OFR Director Promotes Better Data Collection to Measure Credit Risk

Director of the Office of Financial Research Richard Berner discussed the ways in which credit risk affects the stability of the financial system. At a conference at New York University, he touched on current OFR measures for monitoring credit and other risks, examined the interplay between credit and other kinds of risk, and assessed some of the tools that policymakers might use to mitigate those risks.

Mr. Berner asserted that in order to improve the measuring, assessing and monitoring of risk, the quality, scope and accessibility of financial data must be enhanced. Although progress has been made, he said, risks and vulnerabilities that are “neither immediately evident nor easily monitored” remain.

Mr. Berner cautioned that periods of low volatility, credit spreads in cash markets, credit default swap spreads and low repo haircuts – all of which are interpreted traditionally to be signs of low financial market risk – can presage rising market vulnerabilities, since they offer incentives to investors and risk managers to increase leverage. He explained that the implications of this paradox suggest that the distribution of outcomes is asymmetrical, which means that the pricing of all securities with embedded options will be affected by volatility. This inherent asymmetry has an important effect on credit risks, since lending involves selling puts on the probability of default.

Mr. Berner concluded that in order to monitor activity across the financial system, the OFR must continue to improve the “toolkit” that it uses to assess the fundamental sources of instability in the financial system. It also must become more forward-looking and test the system’s resilience to a wide range of events and incentives. He maintained that stress testing “is one of the best tools for assessing potential sources of vulnerabilities,” but added that more granular data are needed to determine who is exposed to those vulnerabilities and by how much.

Lofchie Comment: One of the best books ever written about financial crises is Stabilizing an Unstable Economy, by Hyman Minsky (1986). The book enjoyed a resurgence of popularity in 2010 with a number of articles dating from that period maintaining that we were in a “Minsky Moment” (of the type predicted in the book). A number of Mr. Berner’s conclusions seem to echo Mr. Minsky’s theories, particularly the view that periods of low volatility can seduce investors into taking on too much leverage or other kinds of risk.

Comments are closed.