reform bill.
                                 ______
                                 
                PREPARED STATEMENT OF DANIEL K. TARULLO
        Member, Board of Governors of the Federal Reserve System
                           February 12, 2010
    Chairman Bayh, Ranking Member Corker, and other members of the 
Committee, thank you for inviting me to testify today. I also want to 
thank all of you for taking the time to explore a subject that is 
easily overlooked in the public debate around financial reform, but 
that will be central to ensuring a more stable financial system in the 
future.
    The recent financial crisis revealed important gaps in data 
collection and systematic analysis of institutions and markets. 
Remedies to fill those gaps are critical for monitoring systemic risk 
and for enhanced supervision of systemically important financial 
institutions, which are in turn necessary to decrease the chances of 
such a serious crisis occurring in the future. The Federal Reserve 
believes that the goals of agency action and legislative change should 
be (1) to ensure that supervisory agencies have access to high-quality 
and timely data that are organized and standardized so as to enhance 
their regulatory missions, and (2) to make such data available in 
appropriately usable form to other government agencies and private 
analysts so that they can conduct their own analyses and raise their 
own concerns about financial trends and developments.
    In my testimony this morning I will first review the data 
collection and analysis activities of the Federal Reserve that are 
relevant to systemic risk monitoring and explain why we believe 
additional data should be collected by regulatory authorities with 
responsibility for financial stability. Next I will set forth some 
principles that we believe should guide efforts to achieve the two 
goals I have just noted. Finally, I will describe current impediments 
to these goals and suggest some factors for the Congress to consider as 
it evaluates potential legislation to improve the monitoring and 
containment of systemic risk.
The Federal Reserve and Macro-Prudential Supervision
    The Federal Reserve has considerable experience in data collection 
and reporting in connection with its regulation and supervision of 
financial institutions, monetary policy deliberations, and lender-of-
last-resort responsibilities. The Federal Reserve has made large 
investments in quantitative and qualitative analysis of the U.S. 
economy, financial markets, and financial institutions. The Federal 
Reserve also has recently initiated some new data collection and 
analytical efforts as it has responded to the crisis and in 
anticipation of new financial and economic developments.
    For supervision of the largest institutions, new quantitative 
efforts have been started to better measure counterparty credit risk 
and interconnectedness, market risk sensitivities, and funding and 
liquidity. The focus of these efforts is not only on risks to 
individual firms, but also on concentrations of risk that may arise 
through common exposures or sensitivity to common shocks. For example, 
additional loan-level data on bank exposures to syndicated corporate 
loans are now being collected in a systematic manner that will allow 
for more timely and consistent measurement of individual bank and 
systemic exposures to these sectors. In addition, detailed data 
obtained from firms' risk-management systems allow supervisors to 
examine concentration risk and interconnectedness. Specifically, 
supervisors are aggregating, where possible, the banks' largest 
exposures to other banks, nonbank financial institutions, and corporate 
borrowers, which could be used to reveal large exposures to individual 
borrowers that the banks have in common or to assess the credit impact 
of a failure of a large bank on other large banks. Additional time and 
experience with these data will allow us to assess the approach's 
ability to signal adverse events, and together they will be a critical 
input to designing a more robust and consistent reporting system.
     Furthermore, we are collecting data on banks' trading and 
securitization risk exposures as part of an ongoing, internationally 
coordinated effort to improve regulatory capital standards in these 
areas. Moreover, analysis of liquidity risk now incorporates more 
explicitly the possibility of marketwide shocks to liquidity. This 
effort also is an example of the importance of context and the need to 
understand the firms' internal risk models and risk-management systems 
in designing data collection requirements. Data that only capture a set 
of positions would not be sufficient since positions would not 
incorporate behavioral assumptions about firms, based on information 
about firms' business models and practices.
    The Federal Reserve's responsibilities for monetary policy are also 
relevant for systemic risk monitoring. Systemic risk involves the 
potential for financial crises to result in substantial adverse effects 
on economic activity. As the nation's central bank, the Federal Reserve 
assesses and forecasts the U.S. and global economies using a wide 
variety of data and analytical tools, some based on specific sectors 
and others on large-scale models. In the wake of the crisis, research 
has been expanded to better understand the channels from the financial 
sector to the real economy. For example, building on lessons from the 
recent crisis, the Federal Reserve added questions to the Survey of 
Professional Forecasters to elicit from private-sector forecasters 
their subjective probabilities of forecasts of key macroeconomic 
variables, which provides to us, and to the public, better assessments 
of the likelihood of severe macroeconomic outcomes.
    The Federal Reserve has made substantial investments in data and 
analytical staff for financial market monitoring. Each day, the Trading 
Desk at the Federal Reserve Bank of New York analyzes and internally 
distributes reports on market developments, focusing on those markets 
where prices and volumes are changing rapidly, where news or policy is 
having a major effect, or where there are special policy concerns. 
Those analyses begin with quantitative data, supplemented with 
information obtained through conversations with market participants and 
reviews of other analyses available in the market. Over the past few 
years, the Desk has worked closely with our research staff in 
developing new quantitative tools and new data sources.
    This ongoing monitoring requires continual evaluation of new data 
sources and analytical tools to develop new data as new markets and 
practices develop. For example, information on market volumes and 
prices can be collected from new trading platforms and brokers, data on 
instruments such as credit default swaps, or CDS, are provided by 
vendors or market participants, and fresh insights are gained from new 
methods of extracting information from options data. In some cases, 
publication of data by the private sector may be mandated by 
legislation (such as, potentially, trade data from over-the-counter 
derivatives trade repositories); in other cases, the Federal Reserve or 
other government agencies or regulators require or encourage the 
gathering and publication of data.
    Our experiences with supervision, monetary policy, and financial 
market monitoring suggest that market data gathering and market 
oversight responsibilities must continuously inform one another. In 
addition, efforts to identify stresses in the system are not a matter 
of running a single model or focusing on a single risk. Rather, it is 
the assembly of many types of analysis in a systematic fashion. The 
Supervisory Capital Assessment Program (SCAP) for large financial 
institutions--popularly known as the ``stress test'' when it was 
conducted early last year--illustrates the importance of combining 
analysis by credit experts, forecasts and scenario design by 
macroeconomists, and hands-on judgments by supervisors in assessing the 
financial condition and potential vulnerabilities of large financial 
institutions.
    While considerable steps have been made in the wake of the 
financial crisis, the Federal Reserve intends to do a good deal more. 
The Federal Reserve also will continue to strengthen and expand its 
supervisory capabilities with a macroprudential approach by drawing on 
its considerable data reporting, gathering, and analytical capabilities 
across many disciplines. In the areas in which we are collecting data 
through the supervisory process on measures of interlinkages and common 
exposures among the largest financial firms we supervise, we are 
developing new analytical tools that may lead us to change our 
information requests from supervised firms. The Federal Reserve is 
exploring how to develop analytically sophisticated measures of 
leverage and better measures of maturity transformation from 
information that we can collect from the supervised firms in the 
supervisory process and from other available data and analysis. We 
envision developing a robust set of key indicators of emerging risk 
concentrations and market stresses that would both supplement existing 
supervisory techniques and assist in the early identification of early 
trends that may have systemic significance and bear further inquiry. 
This kind of approach will require data that are produced more 
frequently than the often quarterly data gathered in regulatory 
reports, although not necessarily real-time or intraday, and reported 
soon after the fact, without the current, often long, reporting lags. 
These efforts will need to actively seek international cooperation as 
financial firms increasingly operate globally.
The Potential Benefits of Additional Data
    Improved data are essential for monitoring systemic risk and for 
implementing a macroprudential approach to supervision. The financial 
crisis highlighted the existence of interlinkages across financial 
institutions and between financial institutions and markets. Credit 
risks were amplified by leverage and the high degree of maturity 
transformation, especially outside of traditional commercial banking 
institutions. Moreover, supervision traditionally has tended to focus 
on the validity of regulated firms' private risk-management systems, 
which did not easily allow comparisons and aggregation across firms.
    One key feature of the recent crisis was the heavy reliance on 
short-term sources of funds to purchase long-term assets, which led to 
a poor match between the maturity structure of the firms' assets and 
liabilities. Such maturity transformation is inherently fragile and 
leaves institutions and entire markets susceptible to runs. Indeed, a 
regulatory, supervisory, and insurance framework was created during the 
Great Depression to counter this problem at depository institutions. 
However, in recent years a significant amount of maturity 
transformation took place outside the traditional banking system--in 
the so-called shadow banking system--through the use of commercial 
paper, repurchase agreements, and other instruments. Our ability to 
monitor the size and extent of maturity transformation has been 
hampered by the lack of high-quality and consistent data on these 
activities. Better data on the sources and uses of maturity 
transformation outside of supervised banking organizations would 
greatly aid macroprudential supervision and systemic risk regulation.
    Another feature of the recent crisis was the extensive use of 
leverage, often in conjunction with maturity transformation. The 
consequences of this combination were dramatic. When doubts arose about 
the quality of the assets on shadow banking system balance sheets, a 
