This content is from: Portfolio

The Financial Industry Needs Its Plumbing Fixed to Detect Systemic Risk

Lousy data is clogging up the global financial system and preventing regulators from detecting systemic risk.

The U.S. Senate recently passed to the floor for a full vote Senator Chris Dodd’s (D-Conn) America’s Financial Industry Rehabilitation Act of 2010. It contains a provision for the creation of a Financial Research Data Center. What this little understood provision represents is a back-door way of admitting garbage in/garbage out, the oldest rubric of the Information Age that is still alive and well and clogging the global financial system. That is also what a Federal Reserve governor and assortment of Nobel laureates advised the U.S. Senate Committee on Banking, Housing & Urban Affairs is preventing systemic risk from being detected. In simple terms: a lack of quality data is preventing regulators from seeing that which they are mandated to oversee.

Systemic risk, the latest buzz word to explain the pandemic that caused the financial crisis, is the risk of a system-wide financial crisis caused by the contemporaneous failure of a substantial number of financial institutions, financial markets or both.

In preparation for identifying issues in the Senate’s bill, the Senate Banking Subcommittee on Security and International Trade and Finance heard late last year testimony from an assortment of Ph.D.’s, including Nobel laureates, on how to monitor systemic risk . They concluded that the solution would not be found in an elegant mathematical model nor an enlightening theoretical construct. It would come as a result of getting the data right from the start. It is ironic that Nobel laureates and Ph.Ds are now telling senators that the data identifiers that underpin all financial transactions are broken, and that nothing short of retooling the plumbing will fix it.

Sen. Dodd’s bill calls for the government to set the standard identifiers for companies and instruments in the U.S. financial industry, and maintain it in a reference data base. These identifiers would be used by financial institutions to report their financial transactions and positions to the Data Center.

The idea of gathering quality data for regulators so they can analyze systemic risk is simple to understand, but a very complex procedure to implement. There is no widespread standard for the electronic codes that can be used to identify products and counterparties. There are no universally-accepted identification standards that define the particular terms and conditions of a transaction. If the data is not defined correctly (or consistently), then it leads to huge infrastructure costs and systemic risk. That is what prevented the defaulting pooled mortgages in the collateralized mortgage securities (CMOs), or in the collateralized pools of debt instruments (CDOs) containing these pooled mortgages, not to be traceable nor identifiable. They were incapable of being placed on any regulators’ radar screen.

The current set of systemic failures brings to light the back office paper crisis of Wall Street in the late 1960’s, where the plumbing was first identified as leaky. We thought we had fixed the problem. However, the problems transcended each sovereign regulator or each separately constructed financial market, as firms increasingly transacted business globally and constructed products across financial markets.

The lack of standards results in performing duplicative functions in an attempt to represent each unique product, business entity and valuation price identically. These include duplications of such fundamental identifiers as symbols for corporate issuers and contract markets; numbering conventions for securities; supply chain business entity identifiers; and counterparty identifiers.

A vast infrastructure of payment, clearing and settlement facilities is needed to match transactional data from origin to payment in order to control the data errors introduced from separately-sourced multiple intermediaries. This delays the process and requires each financial institution to support expensive computerized and people intensive mapping and reconciliation activities. For example, in the U.S. securities markets there is a built-in delay of three days for this process to run its course.

Former U.S. Treasury Secretary Henry Paulson identified payment and settlement systems, which are at the root of the intertwined financial global system, as one of the more important systemic risks that lack coordinated regulation. The Group of Thirty’s (G-30) Final Monitoring report on the Global Payments and Settlement System identified the problem as the failure to have a global collaboration amongst financial institutions to arbitrate and distribute standardized product and business entity identifiers and other referential data.

Most industries have invested in universal product and supply chain identification coding systems to uniquely identify their physical products, transportation intermediaries and counterparties. This helped regulators track a tainted Tylenol capsule back to its manufacturing process and find the source of tainted cows’ meat across the globe. However, financial regulators could not find the mortgage that was defaulted on in a U.S. city that wound up as a toxic asset on the balance sheet of a failing bank in Australia. Financial regulators could not see the counterparty positions allegedly held by convicted financial con artist Bernard Madoff at a London OTC options dealer. And they certainly missed the numerous movements of securities bundled into Lehman’s Repo 105 collateral moving from the U.S. to the U.K. and back again to dress up their US leverage ratio.

We don’t need another silo-based government-run data center nor the imposition of government built data standards. The financial industry needs to self administer a coordinated global standard under regulatory oversight by the G-20’s Financial Stability Board, already given the authority and responsibility to oversee systemic risk globally. No financial firm could issue a new product without getting a universal code first. Look at any bar coded product in any supermarket across the world and you’ll see the simplicity of an industry driven solution.

Allan D. Grody is President of Financial InterGroup Advisors and a Founding Board Member of the Journal of Risk Management in Financial Institutions. Dr. Robert M. Mark is the Managing Partner at Black Diamond Risk Enterprises.

Related Content