[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.
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\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.
______
______
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.
______