classic adverse feedback loop ensued in which lenders were increasingly 
unwilling to roll over the short-term debt that was used as funding. 
Liquidity-constrained institutions were forced to sell assets at 
increasingly distressed prices, which accelerated margin calls for 
leveraged actors and amplified mark-to-market losses for all holders of 
the assets, including regulated firms. Here, too, government regulators 
and supervisors had insufficient data to determine the degree and 
location of leverage in the financial system.
    More generally, the crisis revealed that regulators, supervisors, 
and market participants could not fully measure the extent to which 
financial institutions and markets were linked. A critical lesson from 
this crisis is that supervisors and investors need to be able to more 
quickly evaluate the potential effects, for example, of the possible 
failure of a specific institution on other large firms through 
counterparty credit channels; financial markets; payment, clearing, and 
settlement arrangements; and reliance on common sources of short-term 
funding.
    A better system of data collection and aggregation would have 
manifold benefits, particularly if the data are shared appropriately 
among financial regulators and with a systemic risk council if one is 
created. It would enable regulators and a council to assess and compare 
risks across firms, markets, and products. It would improve risk 
management by firms themselves by requiring standardized and efficient 
collection of relevant financial information. It also would enhance the 
ability of the government to wind down systemically important firms in 
a prompt and orderly fashion by providing policymakers a clearer view 
of the potential impacts of different resolution options on the broader 
financial system.
    Additional benefits would result from making data public to the 
degree consistent with protecting firm-specific proprietary and 
supervisory information. Investors and analysts would have a more 
complete picture of individual firms' strengths and vulnerabilities, 
thereby contributing to better market discipline. Other government 
agencies, academics, and additional interested parties would be able to 
conduct their own analyses of financial system developments and 
identify possible emerging stresses and risks in financial markets.
    One area in which better information is particularly important is 
the web of connections among financial institutions though channels 
such as interbank lending, securities lending, repurchase agreements, 
and derivatives contracts. Regulators also need more and better data on 
the links among institutions through third-party sponsors, liquidity 
providers, credit-support providers, and market makers. Knowledge of 
such network linkages is a necessary first step to improve analysis of 
how shocks to institutions and markets can propagate through the 
financial system.
Principles for Developing a System of Effective Data and Analytical 
        Tools
    Moving from the recognition of the need for more data to an 
efficient data system is not an easy task. Data collection entails 
costs in collection, organization, and utilization for government 
agencies, reporting market participants, and other interested parties. 
Tradeoffs may need to be faced where, for example, a particular type of 
information would be very costly to collect and would have only limited 
benefits. The Internet and other applications of information 
technologies have made us all too aware of the potential for 
information overload, a circumstance in which relevant information is 
theoretically available, but the time and expense of retrieving it or 
transforming it into a usable form make it unhelpful in practical 
terms. Collection of more data just for its own sake also can raise 
systemic costs associated with moral hazard if investors view data 
collection from certain firms, products, and markets as suggesting 
implicit support. It is thus particularly worth emphasizing the 
importance of having data available readily and in a form that is 
appropriate for the uses to which it will be put. With these 
considerations in mind, we have derived a number of guiding principles 
for a system of new data and analytical tools for effectively 
supervising large institutions and monitoring systemic risk.
    First, the priorities for new data efforts should be determined by 
the nature of regulatory and supervisory missions. In particular, the 
data need to be sufficiently timely and to cover a sufficient range of 
financial institutions, markets, instruments, and transactions to 
support effective systemic risk monitoring and macroprudential 
supervision, as well as traditional safety-and-soundness regulation. 
The events of the past few years have painfully demonstrated that 
regulators, financial institutions, and investors lacked ready access 
to data that would have allowed them to fully assess the value of 
complex securities, understand counterparty risks, or identify 
concentrations of exposures.
    The data needed for systemic risk monitoring and supervision are 
not necessarily ``real-time'' market data--information about trades and 
transactions that can be reported at high frequency when the events 
occur--but certainly data would need to be ``timely.'' What is 
considered to be ``timely'' will depend on its purpose, and decisions 
about how timely the data should be should not ignore the costs of 
collecting and making the data usable. For many supervisory needs, 
real-time data would be impractical to collect and analyze in a 
meaningful way and unnecessary. For example, while supervisors may 
indeed need to be able to quickly value the balance sheets of 
systemically important financial institutions, very frequent updates as 
transactions occur and market prices change could lead to more 
volatility in values than fundamental conditions would indicate and 
would be extraordinarily expensive to provide and maintain. Certainly, 
real-time data could be needed for regulators responsible for 
monitoring market functioning, and daily data would be helpful to 
measure end-of-day payment settlements and risk positions among the 
largest firms. But for supervising market participants, real-time 
market data could require enormous investments by regulators, 
institutions, and investors in order to be usable while yielding little 
net benefit. As policymakers consider redesign of a system of data 
collection, the goal should be data that are timely and best suited to 
the mission at hand.
    A second principle is that data collection be user-driven. That is, 
data on particular markets and institutions should be collected 
whenever possible by the regulators who ultimately are responsible for 
the safety and soundness of the institutions or for the functioning of 
those markets. Regulators with supervisory responsibilities for 
particular financial firms and markets are more likely to understand 
the relevance of particular forms of standardized data for risk 
management and supervisory oversight. For example, supervisors 
regularly evaluate the ability of individual firms' own risk measures, 
such as internal ratings for loans, and of liquidity and counterparty 
credit risks, to signal potential problems. As a result, these 
supervisors have the expertise needed to develop new reporting 
requirements that would be standardized across firms and could be 
aggregated.
    Third, greater standardization of data than exists today is 
required. Standardized reporting to regulators in a way that allows 
aggregation for effective monitoring and analysis is imperative. In 
addition, the data collection effort itself should encourage the use of 
common reporting systems across institutions, markets, and investors, 
which would generally enhance efficiency and transparency. Even 
seemingly simple changes, such as requiring the use of a standardized 
unique identifier for institutions (or instruments), would make 
surveillance and reporting substantially more efficient.
    Fourth, the data collected and the associated reporting standards 
and protocols should enable better risk management by the institutions 
themselves and foster greater market discipline by investors. 
Currently, because the underlying data in firms' risk-management 
systems are incomplete or are maintained in nonstandardized proprietary 
formats, compiling industry-wide data on counterparty credit risk or 
common exposures is a challenge for both firms and supervisors. 
Further, institutions and investors cannot easily construct fairly 
basic measures of common risks across firms because they may not 
disclose sufficient information. In some cases, such as disclosure of 
characteristics of underlying mortgages in a securitized pool, more 
complete and interoperable data collection systems could enhance market 
discipline by allowing investors to better assess the risks of the 
securities without compromising proprietary information of the lending 
institution.
    Fifth, data collection must be nimble, flexible, and statistically 
coherent. With the rapid pace of financial innovation, a risky new 
asset class can grow from a minor issue to a significant threat faster 
than government agencies have traditionally been able to revise 
reporting requirements. For example, collateralized debt obligations 
based on asset-backed securities grew from a specialized niche product 
to the largest source of funding for asset-backed securities in just a 
few years. Regulators, then, should have the authority to collect 
information promptly when needed, even when such collections would 
require responses from a broad range of institutions or markets, some 
of which may not be regulated or supervised. In addition, processes for 
information collection must meet high standards for reliability, 
coherence, and representativeness.
    Sixth, data collection and aggregation by regulatory agencies must 
be accompanied by a process for making the data available to as great a 
degree as possible to fellow regulators, other government entities, and 
the public. There will, of course, be a need to protect proprietary and 
supervisory information, particularly where specific firm-based data 
are at issue. But the presumption should be in favor of making 
information widely available.
    Finally, any data collection and analysis effort must be attentive 
to its international dimensions and must seek appropriate participation 
from regulators in other nations, especially those with major financial 
centers. Financial activities and risk exposures are increasingly 
globalized. A system without a common detailed taxonomy for securities 
and counterparties and comparable requirements for reporting across 
countries would make assembling a meaningful picture of the exposures 
of global institutions very difficult. Efforts to improve data 
collection are already under way in the European Union, by the Bank of 
England and the Financial Services Authority, and the European Central 
Bank, which has expressed support for developing a unified 
international system of taxonomy and reporting. The Financial Stability 
Board, at the request of the G-20, is initiating an international 
effort to develop a common reporting template and a process to share 
information on common exposures and linkages between systemically 
important global financial institutions.
Barriers to Effective Data Collection for Analysis
    Legislation will be needed to improve the ability of regulatory 
agencies to collect the necessary data to support effective supervision 
and systemic risk monitoring. Restrictions designed to balance the 
costs and benefits of data collection and analysis have not kept pace 
with rapid changes in the financial system. The financial system is 
