President Obama recently spoke to Wall Street, addressing the performance of regulators in the financial crisis as “Regulators may have seen the trees but missed the forest”. Similarly, last year then Sec. Paulson, also referencing the tree analogy, said “Our current regulatory regime is almost solely focused above ground, at the tree level. The real threat to market stability is below ground, at the root level.” If we simply replace the metaphor of a tree with the current reality of silos of regulation and silos of financial businesses, then we can begin to understand the problems in ways that will allow us to fix them.
The unseen forest above, President Obama’s analogy, speaks to the lack of both cohesive and timely US and global regulatory oversight. Former Secretary. Paulson’s problem at the roots refers to the inability of regulators to observe the positions and trades of financial institutions, nor aggregate such data for understanding risk exposures across the entire dimension of their interrelated but separate businesses. For that matter neither can they aggregate this data across the many financial firms that report to them periodically within their individual regulatory silos. This is preventing regulators from observing risk concentrations across all products and markets that they trade in. And they certainly cannot do this in any timely fashion across the global dimension of businesses the largest, most systemically important financial institutions operate in.
“Systems underpinning global financial markets are becoming more interconnected in increasingly complex ways.”
US Treasury Secretary Timothy Geithner
History of Systemic Risk in the Financial System
Not surprisingly, observing and mitigating systemic risk has been a long-standing issue, usually dealt with in reaction to a systemic risk event.
The earliest intervention in the modern era was in 1974 when Germany’s Herstatt Bank failed and the global funds payment and settlement systems seized up in reaction to failed institutions and unsettled transactions. In 1979, an undetected cabal lead by the Hunt brothers attempted to corner the global silver market by accumulating claims on over 200 million ounces of silver using separate, undetected accounts across different firms. Systemic risk mitigation took center stage again in 1987 after the near meltdown of the exchange based securities and contract markets in the US cascaded throughout the global financial system. At that time The Group of Thirty, a think tank of leading academics, regulators, central bankers, and financial executives was engaged to study the related issue of systemic risk of unsettled transactions in the increasingly globalized securities market.
“The implementation of reference data standards has proven difficult. With no global owner of reference data and friction between the needs of the domestic and cross-border market users, progress has been slow. Future progress will require greater efforts by market infrastructure operators and international institutions with global reach.”
The Group of Thirty – Final Monitoring Report
Global Clearing & Settlement Committee
Again in 1998, systemic risk nearly brought down the financial system, this time by the failure of a single hedge fund, Long Term Capital Management, whose excesses caused cascading affects on normally unrelated markets. The most recent systemic risk event, the current financial crisis, placed the global financial system at the precipice of total collapse. In response the US Treasury instituted its Supervisory Capital Assessment Program (SCAP). The SCAP data-gathering phase took months to accomplish and deployed 150 supervisory personnel to normalize positions and projections across nineteen US based systemically important financial entities.
The financial crisis that began in 2007 has alerted regulators to the reality that more timely recognition of risk exposures is crucial as toxic financial transactions can cascade undetected through internal business units of a single financial institution, through interrelated but separately regulated markets, and through mostly unregulated payment and settlement systems.
“…it is clear that risk concentrations may arise from interrelated exposures across the risk categories rendering a silo-based approach insufficient as potential concentrations across categories may not be captured”
Cross-sectoral review of group-wide identification and management of risk concentrations
Basel Committee on Banking Supervision
With more transparency being called for, regulators as well as the private sector now recognize that they have for too long constructed their technology infrastructure around proprietary codes and non-standard conventions, preventing the timely aggregation and observation of potential systemic risk exposures. Attention is now focused on both the silo-based business structures and silo regulatory regimes that are at odds with the interconnected and global nature of financial firms. The role non-standard data plays in adding unnecessary risk and higher costs to each financial firm as well as to the financial system overall is now recognized.
