Director of the Office of Financial Research (“OFR”) Richard Berner discussed the importance of understanding how the financial system functions under stress. He emphasized the need to gather and standardize data for analysis and for policymakers to be able to respond to identified threats to market stability.
The Director argued that financial stability is not about constraining market volatility, but is instead about resilience. He identified two aspects of resilience that must be examined: (i) does the system have enough shock-absorbing capacity so it can still function? and (ii) are incentives, such as market discipline or transparent pricing of risk, aligned to limit excessive risk taking?
Director Berner pointed out that several of the OFR’s analytical initiatives are important for insurance and pension plan sponsors, including the “Financial Stability Monitor,” an OFR-developed tool used to assess risk. Mr. Berner stated that as a result of this tool, we know that overall threats to financial stability remain at a “medium” level, although credit risks are now “prominent.” Further, he noted, liquidity risks appear to have risen in major bond markets, and certain financial activities continue to migrate to presumably less-regulated and less-transparent areas of the financial system.
Finally, Mr. Berner stated that a “robust” stress-testing regime is one of the best tools available in risk management. The OFR is working with the Federal Reserve to suggest ways to conduct systemwide stress tests and to explore how stress tests can include runs and contagion.
Mr. Berner’s remarks were delivered before the Annual Meeting and Public Policy Forum of the American Academy of Actuaries.
Lofchie Comment: While Director Berner identifies his role as being that of a mere aggregator of information, and not as a policy maker, the information that he collects is largely determined by those who have certain policy views on what creates risk to the financial system. Thus, he is concerned with, for example, securities financing transactions, capital levels at banks, and the operation of central clearing houses.
Mr. Berner’s remarks also suggest that this data collection may not identify the real risks threatening the financial system. Start with his identification of credit risk as the largest risk facing the system, by which one may infer that he means a possible rise in interest rates that could lead to a drop in asset prices. Mr. Berner indicates that this problem may be addressed by stress tests at the banks, but how much good would such tests do if interest rates spike? What good are stress tests if ongoing low rates result in the inability of municipal and other pension plans to earn returns that satisfy their obligations?
Mr. Berner notes that “liquidity risks appear to have risen” and that “certain financial activities continue to migrate to presumably less-regulated and less-transparent areas of the financial system.” One may connect the dots and argue that these risks have risen, and that these financial activities have migrated, in response to regulation that may be overly burdensome.
More regulation does not inherently make a safer system. By analogy, the government cannot collect the maximum level of taxes by raising taxes to 100% of income, or by cutting them to 5%; the optimum level is inherently between the two extremes. The path that Mr. Berner should follow is whether the Office of Financial Research is asking a broad enough range of questions: (i) are they all pointed to demonstrating that “more” regulation is needed?; and (ii) are they covering cases in which regulation is not working, or where it is imposing unnecessary costs or requiring procedures that increase systemic risk?