Financial System's Risk Navigator Still Has Blind Spots

The Office of Financial Research's latest annual report highlights a number of improvements in its measurement of systemic risk but stops well short of providing a forward-looking assessment of emerging risks.

The rollout of the office's Financial Stability Monitor provides a glimpse of how this tool will one day be valuable to the Financial Stability Oversight Council in mitigating potential sources of systemic risk. The office should be commended for its efforts in identifying a number of potential threats to the financial system. However, much work remains before decision makers at the council can use this information to ward off another crisis.

The Financial Stability Monitor prototype provides a current-year snapshot of the health of the financial sector along five key areas: macroeconomic; market; credit; funding and liquidity; and contagion risk. It's a tall order for any agency to distill the complexity of the financial sector, participants, products and interrelationships into a simple one-page assessment. The OFR takes a bold step to quantify these risks using state-of-the-art metrics and models.

Applying a color-coded heat map approach similar in concept to Homeland Security terrorist threat levels, the results for 2013 suggest overall risk to the financial sector has not changed much from 2012 and is what would be viewed as moderate risk on OFR's scale. To the agency's credit, it acknowledges that the framework is not forward-looking and needs to better incorporate qualitative aspects of market sentiment and risk appetite than it does. It is absolutely necessary that quantitative measures of systemic risks be developed and deployed in such assessments.

At the same time there tends to be an overreliance on methods that may not perform well before and during stress events due to data and analytical limitations. This is where informed judgment, gathered via an annual survey of industry experts and practitioners drawn from all corners of the financial sector, can augment quantitative results and provider a richer representation of risk. This could be of particular use to OFR in building a forward-looking assessment of the emerging risks that it flags. 

Despite the tangible progress in sizing up threats to the financial system, there appear to be some gaps between what the agency believes are emerging threats and what is portrayed in the Financial Stability Monitor. The good news is the agency has undertaken a considerable effort to call out a number of risks that could potentially affect markets, such as: cyberattacks; the astonishing growth of short-term borrowing by mortgage real estate investment trusts and by the U.S. offices of foreign banks; and the buildup of interest rate risk exposures across the system, among others. Just how important these threats are over the next year or more is left unanswered by OFR. Therein lies a problem requiring the office's immediate attention.

For cybersecurity threats, for instance, the risk assessment largely is confined to isolated distributed denial of service attacks. Threats looming from more coordinated efforts to bring down a financial exchange or other market utility are not mentioned other than as potential technological disruptions as represented by the Flash Crash of 2010. It would seem further efforts to detect the potential for such threats to do greater systemic damage than DDoS scenarios on individual banks are called for in OFR's assessment protocols from now on.

The risk from REITs was highlighted by OFR, noted in part by the concentration risk in the industry from two companies holding two-thirds of the assets in the sector. Moreover, REITs account for nearly one-quarter of all repurchase agreement and Fed Funds liabilities, compared to less than 10% in 2010. In the spirit of "no good deed ever goes unpunished," now that OFR has rightfully called out this potential risk, clearly FSOC should take this issue up in its activities to mitigate risk holistically across the nonbank sector and require OFR to redouble its efforts on assessing this risk.

Another area of concern on OFR's radar is interest rate risk, which appears poised to only get worse over the next 12 months. This year we saw how investor uncertainty over Fed policy can lead to significant losses in bond portfolios. The OFR estimates that a 1% increase in interest rates could lead to a $200 billion loss in bond portfolios given the extension of bond portfolio durations over time. But what efforts are being taken by FSOC to rein in this risk before it becomes a major event?

Overall the OFR's Annual Report underscores major advancements in the detection and measurement of potential threats to the stability of the financial system. To the office's credit, it understands some of the limitations of the latest monitoring tools. Holding them back from making even more progress are a slew of data issues that must be addressed for these efforts to be anything more than interesting analysis.

Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland.