The Financial Crisis and Information Needs for Financial Surveillance

1. The Financial Crisis and Information Needs for Financial Surveillance Christopher Towe Deputy Director Monetary and Capital Markets Department International Monetary Fund

2. Lessons from the Crisis • Information gaps were extreme: • Limited data on risk exposures • Partly due to expansion of intermediation through unregulated channels and new instruments • Gaps in information content • Indicators gave misleading signals, blunting early warning • Unanticipated financial system and cross-border networks and interdependencies • amplified the reach and severity of the crisis for financial systems, the real economy, and internationally. • As a result, even the doomsayers had difficulty in making their cases convincingly

3. Key gaps—Financial Innovation • Rapid innovation and growth in new areas: • Complex structured products • Off-balance sheet entities • Trading books of banks’ balance sheets • Over-the-counter derivative markets • Non-bank financial intermediaries • Investment banks, insurance companies, hedge funds, mortgage broking • These markets and instruments had limited history, disclosure requirements, and data • And were lightly regulated

4. Key Gaps—Major Banks • Gaps related to rapid growth of commercial and investment bank lending: • Use of complex structured products and off balance sheet entities • Contributed to overestimation of risk transfer • Lack of consistency and transparency in disclosures, especially in their granularity • Undermined risk assessments, at an institution level and systemically • Insufficient data on cross-border exposures and capital flows • Hampered analysis of cross-country spillovers

5. Key Gaps—Asset Valuation Techniques and Risk Modeling • Flawed calibration • Based on benign segment of the credit cycle • Inadequate basis for assessing discontinuities during crises; • Fractional coverage • Models often applied to only a portion of portfolios • Limited consideration of interaction between market, liquidity, credit and reputation risks; • Heterogeneous risk modeling across institutions • Complicated supervisory oversight

6. Key Gaps—OTC Instruments • Gaps in information related to lack centralized clearing and exchange • OTC transactions not tracked • Unclear counterparty risks • Lack of netting • But risk layering also led to opacity • With regard to underlying risk of the instrument • And who bore the risk

7. Key Gaps—Non-Banks • The crisis exposed a lack of information on: • Money market funds, insurance companies, mortgage brokers, pension funds, and hedge funds • Including with regard to exposures, leverage, and maturity mismatches • Their inter-connectedness has also been shown to be source of vulnerability

8. Key Gaps—Information Content • Some financial soundness indicators (FSIs) performed poorly as early warning indicators • E.g., CAR and liquidity indicates continued to indicate soundness even as financial conditions deteriorated; • Others, such as sectoral leverage, provided better early warning, but data collection was incomplete. • Market indicators also failed • Driven by contemporaneous information • Risk and volatility measures were at historic lows prior to crisis. • Macro-prudential modeling proved inadequate, and did not address: • systemic risks, • spillover effects, and • network effects

9. Initiatives Are Underway • Enhanced disclosure for banks under Basel II Pillar 3 (BCBS); • Improved disclosure of structured products (project START); • Revised reporting requirements for off balance sheet entities (IASB); • Centralized clearing for CDS (FRBNY) and disclosure of transactions data (DTCC); • Enhanced disclosure by rating agencies (IOSCO); • Improved disclosure by hedge funds to investors/clients and counterparties (HFWG) • Economic Statistics Initiatives • Debt securities (Working Group on Security Databases) • Improved cooperation (Inter Agency Group on Economic and Financial Statistics)

10. But there is more to be done… R1: Strengthen disclosure standards of banks and systemically important NBFIs; R2: Reprioritize Financial Soundness Indicators; R3: Develop data and tool set for analysis of system wide risks; R4: Strengthen disclosure and information exchange on assessments of complex models; R5: Improve transparency in OTC derivative markets.

11. R1: Systemically Important Institutions • Large banks • Disclose market positions, exposures to economic sectors, large counterparties and countries, off-balance sheet activity, and the banking and trading books; • Using common templates across countries to permit aggregation, institutional comparison, and identification of network links; • Systemically important NBFIs • Lesser requirements but should disclose leverage, maturity mismatches, and large exposures in format similar to banks • Financial regulators • Need to assess data quality • Identify material gaps in disclosures.

12. R2: Reprioritized/Expanded FSIs • Focus on information content: • Adapt CAR and liquidity measures for banks • Include leverage and other measures for systemically important NBFIs • Enhance the coverage of sectoral balance sheets (households, corporations) and asset prices • Develop and incorporate indicators of systemic risk • Enhance attention to flow-of-funds data • Will require analytical follow up • And will need to take into account country, institution, and market-specific circumstances

13. R3: Systemic Analysis • Identify systemically important institutions, markets, and instruments • Basic indicators (size, concentration) • Networks and co-dependencies • Will require enhanced data • Inter-institution exposures • Monitoring of entities outside the regulatory perimeter • Build tools for analysis: • Multi-dimensional scoring techniques • Methodologies for analyzing networks • Models of tail events/discontinuities

14. R4: Transparency of Risk Assessments • Systemically important institutions • Including both banks and nonbanks • Should disclose characteristics of • Risk management practices • Valuation techniques and risk models; • Stress test results • Financial authorities • The onus will be to assess quality • And integrate information into financial stability assessments

15. R5: Transparency of OTC Derivative Markets • Data • Shift of focus from information on volumes to information on exposures, counterparties and market concentration • Infrastructure • Disclosure/data would be enhanced by moving transactions to: • Centralized clearing house • Central exchange

16. The task ahead… • International coordination critical: • To ensure consistency in data collection and definition • To facilitate collection of cross-border exposures • To avoid regulatory arbitrage. • The challenges: • Prioritize among the areas for attention • Identify how best to fill the gaps • Define responsibilities to avoid overlap • Set targeted deliverables