likely to continue to change rapidly, and both regulators and market 
participants need the capacity to keep pace.
    Regulators have been hampered by a lack of authority to collect and 
analyze information from unregulated entities. But the recent financial 
crisis illustrated that substantial risks from leverage and maturity 
transformation were outside of regulated financial firms. In addition, 
much of the Federal Reserve's collection of data is based on voluntary 
participation. For example, survey data on lending terms and standards 
at commercial banks, lending by finance companies, and transactions in 
the commercial paper market rely on the cooperation of the surveyed 
entities. Moreover, as we have suggested, the data collection authority 
of financial regulators over the firms they supervise should be 
expanded to encompass macroprudential considerations. The ability of 
regulators to collect information should similarly be expanded to 
include the ability to gather market data necessary for monitoring 
systemic risks. Doing so would better enable regulators to monitor and 
assess potential systemic risks arising directly from the firms or 
markets under their supervision or from the interaction of these firms 
or markets with other components of the financial system.
    The Paperwork Reduction Act also can at times impede timely and 
robust data collection. The act generally requires that public notice 
be provided, and approval of the Office of Management and Budget (OMB) 
be obtained, before any information requirement is applied to more than 
nine entities. Over the years, the act's requirement for OMB approval 
for information collection activity involving more than nine entities 
has discouraged agencies from undertaking many initiatives and can 
delay the collection of important information in a financial crisis. 
For example, even a series of informal meetings with more than nine 
entities designed to learn about emerging developments in markets may 
be subject to the requirements of the act. While the principle of 
minimizing the burdens imposed on private parties is an important one, 
the Congress should consider amending the act to allow the financial 
supervisory agencies to obtain the data necessary for financial 
stability in a timely manner when needed. One proposed action would be 
to increase the number of entities from which information can be 
collected without triggering the act; another would be to permit 
special data requests of the systemically important institutions could 
be conducted more quickly and flexibly.
    The global nature of capital markets seriously limits the extent to 
which one country acting alone can organize information on financial 
markets. Many large institutions have foreign subsidiaries that take 
financial positions in coordination with the parent. Accordingly, 
strong cooperative arrangements among domestic and foreign authorities, 
supported by an appropriate statutory framework, are needed to enable 
appropriate sharing of information among relevant authorities. Strong 
cooperation will not be a panacea, however, as legal and other 
restrictions on data sharing differ from one jurisdiction to the next, 
and it is unlikely that all such restrictions can be overcome. But 
cooperation and legislation to facilitate sharing with foreign 
authorities appears to be the best available strategy.
    Significant practical barriers also exist that can, at times, limit 
the quality of data collection and analysis available to support 
effective supervision and regulation, which include barriers to sharing 
data that arise from policies designed to protect privacy. For example, 
some private-sector databases and bank's loan books include firms' tax 
identification (ID) numbers as identifiers. Mapping those ID numbers 
into various characteristics, such as broad geographic location or 
taxable income measures, can be important for effective analysis and 
can be done in a way that does not threaten privacy. However, as a 
practical matter, a firm may have multiple ID numbers or they may have 
changed, but the Internal Revenue Service usually cannot share the 
information needed to validate a match between the firm and the ID 
number, even under arrangements designed to protect the confidentiality 
of the taxpayer information obtained.
    In addition, a significant amount of financial information is 
collected by private-sector vendors seeking to profit from the sale of 
data. These vendors have invested in expertise and in the quality of 
data in order to meet the needs of their customers, and the Federal 
Reserve is a purchaser of some of these data. However, vendors often 
place strong limitations on the sharing of such data with anyone, 
including among Federal agencies, and on the manner in which such data 
may be used. They also create systems with private identifiers for 
securities and firms or proprietary formats that do not make it easy to 
link with other systems. Surely it is important that voluntary 
contributors of data be able to protect their interests, and that the 
investments and intellectual property of firms be protected. But the 
net effect has been a noncompatible web of data that is much less 
useful, and much more expensive, to both the private and the public 
sector, than it might otherwise be.
    Protecting privacy and private-sector property rights clearly are 
important policy objectives; they are important considerations in the 
Federal Reserve's current data collection and safeguarding. Protecting 
the economy from systemic risk and promoting the safety and soundness 
of financial institutions also are important public objectives. The key 
issue is whether the current set of rules appropriately balances these 
interests. In light of the importance of the various interests 
involved, the Congress should consider initiating a process through 
which the parties of interest may exchange views and develop potential 
policy options for the Congress's consideration.
Organization Structure for Data Collection and Developing Analytical 
        Tools
    In addition to balancing the costs and benefits of enhanced data 
and analytical tools, the Congress must determine the appropriate 
organizational form for data collection and development of analytical 
tools. Budget costs, production efficiencies, and the costs of 
separating data collection and analysis from decisionmaking are 
important considerations. Any proposed form of organization should 
facilitate effective data sharing. It also should increase the 
availability of data, including aggregated supervisory data as 
appropriate, to market participants and experts so that they can serve 
the useful role of providing independent perspectives on risks in the 
financial system.
    The current arrangement, in which different agencies collect and 
analyze data, cooperating in cases where a consensus exists among them, 
can certainly be improved. The most desirable feature of collection and 
analysis under the existing setup is that it satisfies the principle 
that data collection and analysis should serve the end users, the 
regulatory agencies. Each of the existing agencies collects some data 
from entities it regulates or supervises, using its expertise to decide 
what to collect under its existing authorities and how to analyze it. 
Moreover, the agencies seek to achieve cost efficiencies and to reduce 
burdens on the private sector by cooperating in some data collection. 
An example is the Consolidated Reports of Condition and Income, or Call 
Reports, collected by the bank regulatory agencies from both national 
and state-chartered commercial banks. The content of the reporting 
forms is coordinated by the Federal Financial Institutions Examination 
Council, which includes representatives of both state and Federal bank 
regulatory agencies.
    A standalone independent data collection and analysis agency might 
be more nimble than the current setup because it would not have to 
reach consensus with other agencies. It might also have the advantage 
of fostering an overall assessment of financial data needs for all 
governmental purposes.
    However, there would also be some substantial disadvantages to 
running comprehensive financial data collection through a separate 
independent agency established for this purpose. A new agency would 
entail additional budget costs because the agency would likely need to 
replicate many of the activities of the regulatory agencies in order to 
determine what data are needed. More importantly, because it would not 
be involved directly in supervision or market monitoring, such an 
agency would be hampered in its ability to understand the types of 
information needed to effectively monitor systemic risks and conduct 
macroprudential supervision. Data collection and analysis are not done 
in a vacuum; an agency's duties will inevitably reflect the priorities, 
experience, and interests of the collecting entity. Even regular arms-
length consultations among agencies might not be effective, because 
detailed appreciation of the regulatory context within which financial 
activities that generate data and risks is needed. The separation of 
data collection and regulation could also dilute accountability if 
supervisors did not have authority to shape the form and scope of 
reporting requirements by regulated entities in accordance with 
supervisory needs.
    An alternative organizational approach would be available if the 
Congress creates a council of financial regulators to monitor systemic 
risks and help coordinate responses to emerging threats, such as that 
contemplated in a number of legislative proposals. Under this approach, 
the supervisory and regulatory agencies would maintain most data 
collection and analysis, with some enhanced authority along the lines I 
have suggested. Coordination would be committed to the council, which 
could also have authority to establish information collection 
requirements beyond those conducted by its member agencies when 
necessary to monitor systemic risk.
    This approach might achieve the benefits of the current arrangement 
and the proposed independent agency, while avoiding their drawbacks. 
The council would be directed to seek to resolve conflicts among the 
agencies in a way that would preserve nimbleness, and it could 
recommend that an agency develop new types of data, but it would leave 
the details of data collection and analysis to the agencies that are 
closest to the relevant firms and markets. And while this council of 
financial supervisors could act independently if needed to collect 
information necessary to monitor the potential buildup of systemic 
risk, it would benefit directly from the knowledge and experience of 
the financial supervisors and regulators represented on the council. 
The council could also have access to the data collected by all its 
agencies and, depending on the staffing decisions, could either 
coordinate or conduct systemic risk analyses.
Conclusion
    Let me close by thanking you once again for your attention to the 
important topic of ensuring the availability of the information 
necessary to monitor emergent systemic risks and establish effective 
macroprudential supervisory oversight. As you know, these tasks will 
not be easy. However, without a well-designed infrastructure of useful 
and timely data and improved analytical tools--which would be expected 
to continue to evolve over time--these tasks will only be more 
difficult. We look forward to continued discussion of these issues and 
to a development of a shared agenda for improving our information 
sources. I would be happy to answer any questions you might have.
                                 ______
                                 
