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The OFR Should Leverage Existing Regulatory Reports and Focus on Systemic Risk Only, Says the Cluff Fund Report

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Following on from the decision to establish two new US federal bodies to monitor and address systemic risk – the Financial Stability Oversight Council and the Office of Financial Research – as part of the Dodd-Frank Act, the Anthony T Cluff Research Fund has collected together industry opinion on how these two bodies should operate, including important data collection considerations. The industry group, which includes representatives from a number of systemically important US banks, recommends the use of existing regulatory reports to gather the required data for the monitoring of systemic risk and seeks to clarify the remit of this endeavour.

The Cluff Fund indicates that up until this point, “little public discussion” about the operation of the systemic risk bodies has taken place and the report is part of its endeavour to rectify that deficiency. It stresses the need for a set of guiding principles for the new regulatory agencies and the addition of an industry advisory committee to ensure that the dialogue between both parties is continued once the groundwork has been completed. It also suggests a set of metrics that should be adopted by the Office of Financial Research in order to help it “identify activities and practices most likely to contribute to systemic risk”.

The suggested guiding principles for both bodies are largely common sense: balancing the needs of financial stability and economic growth; reflecting the needs of consumers and the economy; focusing on “targeted, material risks from interconnectedness” across the markets; allowing the market a chance to correct itself before regulators step in; and keeping in line with global standards. The last of which is a very important consideration, given the potential imposition of new legal entity and instrument identification standards.

The report asks for further clarification of the term “systemic risk” in order to enable firms to provide the right data to the regulatory bodies in this context and “better allocate resources” to carry out this task. It has been previously noted by industry participants that “systemic risk” may mean different things to different people and therefore such clarity is an important prerequisite to the successful establishment of such bodies.

The Cluff Fund therefore suggests a definition that could potentially be adopted: “Systemic risk is the threat that a material event (whether an unexpected crisis, the failure of proper risk management, or the result of public policies) would result in the failure of either financial markets or a significant number of financial firms and cause significant harm to the US economy because of the interconnections between such markets and firms.”

In terms of data collection considerations, the group is eager for the Office of Financial Research to use existing reports to gather data, rather than imposing a whole raft of new reporting requirements. It notes that the new agency’s powers to gather data are “unlimited” and, as such, it indicates a wariness on the part of the industry with regards to these new powers. As noted recently by Nick Skinner, head of data management strategy at custodian bank Northern Trust, many firms are taking the matter so seriously that they have hired dedicated executives to monitor systemic risk developments.

The group seemingly wants the agency to focus on the goal of monitoring systemic risk, rather than trying to extend its tentacles too far into monitoring individual firms’ data practices. With this in mind, it suggests three data items that should be monitored: “institutional information already collected from financial institutions that could be better leveraged by the Council in a systemic context; other financial market information already available publicly and broad macroeconomic data, which are not reviewed holistically by any single authority; and data on interconnectedness.”

The information that is already being collected by prudential regulators includes items such as credit trends, data on capital adequacy and funding and liquidity data, all of which is already available in a reported format (and hence should be easier to aggregate). Market data that is not currently collected but is publically available includes items such as macroeconomic statistics or credit default swap (CDS) spreads, which, again, should be much easier to aggregate. It is the interconnectedness between firms that will pose the biggest challenge.

The lack of a universally adopted legal entity identification standard is one big sticking point, but it is not something that is detailed within the report. The Cluff Fund suggests that a starting point for this data is via reports provided to primary regulators such as those for counterparty risk reporting, the reporting of long and short positions, and credit ratings information.

The Cluff Fund report is, however, only one part of the dialogue that the regulatory community has been attempting to initiate with the industry regarding the practicalities of systemic risk monitoring. To this end, a request for comment has also recently been posted within the Federal Register about the legal entity identification challenge. The Office of Financial Research has stated its “preference to adopt through rulemaking a universal standard for identifying parties to financial contracts that is established and implemented by private industry and other relevant stakeholders through a consensus process,” and the industry has until the end of January to respond.

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