On Friday, the Security and International Trade and Finance Subcommittee of the Senate Committee on Banking, Housing, and Urban Affairs held a hearing entitled “Equipping Financial Regulators with the Tools Necessary to Monitor Systemic Risk.” The hearing focused on the need for collection of additional data to enable regulators to understand and regulate systemic risk, how and with whom the data should be shared, and the potential problems that may arise from such a data collection process. Testifying before the hearing were the following witnesses: Panel 1:

  • Daniel K. Tarullo, Member, Board of Governors of the Federal Reserve System

Panel 2:

  • Allan I. Mendelowitz, Founding Member, Committee to Establish the National Institute of Finance (NIF)
  • John C. Liechty, Associate Professor of Marketing and Statistics, Smeal College of Business, Pennsylvania State University
  • Robert Engle, Professor, Stern School of Business, New York University
  • Stephen C. Horne, Vice President, Master Data Management and Integration Services, Dow Jones Business and Relationship Intelligence

In his opening remarks, Senator Jack Reed (D-RI) asserted that financial regulators lack the information necessary to effectively understand and regulate systemic risk. During the recent credit crisis, he recalled, regulators were “flying blind” with no way to measure systemic risk. He acknowledged the need for additional information and first called on Mr. Tarullo to advise the Committee on potential approaches to collecting and utilizing the necessary information.

Mr. Tarullo began by outlining two primary goals that any legislative action should have: (1) Provide supervisory agencies with high-quality and timely data that are organized and standardized; and (2) share the data in an appropriate way with other government agencies and private analysts. He introduced the concept of “interconnectedness” and described how financial regulators and market participants were incapable of measuring the extent to which financial institutions and markets were interconnected. An improved data collection system would enable regulators and market participants to evaluate the consequences of a potential shock to the credit system, such as a failure of a major financial institution. He emphasized that a cost-benefit analysis must be considered at all stages of reform; for instance, the data should be collected in a timely fashion, but not necessarily in real-time.

To minimize costs and maximize efficiency, Mr. Tarullo encouraged mandated standardization of data wherever practical. He reminded the committee members of the widespread international effect of the credit crisis and expressed the view of the Federal Reserve Board that an effective legislative reform must cooperate with international efforts. Mr. Tarullo then identified and urged the removal of certain barriers to effective data collection, including the lack of authority of regulators to require such data, time-consuming notice requirements under the Paperwork Reduction Act, and the limited ability of agencies to share data with each other.

Mr. Tarullo endorsed congressional creation of a council of financial regulators to monitor systemic risks, coordinate responses to emerging threats, oversee the other regulatory agencies that collect most of the data, resolve issues between them, and authorize, where appropriate, additional means of data collection.

Senator Reed asked Mr. Tarullo whether the proposed data sharing requirements would be limited to financial institutions that are “too big to fail,” or whether they would encompass smaller institutions that may be “too interconnected to fail.” Mr. Tarullo agreed that financial institutions of an intermediate size could, in the aggregate, create a systemic risk and, therefore, should be included in the proposed reform.

Senator Bob Corker (R-TN) raised the issue of privacy and asked how the proposed reform would prevent misuse of the collected data. Mr. Tarullo responded the data could be collected in a substantially aggregated form to protect privacy, while still maintaining sufficient specificity to provide useful information.

Senator Corker asked each panel to identify the types of data the access to which would be most helpful for regulators and market participants. Mr. Tarullo focused on interbank lending, securities lending, repurchase agreements and derivatives contracts. Professor Engle focused more generally on counterparty risk ? data that would identify the exposure that a counterparty to a particular contract has with similar contracts with other counterparties. Professor Engle also urged that a centralized clearing system would provide even more information in a more cost-effective and timely manner. Although a substantial amount of information is already available, he explained, it is not the type of data that could inform an assessment of systemic risk. For instance, “risk reports” are provided by financial institutions on a daily basis, but they address the risks only to the individual institution, not the system as a whole.

Senator Reed invited the members of the second panel to comment on the degree to which the proposed NIF or other agency should be independent. Mr. Mendelowitz emphatically responded that the independence of the NIF would be an absolute necessity. Under his proposal, the NIF would not provide substantial analysis or carry any regulatory responsibilities. In his opinion, an organization that engages in high-level decisions would necessarily be its own judge and consequently sacrifice independence. In addition, unless the NIF is free from political influence, its ability to make unpopular, but necessary, decisions would be adversely affected. Thus, the NIF should operate as an independent, self-funded organization with authority strictly limited to setting data collection standards. Professor Liechty echoed Mr. Mendelowitz’s views on political influence, but advocated for an organization with leaders of a “high-stature” who could make high-level decisions and “speak the truth in a time of crisis.” Professor Engle also supported the notion of independence, but suggested that the new agency be created within an existing agency that is already independent. By doing so, he suggested, costs would be significantly reduced.