            PREPARED STATEMENT OF ALLAN I. MENDELOWITZ, Ph.D
              Founding Member, the Committee to Establish 
                   the National Institute of Finance
                 PREPARED STATEMENT OF JOHN C. LIECHTY
            Associate Professor of Marketing and Statistics,
                 Smeal College of Business, Penn State
      University, and Founding Member, the Committee to Establish 
                   the National Institute of Finance
                           February 12, 2010

   Providing Financial Regulators with the Data and Tools Needed to 
                     Safeguard Our Financial System

    Mr. Chairman and Member of the Subcommittee:

    We thank you for the opportunity to appear before you on behalf of 
the Committee to Establish the National Institute of Finance (CE-NIF). 
The primary objective of the CE-NIF is to seek the passage of 
legislation to create a National Institute of Finance (NIF). In our 
testimony today we would like to provide the reasons why we see this as 
an urgent national need and the role we see for the proposed National 
Institute of Finance in strengthening the government's ability to 
effectively regulate financial institutions and markets and to respond 
to the challenges of systemic risk.
    The CE-NIF is unique. We are a volunteer group of concerned 
citizens brought together by a common view that the Federal Government 
and its financial regulators lack the necessary data and analytical 
capability to effectively monitor and respond to systemic risk and to 
effectively regulate financial firms and markets. The members of the 
CE-NIF consist of individuals from academia, the regulatory agencies, 
and the financial community. We have raised no money to support our 
effort, we represent no vested interests, and we have paid what few 
expenses we have incurred out of our own pockets. We share what we 
believe to be a legislative objective that is critical to the long-term 
well-being and prosperity of our nation.
Lessons of the Credit Crisis: Critical Weaknesses in Financial 
        Regulation Were Revealed
Government Officials Lacked the Data To Understand
The Consequences of Alternative Options
    The events of the most recent financial crisis have laid bare the 
dire consequences that can flow form poorly understood and 
ineffectively regulated financial institutions and markets. In response 
to the crisis, a lot of attention has been paid to how to strengthen 
the legal authorities and organizational structure of the financial 
regulatory community. Unfortunately, far less attention has been paid 
to what data and analytical capability is needed to enable regulators 
to use those new powers effectively. Data and analytics are not the 
stuff of headlines and stump speeches; however, when they are 
deficient, they are the Achilles' heel of financial regulation. 
Unfortunately, we have ample evidence that the recent crisis was due in 
part to a lack of appropriate data and analytic tools. A review of key 
events from the recent crisis makes this point very clear.
    When Lehman Brothers tottered on the brink of bankruptcy in 
September, 2008 government officials were faced with a choice between 
two stark alternatives: save Lehman Brothers and signal to the markets 
and other large and highly inter-connected financial institutions that 
they could count on an implicit government safety net, irrespective of 
how risky their financial excesses might be; or let this large and 
important investment bank go under--reaffirming to the market that 
there are consequences to risky business practices--but run the risk of 
setting off a cascade of bankruptcies and market disruptions.
    Forced to make a quick decision, officials let Lehman go under, a 
decision that sparked a horrifying downward spiral of the financial 
markets and the economy. That decision was based, in part, on the 
belief at Treasury that participants in the financial markets had been 
aware of the problems at Lehman for a number of months and had ample 
time to prepare by limiting their exposure.\1\ Officials did not have 
access to the types of information that would have given them a better 
picture of how interconnected firms and the broader markets were to 
Lehman's fate. The day after the failure, the Reserve Fund--a $64.8 
billion money market fund--`broke the buck' because of its exposure to 
Lehman. That is, its assets were no longer sufficient to support a 
$1.00 value for the price of its shares. This sparked a massive run on 
the $3.5 trillion money market industry and, because of the important 
role that the money market funds play in providing liquidity in the 
commercial paper market (a market for providing short-term corporate 
loans) the $2.2 trillion commercial paper market froze. When the 
broader economy was no longer able to access funding and credit, the 
crisis had become systemic.
---------------------------------------------------------------------------
    \1\ ``The view at Treasury . . . was that Lehman's management had 
been given abundant time to resolve their situation by raising 
additional capital or selling off the firm, and market participants 
were aware of this and had time to prepare.'' Phillip L. Swagel--
Assistant Secretary for Economic Policy at the U.S. Treasury during 
crisis--Brookings Papers March, 2009.
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    Whether the government could have done a better job of responding 
to that challenge or foreseen the catastrophic fallout of the Lehman 
decision is an open question. The point that is clear, however, is that 
at this critical moment in time they did not have the data needed to 
fully understand the counterparty relationships linking Lehman to the 
system, nor did they have in place the capacity to analyze such data to 
form a clear picture of the consequences of the alternatives they 
faced. Simply put, at this critical juncture, government officials were 
flying blind.
    Unfortunately, this lack of data was representative of the problems 
the government faced in understanding what was going on across the 
breadth of the market. At the very same time that Secretary of the 
Treasury was grappling with the problems at Lehman, he learned for the 
first time the extent of the problems at AIG caused by the excessively 
large concentration of Credit Default Swaps (CDSs) on the books of 
AIG's Financial Products unit. AIG had written $441 billion in CDSs--
linked to Private Label Mortgage Backed Securities (PLMBSs). Those 
PLMBSs were rapidly becoming the `Toxic Assets' of this crisis and 
falling in value, sharply increasing the value of AGI's obligation to 
make good on those CDSs. Officials were apprised of the scale of the 
problem, but they faced two key problems that were evaporating trust in 
the market: the growing uncertainty over how to value these CDS and the 
fact that they had no way of understanding the Domino risks, i.e. the 
risk that the failure of one firm (AIG) would cause a cascade of 
failures throughout the system. Facing these uncertainties, government 
officials felt they had no choice but to provide massive government 
assistance to prevent AIG from failing.
    In addition to being an essential component of measuring and 
monitoring systemic risk, having or not having comprehensive 
counterparty data has important forensic consequences, as well. Bernie 
Madoff ran the largest and most damaging Ponzi scheme in history. He 
reported consistently high earnings based on a purported complex 
trading strategy that made ample use of derivative transactions. He was 
able to perpetrate this very long running fraud, in part, because 
officials did not have good data on the network of counterparties to 
derivative transactions. Madoff's consistently high reported earnings 
raised questions among a few in the financial community, and although 
the SEC investigated several times they found nothing amiss. If they 
would have had access to data on the counterparty network for 
derivative transactions the outcome of those investigations could have 
been very different because Madoff's reported derivatives trades were, 