“…creating a standard for reference data on securities and issuers, with the aim of making such data available to policy-makers, regulators and the financial industry through an international public infrastructure”
Jean-Claude Trichet, President of the ECB,
A parallel concern is that there are many gaps in the data submitted by financial institutions operating across multiple regulatory regimes. Autonomously-run business units create multiple reporting “silos” of information. Such separate methods of reporting on both financial performance and risk pervade global financial institutions. This separation, while causing data inconsistencies and presenting aggregation issues within the firms themselves, are being perpetuated on a grander scale in reports submitted to sovereign country and regional regulators.
The financial crisis has spawned many proposed public and private sector solutions. However, these solutions fall far short of resolving the data inconsistencies and aggregation issues inherent in regulatory regimes based on such separate “silos” of reporting. One private initiative, an industry sponsored global Central Counterparty for Data Management, is thought best able to solve the data issue, giving regulators systemic risk “seeing” ability across the reporting silos of individual financial institutions as well as across the many silos of information at different regulatory agencies.
Today, there is an oversupply of solutions either proposed or to some degree under way to organize the systemic-risk data-gathering exercise across firms and among regulators. The ultimate aim is to observe financial transactions in a common automated context so that risk can be analyzed more frequently without the manual labor that such efforts now require.
However, all of these efforts are interjecting more complexity, more overlap, more government involvement and ownership, more standards that are not global standards, a whole new generation of non standard data tags, and more silo based, redundant accumulations of identifying data, and financial transaction and position data.
“Regulatory reform needs to be addressed as a single package, not piecemeal”
Secretary Timothy Geithner
Testimony before the House Financial Services Committee
July 23, 2009
These current efforts can be thought of as analogous to the early initiatives undertaken when the internet, previously owned by the government, had not yet evolved into the World Wide Web. Then it was thought that in order to get at information efficiently, centralized “super sites” were needed to aggregate this information. These early efforts did not anticipate the evolving distributed nature of information storage on the internet and the standardization of browser and coding technologies. Nor did it anticipate the global acceptance of standard messaging protocols and centralized issuance of Web addresses, enabling search engines and, in turn, universal, real-time access to locally stored information.
The Case for a Simple Solution
Like the Internet, the financial industry needs a nudge from its regulators to rally around a single solution – a global data standard and the mechanism to assign, maintain and distribute standard and assured identifying data sets. Such standards allowed the evolution of disconnected data networks into what has become a seem-less World Wide Web. This is the solution that had been anticipated by the Group of Thirty for the financial industry in its technology equivalent, the globally communications network we call the financial system.
Like our manufacturing and retail sectors, efficiency and auditability was created when the universal bar code and the Electronic Data Interchange (EDI) standards were developed. We can track a tainted Tylenol capsule back to its manufacturing process and find the source of tainted cows’ meat across the globe. However, we couldn’t find the mortgage that was being defaulted on in Peoria that was in the toxic Collateralized Debt Obligation on the balance sheet of a failing bank in Australia.
Remedies are simple to postulate, a global systemic regulator having the ability to both gather and then aggregate data in a time frame that more closely relates to the real-time nature in which financial transactions accumulate risk exposures. The regulatory framework is already in place. The G20, overseer of the only global financial regime to date, the Basel Capital Accords, has already chartered a Financial Stability Board to regulate global systemic risk. What is now needed is this body to prod the industry to organize itself around universal standards of its equivalent of product and counterparty bar codes and supply chain electronic data interchange standards; centralize its administration and distribution in a Central Counterparty for Data Management repository, a long sought goal that seems finally to have been forced into being by the financial crisis, and thereby provide the auditability of financial transactions to see the forest, from the trees, at its roots.
Maintaining the momentum for permanent change is what our leaders have pledged and what is required if we are to overcome the prospect of another financial crisis. There is no excuse for not fixing the problems we already know about.
Allan D. Grody is the pPresident of Financial InterGroup Advisors, a founding board member of the Journal of Risk Management in Financial Institutions, the founding partner of Coopers & Lybrand’s (now PWC’s) Financial Services Practice, and a retired adjunct professor at NYU’s Stern Graduate School of Business where he founded their Risk Management Systems course.