Agency Preps 'War Room' to Guard Financial Stability

WASHINGTON — There are no alarm bells and the walls are not covered by dozens of screens showing details of economic hot spots across the world that might warn of impending doom.

Still, that is one way to imagine the work of the Office of Financial Research, a new Treasury Department agency dedicated to sifting through rafts of economic and bank data to detect systemic threats. Its goals are ambitious, attempting to act as the connective tissue across the entire spectrum of the financial system, searching for gaps of information and continuously evaluating and testing whether its measurements are precise enough to determine emerging risks.

But even with the best of tools, it is far from a perfect science. It is a process that slowly evolves and grows as new products and services emerge, while the fault lines of risk simultaneously shift alongside it.

The fledgling agency, which now has 120 staff members, most of them based in D.C., is relatively unknown. For those that have heard of it — and many critics — it is seen as a dark and mysterious entity, the financial equivalent of the Central Intelligence Agency, with a murky mission and unlimited power and resources.

But it's an image the agency's first director, Richard Berner, who was confirmed for a six-year term in January after waiting a year, says is misguided. Berner, who will make his first appearance as director Thursday before a House Financial Services subcommittee, said the agency's job is not to supplant existing data collection efforts or serve as an all-powerful agency.

"Financial regulators and policymakers are always going to need data to inform their judgment," said Berner in an interview. "We don't aspire to centralize and put in one place all those data. Our mission of filling in the gaps is very different from collecting and storing information on the financial system in a massive central data hub."

The financial crisis revealed that regulators weren't aware of what was happening across the entire scope of the system, and therefore were unable to ask the right questions to head off the crisis. Regulators were each focused on their own silos and not asking how new products and markets were affecting financial tasks or whether new risk concentrations were developing.

Berner's goal for the agency is to support the needs of the Financial Stability Oversight Council, a new interagency group created, along with OFR, by the Dodd-Frank Act. Ultimately, he wants his agency to be an authoritative and credible source of information for the council and other regulators.

"It's still the early days," said Berner, a former chief economist at Morgan Stanley, who was hired by Treasury in April 2011 to begin setting up the office. "The good news is I think a lot of people are rooting for us. I think that there are in some way, shape, or form broadly recognized gaps in our knowledge."

But the agency, he notes, is only one collaborator out of many with the same pursuit of keeping the financial system resilient and maintaining financial stability.

"The job is so large and complex and demanding," said Berner. "No one entity is going to be able to begin to master it. The hope is working together and if we can provide that connective tissue and fill in those gaps we'll come closer to achieving what we want to achieve."

But there are challenges and uncertainties that arise in building an agency from scratch and attempting to go where others haven't gone before.

"We have been thoughtful about getting it right," said Berner. "We didn't think we would have a lot of chances to make mistakes. We realized we had to start acting quickly and we have."

The agency has already started to make progress in the establishment of a barcode for a financial transactions known as a Legal Entity Identifier, which has taken years to develop and will ultimately save the industry billions of dollars. The official launch of the global initiative, endorsed by the Group of 20 nations, will happen later this month.

The purpose of such an identifier will help to improve data standards, one of the core missions of the OFR. With such a barcode, both regulators and institutions themselves can easily keep track of the parties to particular transactions and any monies owed between institutions.

"If we can standardize data in a way that works for everybody's benefit that's going to be really helpful in understanding what the data represent — what they're telling us — and identify parties to the transactions," said Berner.

Such a tool, if further developed, could also be a critical asset for supervisors as they survey for potential interconnectedness-related risks among the largest U.S. bank holding companies. That is a key concern as regulators review each institution's "living will" plans that are required under Dodd-Frank to ensure firms can be safely unwound.

For example, supervisors at the Federal Reserve could potentially use the LEI to develop a networking map that could connect transactions among firms and even within the enterprise itself to better judge the potential spillover effect.

"Organizing data is going to be very helpful, and we're still in the early stages. It's going to be useful to supervisors to have those data submitted with standards attached to them," said Berner.

The agency's other mandate serves to fulfill a separate function: developing better tools to detect systemic risk and discern among the hundreds of systemic risk indicators which are the most precise. By doing so, the agency hopes to gradually move toward a more real-time method of monitoring risk, rather than static moments of time that do not provide a complete picture.

"What we really need is — instead of a snapshot — a movie to watch it unfold and to sort of anticipate which way it's headed," said Berner. "We don't have that and so we can only — through our analysis and through our increased ability to measure — try to divine where the system might be going and think about the incentives that people have to make it go in that direction."

But while it may aspire to such a goal, Berner acknowledges that no agency can possibly know and catch everything.

"We don't have any magic metrics to tell us when the needle immediately goes from green to yellow or red," said Berner, noting the agency's constant work in developing tools to monitor risk in the financial system to help inform supervisors' judgment.

The agency is looking beyond the set of traditional tools to other fields to glean better measurements for detecting risk. For example, in one of the six research papers posted on the agency's Web site, work is being done to use an agent-based modeling tool, which Berner thinks has some potential to identify threats and identify behavior that might give rise to threats spread out across the financial system.

"Most people would have said maybe it doesn't have applicability to analyze financial activity, because it wasn't really firmly grounded in the kind of analytical framework that we are used to seeing," said Berner. "But, people are now willing to take a broader view and try to expand their peripheral vision to understand whether or not there are tools out there that might help us understand and learn more about how the financial system behaves and acts."

The agency has already broadly named risks to financial stability in its annual report, discussing external events like Europe's sovereign debt crisis as well as domestic issues such as persistently low-interest rates and a sluggish housing finance market. It has also identified specific cyclical and structural risks, like short-term funding markets and the perception of 'too big to fail.'

Policymakers, Berner says, may have the ability to anticipate some of those threats better than others as they come up, but the challenge facing researchers is to be able to think about the evolution of a particular threat and have the foresight to anticipate where those risks may travel across the system.

One way to protect the system is by developing tools, which he calls "guardrails," that are placed around the financial system to help create incentives for institutions and markets to limit potential risks that could threaten the system, alongside the usual shock absorbers such as capital.

There's a reasonable chance policymakers will be able to accomplish that in due time, said Berner.

"We're always going to be trying to think out where the system is going," said Berner. "There's still a lot more that we don't know. We have a lot more work to do. But we're going to continue to do that."