of course, fictitious. A simple check of the counterparty data would 
have revealed that no one reported being on the other side of Madoff's 
trades, and that they had to be fictitious. That evidence would have 
confirmed the fraud.
Critical Components of Effective Regulation Were ``Outsourced''
    The extent to which the government lacked the necessary data and 
analytical capability to effectively regulate financial institutions 
and markets was hidden from view in some cases because of the extent to 
which the government has in effect outsourced critical regulatory 
capabilities.
    Some of that outsourcing enabled the creation of the toxic assets 
that became a central part of the crisis. When these private label 
subprime mortgage backed securities were initially issued, large 
tranches were rated triple-A or double-A by private rating agencies. 
Rating these securities and advising issuers on how to qualify for the 
desired rates was a large and profitable business for the rating 
agencies. These rating received the blessing of the financial 
regulators and that made it easy for investment and commercial banks to 
sell many ultimately troubled asses to highly regulated financial firms 
(such as insured depositories, insurance companies, pension funds, 
Federal Home Loan Banks, Fannie Mae and Freddie Mac).
    Comptroller of the Currency John Dugan in a speech in 2008 alluded 
to this outsourcing of responsibilities to the rating agencies. ``In a 
world of risk-based supervision,'' he said, ``supervisors pay 
proportionally more attention to the instruments that appear to present 
the greatest risk, which typically does not include triple-A-rated 
securities.'' In other words, the regulators were relying on the rating 
agencies to determine what ``appear(s) to present the greatest risk.''
    The transformation of these assets from triple-A rated to Toxic 
Assets started when rising delinquencies and defaults in the underlying 
subprime mortgages forced the rating agencies to downgrade many of 
those securities. Those downgrades raised questions in the market about 
the credit quality of a whole range of structured investment products. 
However, in many, if not most, cases market participants lacked the 
ability to see through these complicated structured financial products 
to the underlying collateral and only a handful of market participants 
had the sophistication to allow them to independently assess their 
value and inherent riskiness.
    When the financial markets crashed and the major surviving 
financial firms teetered on the brink the Federal Government had to 
determine whether these firms were adequately capitalized. However, 
neither the Treasury nor the regulatory agencies were able to make such 
determinations completely on their own because they lacked the 
necessary data and analytical capacity to do so. The government turned 
to the banks themselves to do the assessments. Although the bank's 
systems were not designed to anticipate domino risks and deal with the 
lack of market liquidity, they were the best that was available. The 
Treasury posited a few economic stress scenarios and instructed the 
regulated banks to assess how they would fare under those scenarios. 
The banks were then to report the results of their analyses back to the 
Treasury and their regulators.
    It is an ironic twist that the regulators had to rely on the same 
models that were employed to manage banks' exposure to risk during the 
run-up to the crisis in order to perform this analysis. Of course, 
banks should have the capability to perform such analysis; it is part 
and parcel of competent corporate management and governance. However, 
this crisis demonstrates the importance of having a regulatory 
community that is capable of generating independent assessments of the 
credit quality of a security or the safety and soundness of a bank, 
market or the financial system that they regulate.
Systemic Risk: the Whole is Greater Than the Sum of the Parts
    The capital markets exist to move capital from less efficient uses 
to more efficient uses. The capacity of the markets to intermediate 
risk and provide for these flows of capital was seriously threatened in 
the recent crisis, and there are several alternative ways of trying to 
prevent another crisis that are being looked at. One prevailing line of 
thinking is that systemic risk can be managed by identifying a 
relatively small number of systemically important institutions and 
regulating them especially well. There are critical conceptual errors 
in this thinking. When it comes to systemic risk, the whole is greater 
than the sum of the parts. Even if there were no large, systemically 
important institutions, there would still be the risk of systemic 
failure. A couple of representative examples follow, along with the 
identification of the type of data needed to monitor and respond to 
systemic risk related to these examples.
    Systemic risk may arise as a consequence of the way financial firms 
are tightly linked to one another by multiple complex contractual 
relationships. For example, when LTCM teetered on the brink of failure 
in 1998 the government organized a group of large financial 
institutions to step in and provide sufficient capital to prevent that 
failure. One investment bank, whose exposure to LTCM was about $100 
million, was asked to contribute more than $150 million to support 
LTCM. As a narrowly defined business proposition it does not make much 
sense to put $150 million at risk to try to protect an exposure of $100 
million. This was especially true when that institution could have 
withstood the loss of the $100 million without impacting its ability to 
continue operating. Why did they do it? Although a $100 million loss 
would not have caused that firm's failure, they did not know how 
exposed their other major trading partners were to LCTM. If one or more 
of their major counterparties failed as a result of their exposure to 
LTCM, they could have been dragged down as well. Financial regulators 
need detailed counterparty data to monitor the domino risks that comes 
from connectedness.
    Systemic risk may arise from excessively large concentrations of 
risk on the books of a financial institution or a group of firms. 
Concentrations in and of themselves are not necessarily a systemic 
risk. However, the interplay between concentrations and connectedness 
can create systemic risk. In this crisis the best example was the 
dangerously large concentration of CDSs on the books of AIG's Financial 
Products unit. Investors in Private Label Mortgage Backed Securities 
(PLMBS) turned to the CDS market to lower the credit risk of their 
investments. Issuers of PLMBS entered into CDS transactions to raise 
the credit ratings of the securities they were issuing. AIG aggregated 
that market-wide risk on their balance sheet by writing $441 billion of 
CDS contracts against the risk of loss associated in those PLMBS, 
without hedging that risk or having sufficient assets in reserve to 
cover the losses that developed. To stave off the consequences of a 
failure to those already fragile firms doing business with AIG, the 
Federal Government committed to put almost $200 billion in capital into 
AIG. Financial regulators need market-wide position data to monitor the 
buildup of systemic risk that may flow from such concentrations.
What We Do Know About the Next Systemic Financial Crises
    No matter how much we improve the government's ability to 
understand and remediate systemic risk, that risk cannot be reduced to 
zero. Therefore, we must prepare for the next financial crises. And, in 
that regard, there are several things that we do know:

    The first is that while there may be some similarities with 
        previous crises and lessons to be learned from them, the cause 
        of tomorrow's crisis will likely be different than yesterday's 
        crisis.

    The second is that you cannot prepare for tomorrow's crisis 
        by simply collecting the data and building the models you 
        needed to understand yesterday's crisis. You must cast a 
        broader net.

