Some readers may take issue with the headline, but bear me out.
Within ten days of 1987 stock market crash, President Reagan established what was popularly called the Brady Commission to investigate the causes of the meltdown and recommend remedies. A little more than two months after it was created, the Commission submitted its report.
The 1987 crash was trivial in complexity compared to our current mess. Stocks trade on exchanges, so transaction sized, prices, and execution time are a matter of public record. Even though foreign markets swooned in sympathy with the US downdraft, the crisis was a domestic event.
Contrast the 1987 panic with our credit meltdown. The 1987 crash was a single country event, in transparent markets (equities and equity futures). This crisis revolves around multiple over the counter markets (asset backed securities, including securitized auto, student, residential and commercial real estate loans, CDOs, CLOs, CDS) that were originated and sold around the world. The authorities have an weak to non-existent picture of trading volumes and prices. In addition. they also do not have a good feel for the terms of the instruments themselves (these were privately negotiated agreements; unlike registered securities, the offering documents are not a matter of public record). And the lack of an understanding of the range and mix of types of deals impedes developing sound policy. For instance: it is widely known that many residential mortgage-backed securities contain restrictions on modifying mortgages. Admittedly, some do not prohibit them, but some bar them completely, others limit them to a certain percentage of the pool. But since these deals were all sold OTC with no document registry, no one knows what the distribution among these three types is.
I have complained for some time that it is inexcusable for the authorities to be fumbling in the dark as they are without trying to light a candle. One could argue that in the first two acute phases of the crisis (August-September 2007 and November-December 2007), the authorities. could tell themselves that their remedies would work, this would pass relatively quickly. like the Asian crisis (while the affected countries suffered a long aftermath, the international market disruption resolved itself much faster). But by the Bear failure, with other investment banks known to be in precarious shape, it was clear this crisis was not going to resolve itself quickly. That was when the need to get a better grasp on what was going on was undeniable.
Before readers say it would take too long and be too hard, consider: if you had a mysterious disease, would you rather have your doctor treat by analogy to common ailments or do the needed testing to come up with a diagnosis?
Even with a full court press starting in March 2008, it probably would have taken 6 months to get a better picture. It would be impossible to get a full picture in that time, but if one set investigation priorities well, one could have a great deal of insight on the key issues (most things in life are 80/20, meaning 80% of the value comes from the top 20%; there is no reason why an effort like this should be any different). And before you say regulators were overtaxed and lacked sufficient personnel, the Brady Commission was headed on a day-to-day basis by a Harvard Business School finance professor and staffed largely by junior-mid career people from the private sector with relevant analytical and industry knowledge (they were seconded from their firms; it was considered an honor and a career boost to participate).
A Financial Times comment recognized the same underlying problem, but suggests going about it in a different way. Otmar Issing and Jan Krahnen suggest putting in place mechanisms to capture information that would help give a better overview of the financial system, as opposed to just individual institutions. I am not convinced that the data gathering would create a “risk map” as they contend, but it would provide an enormously valuable database and should greatly reduce the number of regulatory blind spots (at least those due to lack of data).
From the Financial Times:
Consider the insights gained during this crisis. First, supervision has to focus on containing systemic risk rather than on avoiding individual bank defaults. Second, early warning signals need to be backed up by reliable information on all financial markets, including derivatives. Both aspects have been neglected in the past and continue to be neglected today.
Setting up a solid information base capturing global financial exposures is imperative. There is a long list of exposures that are not transparent today, for example the cross-border links between large, complex financial institutions (LCFIs) and the whereabouts of credit default swaps, collateralised debt obligations and other asset-backed securities. Putting together a global “risk map” displaying financial links among LCFIs as well as the most important risk drivers, such as asset price changes and yield spread dynamics, would enable authorities to carry out financial system stress tests.
The basis for the risk map would be a global database. We have proposed that standards be defined by a task force of experienced international agencies, such as BIS, the European Central Bank, the Organisation for Economic Co-operation and Development and the International Monetary Fund, allowing the data to be aggregated by region or by product. Data privacy conditions and capacity limits mean data collection must be defined on a discrete – for example, quarterly – basis. The risk map project could be chaired by the IMF. Data sharing could be on an aggregated level to preserve data privacy and to maintain a level playing field for international competition. Furthermore, data analysis would focus on an early warning methodology and a general assessment of systemic risk, which in turn could feed directly into the minimum capital requirement of international banks. Such a hard-wiring of systemic risk analysis to capital standards would allow supervisors to carry out counter-cyclical policies.
The control of systemic risk could be further enhanced by the use of a global credit register, which would essentially extend the risk map to exposures of banks with regard to large corporations. Existing credit registers are basically still national. This is an anachronism at a time when companies borrow and banks lend on a global scale.
Returning to our initial questions: have central banks and supervisors taken appropriate action to establish a reliable data foundation for systemic risk assessment? The answer is, unfortunately, no. Although 18 months have elapsed since the outbreak of the financial crisis, there is still no co-ordinated initiative.
What explains the reluctance of governments to get involved in a data generation exercise? The most likely explanation draws on the competitive situation in international financial markets, with governments aiming at preserving the competitive advantage of national banking industries.
Referring to the first question in the introduction, the answer is negative as well. We are still not prepared to avoid a disastrous financial crisis like the one that started 18 months ago.
However, in the interest of improved macro-prudential super vision, one can see at least what needs to be done. As the huge losses caused by the financial crisis forcefully show, macro-financial stability is a public good that has to be actively managed. The risk map is one element in such an endeavour, and a vital element for that matter.