    The third is that when a new crisis begins to unfold it 
        will be too late to try to collect the additional data, build 
        the analytics, and undertake the research needed to make better 
        regulatory and policy decisions. Policy makers and regulators 
        will be stuck using the data and the analytics that they have 
        at hand to try to develop the best policy response.
The National Institute of Finance: An Essential Response
    Most of the debate related to regulatory reform has focused on 
altering the regulatory organizational structure and providing 
regulators with new legal authorities. Very little attention has 
focused on providing the capacities (data, analytic tools and sustained 
research) needed to be able to measure and monitor systemic risk and 
correct the current deficiencies in regulatory capabilities. In order 
to address these weaknesses we propose the creation of a National 
Institute of Finance (NIF). The NIF would have the mandate to collect 
the data and develop the analytic tools needed to measure and 
understand systemic risk, and to strengthen the government's ability to 
effectively regulate financial institutions and markets. In addition, 
the NIF would provide a common resource for the entire regulatory 
community and the Congress.
Key Components and Authorities
    The NIF would be an independent resource supporting the financial 
regulatory agencies. It would not be a regulatory agency itself. The 
only regulatory authority it would have would be to provide reference 
data, set data reporting standards, and compel the provision of data. 
The NIF would have two key organizational components: the Federal 
Financial Data Center (Data Center) and the Federal Financial Research 
and Analysis Center (Research Center). The Research Center would have 
the responsibility to build analytics, and sponsor and perform 
research. Last, the NIF would be funded by a direct assessment on the 
firms required to report to it.
    The Data Center will collect and mange transaction and position 
data for (1) U.S. based entities (including for example, banks, broker-
dealers, hedge funds, insurance companies, investment advisors, private 
equity funds and other highly leveraged financial entities) and their 
affiliates; and (2) U.S.-based financial transactions conducted by non-
U.S. based entities. In order to carry out this responsibility, the 
Data Center will develop and maintain standards for reporting 
transaction and position data, including the development and 
maintenance of reference databases of legal entity identifiers and 
financial products. It will also establish the format and structure for 
reporting individual transactions and positions. It will collect, 
clean, and maintain transaction and position data in secure databases. 
It will provide regulators access to the data, and it will provide 
public access to aggregated and/or delayed data to improve market 
transparency--providing no business confidential information is 
compromised. Keeping this data secure will be an important 
responsibility of the Data Center. In this regard, the Federal 
Government has a long-standing and excellent track record in 
maintaining the security of all kinds of very sensitive data, including 
financial, military, intelligence, tax and census data and the NIF 
would adhere to the same data security standards used for existing 
secure data centers.
    The Research Center will develop metrics to measure and monitor 
systemic risk and continually monitor, investigate and report on 
changes in system-wide risk levels. In addition, the Research Center 
will develop the capacity to assess the financial condition of large 
financial institutions and assess their capital adequacy in stress 
scenarios. The Research Center will be responsible for conducting, 
coordinating and sponsoring the long-term research needed to support 
systemic risk regulation. The Research Center will provide advice on 
the financial system and policies related to systemic risk. In 
addition, it will undertake assessments of financial disruptions in 
order to determine their causes, and make recommendations for 
appropriate regulatory and legislative action in response to those 
findings.
    An Independent Voice: It is critical that the NIF have the ability 
and responsibility to report its findings in a fully independent 
manner. Because the NIF does not have any financial regulatory 
authority, per se, its objectivity will not be diminished by a conflict 
of interest that could arise if it had to report on its own regulatory 
actions. In addition, it is structured in a way that helps insulate it 
from political pressures. This structure plays a key role in assuring 
that the NIF will offer its very best unbiased assessments of the risks 
facing the financial system and the broader economy, as well as its 
best unbiased recommendations for responding to those risks.
    Funding from Assessments: The NIF will be funded by assessments on 
reporting institutions. This method of funding is used by financial 
regulatory agencies and is appropriate for several reasons. First, the 
financial sector will benefit from an annual reduction in operating 
cost of tens of billions of dollars as a result of the standardization 
of data and reporting. Having the beneficiaries of these cost savings 
use some of those savings to fund the NIF is the fair thing to do. In 
addition, like the financial regulatory agencies, the use of industry 
assessments will make it possible for the NIF to pay salaries that are 
above the standard civil service pay scale and better enable the NIF to 
attract the highly skilled staff it will need to fulfill its 
responsibilities.
Benefits of Establishing a National Institute of Finance
    Establishing a National Institute of Finance will bring substantial 
benefits to our financial system and the broader economy. The 
fundamental benefits of the NIF are many.
    It will improve the efficiency and effectiveness of financial 
regulation. The Institute will provide regulators with the ability to 
independently assess the safety and soundness of a bank, market or the 
financial system, stopping the outsourcing of critical capacity to 
banks and rating agencies. It will investigate market disruptions and 
conduct the fundamental research needed to improve regulation of 
financial institutions and markets. It will also ensure that these 
findings and advances are integrated into the systemic risk monitoring 
systems. In addition it will provide an invaluable resource for the 
analysis of proposed regulatory policy and monitoring of existing 
policy to help refine and strengthen the overall approach to 
regulation.
    It will reduce the likelihood of systemic crises and costly 
institutional failures. As the NIF develops models and metrics for 
systemic risk and collects the appropriate data, it will be able to 
provide a better understanding of system-wide aggregation, of the level 
of liquidity in the system, and gain a better understanding of 
potential for liquidity failures and fire sales, which are part of the 
early warning stages of a systemic failure. When it is fully mature, 
the NIF will have the ability to see through the entire counterparty 
network, allowing it to quantify Domino risks--the risk of a cascading 
failure that might result from the failure of other financial 
entities--and identify critical nodes in the counterparty network. 
Along with market participants, it will also have the ability to see 
through complex structured products down to the underlying collateral 
(e.g. loans or mortgages providing the cash-flows)--helping improve 
transparency and avoiding the rise of new types of toxic assets that 
could trigger a future crisis.
    It would create a safer and more competitive market. By helping 
improve individual firm risk management and providing better tools to 
the regulators to monitor and oversee systemic risk, the U.S. financial 
markets will be made safer, and will attract more business than 
competitors that are more prone to major shocks or collapses during 
times of economic stress.
    In addition, the NIF would actually benefit the U.S. financial 
services industry, as well.
    It would reduce operating costs. Standardizing data reporting will 
dramatically reduce back office costs (costs associated with verifying 
details of trades with counter parties) and costs associated with 
maintaining reference databases (legal entity and financial instrument 
databases). Morgan Stanley estimates that implementation of the NIF 
will result in 20 percent to 30 percent savings in operational costs.
    It would facilitate risk management. By requiring daily reporting 
of all positions to the NIF, firms will be able to present a complete 
picture of their positions to their own internal risk management 
groups. This will in turn ensure that senior management has a 
consistent and clear understanding of the firm's exposures--
particularly their exposure to different counterparties during times of 
economic stress.
Conclusion
    The Federal Government has responded to a number of threats to our 
national well-being by organizing major research and monitoring 
efforts. The threat of natural disasters led to the creation of the 
National Oceanic and Atmospheric Administration, containing the 
National Weather Service and National Hurricane Center, whose skill in 
forecasting the weather and warning of impending natural disasters has 
saved many lives. The Centers for Disease Control and the National 
Institutes of Health have advanced the state of medical research, 
developed new treatments for deadly diseases, and mobilized to protect 
the population from the threats of pandemics. The nation's national 
security has been greatly advanced by the outgrowth of the sustained 
research programs supported by DARPA.
    When we look at the financial losses suffered by the American 
public and the burden placed on U.S. taxpayers by the government's 
response to this most recent financial crisis, it is fair to ask why we 
have not created a similar sustained research and monitoring effort to 
protect the American people from the high costs of systemic risk and 
financial implosions. The regulatory reform legislation that recently 
passed in the House charges a new Financial Services Oversight Council 
(FSOC) with the task of monitoring systemic risk and provides some new 
legal authorities to intervene in a time of crisis. However, it fails 
to provide the tools necessary to carry out the systemic risk 
monitoring responsibility. That responsibility can only be carried out 
well if the proposed FSOC has a deep understanding of how our financial 
system works. Such an understanding can only be based on access to much 
better system-wide data and the analytic tools needed to turn that data 
into relevant information on systemic risk. This is something that is 
currently beyond the government's capability. Unfortunately, as set 
forth in the House bill, the FSOC would have no permanent staff and no 
specific authority to collect the many kinds of system-wide data 
needed. As it stands the FSOC represents little more than a hollow 
promise when it comes to its ability to monitor systemic risk and warm 
of future crises.
    Our nation's financial markets are a public good. The safety of our 
country and the well being of our population depend on well functioning 
financial markets. We have incurred very high costs in this recent 
crisis as a result of the failings of our current approach to 
regulating financial markets and institutions. This approach has relied 
on a fragmented, data poor, regulatory structure that despite its best 
efforts did not have the tools with which to understand and respond to 
the threat presented by systemic risk.
    The Senate has an opportunity to materially strengthen any proposed 
financial regulatory reform legislation by creating a National 
Institute of Finance that will equip regulators and a systemic risk 
regulator with the data and analytical tools needed to correct the 
deficiencies that were made so apparent in this recent crisis. The full 
capabilities of the NIF will take several years to realize, however, 
benefits will ensue from each stage of its development. Although it 
will take time and substantial effort to stand up the National 
Institute of Finance, the benefits should far outweigh the cost.
    Lastly, we were pleased to learn that on February 4, 2010 Sen. Jack 
Reed introduced S. 3005, ``The National Institute of Finance Act of 
2010.'' This act lays out a strong case for the creation of the 
National Institute of Finance. Furthermore, it proposes the creation of 
the NIF in a way that insures its ability to fulfill the role 
envisioned by the CE-NIF. It would have the authority to collect the 
data necessary to monitor systemic risk. It would have the 
responsibility to establish a Research Center that will develop the 
metrics for monitoring systemic risk and to report on its monitoring of 
that risk. It would have the capacity to be a significant resource for 
the regulatory community. It would have the ability to fund itself in a 
way that insures that it will have adequate resources for its important 
mission, and it is structured so that it will be a truly independent 
and technically expert voice on matters relating to the regulation of 
financial institutions and markets and the threats of systemic risk.
    Mr. Chairman and Members of the Subcommittee, this concludes our 
prepared statement. Thank you for the opportunity to present the 
recommendations of the Committee to Establish the National Institute of 
Finance. We will be happy to answer any questions the committee may 
have.
                                 ______
                                 

                  Financial Hurricanes Will Come Again

    When the financial hurricane of 2008 made landfall, the regulators 
and policymakers charged with keeping our financial system safe were 
taken by surprise. Although there were some indications of financial 
uncertainty, this financial storm hit with the same unexpected 
suddenness as the New England Hurricane of 1938--which slammed into 
Suffolk County, Long Island, and then continued into Connecticut, Rhode 
Island, Massachusetts, New Hampshire, Vermont and finally Canada. The 
Martha's Vineyard Gazette noted at the time, ``This tragedy was not the 
loss of nearly 10,000 homes and business along the shore. It was the 
psychic destruction of summer for an entire generation.''
    Earlier hurricanes had brought structural responses from the U.S. 
Government. In 1807 the United States Coast and Geodetic Survey was 
established by Thomas Jefferson, a quarter century after the Great 
Hurricane of 1780--the deadliest on record, killing over 27,500 people. 
The Weather Bureau was formed in 1870 under President Ulysses S. Grant 
to gather data on the weather and provide warnings of approaching 
storms. Even though the Weather Bureau was in place, it was not able to 
offer any warning for the Category 4 Hurricane that devastated 
Galveston, Texas on September 8th, 1900. By 1926 reports from sea could 
be delivered with a varying level of reliability, which was part of the 
reason that there were a few hours warning for the Miami Hurricane of 
September 18th, 1929. By the time the New England Hurricane of 1938 
hit, the Weather Bureau had better data and better models. Still, as 
the New York Times observed, ``Except for Charlie Pierce, a junior 
forecaster in the U.S. Weather Bureau who predicted the storm but was 
overruled by the chief forecaster, the Weather Bureau experts and the 
general public never saw it coming''.
    Are our regulators and policymakers any better equipped today than 
the Weather Bureau of 1938? In his opening remarks to the Senate 
Banking Committee on June 18, 2009, Secretary Geithner observed, ``If 
this crisis has taught us anything, it has taught us that risk to our 
system can come from almost any quarter. We must be able to look in 
every corner and across the horizon for dangers, and our system was not 
able to do that.''
    In 1970, President Richard Nixon created the National Oceanic and 
Atmospheric Administration (NOAA), with the mandate to: i) develop data 
collection networks to document natural variability and support 
predictive models, ii) develop new analytical and forecasting tools to 
improve weather services and earlier warnings of natural disasters and 
iii) conduct experiments to understand natural processes. While NOAA's 
real-time data collection and analysis infrastructure are significant 
and continue to bring a range of substantial benefits to society, they 
were made possible largely through the research arm of NOAA--the Office 
of Oceanic and Atmospheric Research (OAR)--with its seven research 
laboratories, six undersea laboratories and a range of research 
partners. Clearly our financial markets are at least as important and 
as complicated as the weather. Why don't we have the equivalent of NOAA 
or OAR for the financial markets?
    The current regulatory reform legislation that was passed in the 
House charges a new Financial Services Oversight Council (FSOC) with 
the task of monitoring systemic risk--watching for future financial 
hurricanes--and provides some new legal authorities to intervene in the 
time of crisis. However, it fails to provide a NOAA type mandate to 
collect system-wide data and build realistic system-wide models, which 
can only be built upon a deep understanding of how our financial system 
works. The FSOC will have no permanent staff and no specific authority 
to collect the many kinds of system-wide data needed. As it stands the 
FSOC represents a hollow promise that will leave us unprepared for the 
financial hurricanes that will surely come.
    The Senate has an opportunity to strengthen the FSOC in their 
version of the legislation by creating a National Institute of Finance 
along the lines of NOAA's key components: providing regulators with 
better data and better models--built on a sustained research effort. 
When it comes to safeguarding our financial system our goals should be 
bold, our expectations realistic and our dedication to the task 
substantial. Although it will take time, the benefits will far outweigh 
the cost, just as they have done with hurricanes.

Richard Foster, Senior Faculty Fellow, Yale School of Management; 
Emeritus Director, McKinsey & Company

John Liechty, Associate Professor, Penn State University; Co-Founder, 
Committee to Establish the National Institute of Finance
                                 ______
                                 
                   PREPARED STATEMENT OF ROBERT ENGLE
            Professor of Finance, Stern School of Business,
                          New York University
                           February 12, 2010
    Good morning, Mr. Chairman and members of the Subcommittee. My name 
is Robert Engle. I am a Professor at the Leonard Stern School of 
Business at New York University. I recently co-authored a report of the 
National Research Council that summarized a workshop on Technical 
Capabilities Needed for the Regulation of Systemic Risk. The Research 
Council is the operating arm of the National Academy of Sciences, 
National Academy of Engineering, and the Institute of Medicine, 
chartered by Congress in 1863 to advise the government on matters of 
science and technology. This workshop and its report were sponsored by 
the Alfred P. Sloan Foundation. After I summarize our report, I would 
like to give you my personal response to the questions posed in your 
letter as well as the pending legislation on the National Institute of 
Finance.

    Key findings of the National Research Council's report are as 
follows:

  1.  With better data and better analytical tools, the participants 
        were confident that we could measure, monitor and ultimately 
        lessen systemic risk.

  2.  Research to accomplish this goal is already underway in academic 
        and regulatory institutions and is being presented in scholarly 
        and practitioner meetings. This research is now primarily based 
        on publicly available market, size and leverage data. The 
        research however has far to go.

  3.  Additional data across asset classes and with counterparty, 
        position, collateral and valuation information would be very 
        helpful. But many participants at our meeting said it was not 
        yet possible to determine which specific data would be needed.

  4.  Compilation and analysis of such data would require 
        standardization and classification that does not yet exist and 
        which would be valuable for the industry as well as for the 
        regulators.

  5.  Data alone will not be sufficient to understand risk, 
        illiquidity, bank runs, bubbles and other features central to 
        assessing systemic risk. These can only be examined within 
        models, and research is needed to develop some of those models 
        and improve others. As Andrew Lo of MIT summarized, systemic 
        regulators need to know the four Ls: leverage, linkages, 
        liquidity and losses.

I request that the full report be attached to my testimony.

    In response to the specific questions and the pending legislation 
on the National Institute of Finance, I would like to make several 
points. These comments are my own, not the National Research Council's. 
I have endorsed the concept of the National Institute of Finance in a 
letter from Harry Markowitz which is also signed by William Sharpe, 
Robert Merton, Myron Scholes, and Vernon Smith, all Nobel Laureates. 
These comments suggest the aspects I find particularly strong or weak 
about the proposal.

    First, let me address the status of data available to regulators.

  6.  Data collection by supervisory agencies takes various forms. Some 
        obtain detailed information in response to specific requests of 
        entities that they supervise, but it is not automatically 
        generated and reported. Because of privacy issues, these data 
        cannot be shared even within a regulatory body or with other 
        regulatory entities. Thus only partial views of all information 
        are available.

  7.  Useful data sets exist within clearing houses, self-regulatory 
        organizations such as DTCC or FINRA and surveillance operations 
        in exchanges or regulators. These data will have positions, and 
        counterparties at a fine level of disaggregation. Upon specific 
        request, regulators have been able to access these data but 
        generally cannot share them.

  8.  Risk reports that summarize major firm risks at a point in time 
        are automatically submitted to supervisory agencies. However, 
        these generally do not have counterparty information, and their 
        information might not be freely available throughout the 
        agency.

  9.  In summary, regulators have access to more data than the public, 
        but the collection is fragmented, discontinuous and possibly 
        quite delayed in time. Improved data availability would enhance 
        all regulatory processes.

    Further comments on the NIF.

  10.  The data collection and aggregation functions of the NIF 
        proposal are staggering. Some aspects are likely to be more 
        important than others. In particular, the OTC contracts are the 
        most complex and have the greatest chance of being systemic. 
        Many of these have substantial counterparty exposure so they 
        are inherently more systemically risky. Thus, collection of OTC 
        position and transaction data could be the most important 
        starting point. Establishment of some standardization and 
        common identifiers for contracts, as noted above, would be an 
        important step for making such data more useful.

  11.  Systemic risk assessment requires selecting entities to monitor 
        and then obtaining data to monitor them. Consequently, a great 
        deal of data on entities that are not risky can be ignored, 
        once the selection is accomplished. This selection process is 
        not completely obvious, because small entities can sometimes 
        pose systemic risks, so it needs to be done through careful 
        analysis and revisited from time to time.

  12.  The independence of the NIF is important in order to insulate it 
        from corporate or government pressures. However, this could be 
        satisfied by an NIF that was embedded within a regulatory 
        agency that was itself independent and had systemic regulatory 
        oversight responsibilities. There could be important cost 
        savings from such embedding as well.

  13.  International collaboration is of great importance. Systemic 
        crises are global and the markets are global, hence regulators 
        that only see domestic positions will miss important features. 
        The NIF should immediately coordinate with relevant 
        international agencies to collaborate on data acquisition and 
        analysis. This coordination is important within the US and it 
        is even more important for the smaller countries and regulators 
        around the globe. Sovereign crises such as those experienced in 
        the past in Ireland, Iceland, Latvia and Hungary and in Greece, 
        Portugal and Spain today emphasize the interlinking of our 
        financial system.

  14.  The security of these data must be ensured. Otherwise, 
        compliance may be difficult to achieve.

  15.  Congress and the NIF should have as a goal making partially 
        aggregated or delayed versions of the OTC data public so that 
        counterparties can better price and manage the risks that they 
        face. Better individual firm risk management contributes to 
        better systemic risk management. Transparency in financial 
        markets is a powerful supplement to regulation.
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                 PREPARED STATEMENT OF STEPHEN C. HORNE
              Vice President, Master Data Management and 
                 Integration Services, Dow Jones & Co.
                           February 12, 2010
    Good morning, Chairman Bayh, Ranking Member Corker and Members of 
the Subcommittee.
    My name is Steve Horne and I am the Vice President of Master Data 
Management for Dow Jones. I have spent over 30 years building complex 
databases, transforming highly complicated data into usable 
information.
    Thank you for inviting me to speak with you today.
    I have testified many times over the past year on the impact of the 
financial meltdown and the need for a comprehensive analytic database 
that is designed to capture the appropriate real-time information 
necessary to prevent waste, fraud and abuse of the TARP program and to 
ensure that the American taxpayer's money is being used as intended.
    Legislation that would create such a database has been introduced 
by Senator Warner, S. 910, with a companion bill that has already 
passed in the House, H.R. 1242, by a vote of 421-0. Both these bills 
have been strongly endorsed by organizations such as the U.S. Chamber 
of Commerce, OMB Watch, and the Center for Democracy in Technology.
    Using the same basic infrastructure of the database that would be 
created under the legislation described above, we at Dow Jones have 
identified over 400 leading indicators that when used together can 
identify potential systemic risk within the financial system and many 
other parts of the economy. The challenge is to combine this disparate 
data into a structured database to be able to make informed judgments 
about the risks.
    Systemic breakdowns that impact individual geographic markets in 
this country are caused by a combination of factors, including 
unemployment, bankruptcy, foreclosures and commercial real estate 
failure.
    For example, in Las Vegas, a huge influx of different socio-
economic groups moved into this market over the past 10 years. One of 
these groups is retirees. When the financial meltdown occurred, these 
Americans were mostly living on fixed incomes: savings, retirement 
investments and their social security. They bought retirement homes 
either with cash or with mortgages that were smaller than many, but 
they still incurred new debt. Over the last 3 years, the income from 
their retirement investments went negative and they have had to dip 
into the principal as the only way for them to gain cash.
    As the foreclosures generally grew around them, retirees saw the 
value of their homes decrease in half as well. Those who had mortgages 
were now upside down, those who did not, saw the major investment they 
had spent a lifetime building dwindle in value.
    Now these senior citizens face a much more difficult situation. 
With a major portion of their principal gone, many cannot afford to 
live on their fixed income and have to go back to work. In Las Vegas, 
16 percent unemployment does not bode well for anyone looking for work. 
If they own their home, new mortgages are very difficult to get. 
Reverse mortgages are not an option because of the reduced availability 
of these programs. The combination of these factors shows the market 
for retirees in Las Vegas is in systemic failure right now.
    This example is known in statistical terminology as the 
``Compounding Effects of Multiple Indices.'' If we can integrate this 
data into an actionable database, regulators can quickly implement 
surgical solutions that will apply the appropriate programs/funds to 
the most serious problems.
    We are currently observing markets in North Carolina and Tennessee 
that are at risk of systemic failure. If the proposed data base were in 
place the government would be in a better position to confirm, quantify 
and tackle these problems proactively.
    Unfortunately, the data is in disparate systems that cannot talk to 
each other. The value of the data base that is proposed in S. 910 is in 
its ability to combine and analyze this data to predict and prevent 
systemic risk. The transformation of this data into actionable 
information is neither easy nor inexpensive. However, the 
implementation of the proposed data base will save significant taxpayer 
dollars in three ways: first, through more efficient targeting of 
resources and serving the areas of greatest need; second, by enabling 
the government to insure that the appropriate actions are taken before 
systemic failure occurs; and, third, by helping prevent waste, fraud, 
and abuse of taxpayer's money.
    The data base proposed should not create additional security 
concerns. The security methodologies under the IPSA Act (Information 
Protection and Security Act of 2009) and the contractual controls for 
the use of commercial data are sufficient to protect this information. 
In addition, language included in H.R. 1242 that passed the House 
provides for even greater protections for non-public data.
    The system being proposed is designed to expand to cover global 
data. Although some of the data from overseas may not be accessible due 
to laws of specific countries, other international data is in better 
shape and can be built into accurate analytic systems because of the 
early adoption of XBRL technology by many countries.
    In summary, the data and technology exist today to equip financial 
regulators with the tools necessary to monitor systemic risk. The only 
thing lacking is government action to make it happen.
    Thank you again, Chairman Bayh, Ranking Member Corker and the 
Members of the Committee for your time and attention. I am happy to 
answer any questions you may have.
                                 ______
                                 
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