«Leonard Nakamura Federal Reserve Bank of Philadelphia June 23, 2010 Durable Financial Regulation: Monitoring Financial Instruments as a Counterpart ...»
WORKING PAPER NO. 10-22
DURABLE FINANCIAL REGULATION: MONITORING
FINANCIAL INSTRUMENTS AS A COUNTERPART TO
REGULATING FINANCIAL INSTITUTIONS
Federal Reserve Bank of Philadelphia
June 23, 2010
Durable Financial Regulation: Monitoring Financial Instruments as a
Counterpart to Regulating Financial Institutions *
June 23, 2010
Federal Reserve Bank of Philadelphia Abstract This paper sets forth a discussion framework for the information requirements of systemic financial regulation. It specifically proposes a large macro-micro database for the U.S. based on an extended version of the Flow of Funds. I argue that such a database would have been of material value to U.S. regulators in ameliorating the recent financial crisis and will be of aid in understanding the potential vulnerabilities of an innovative financial system in the future. I also argue that the data should – under strict confidentiality conditions – be made available to academic researchers investigating the detection and measurement of systemic risk.
* The views expressed here are those of the author and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. This paper is in preliminary form and is being circulated for purposes of discussion and comment. I would like to thank Viral Acharya, John Bell, Mitchell Berlin, Robert Bliss, John Bottega, Paul Calem, Satyajit Chatterjee, Larry Cordell, Ronel Elul, Jose Fillat, Jeff Fuehrer, Josh Gallin, Itay Goldstein, Chris Henderson, Bob Hunt, Tor Jacobson, George Kauffman, Arthur Kennickell, Bill Lang, Jamie McAndrews, Susan McIntosh, Greg Nini, Kasper Roszbach, Tom Stark, Todd Vermilyea, Larry Wall, Christian Wang, and participants in seminars at the Sveriges Riksbank and at the Federal Reserve Banks of Boston, New York, and Philadelphia, and the Federal Reserve System Conference on Real-Time Policy Issues for many helpful comments. This paper is available free of charge at www.philadelphiafed.org/research-and-data/ publications/working-papers/.
2 Durable Financial Regulation: Monitoring Financial Instruments as a Counterpart to Regulating Financial Institutions I. Introduction: A Financial Regulatory Database for Durable Financial Regulation In the wake of the recent financial crisis, an effort is underway to redesign the regulation of financial institutions. As part of the new regulatory structure, a new information framework may be desirable. In particular, I here advocate a system for monitoringfinancial instruments as a complement to the regulation of financial institutions. If a system of financial regulation is to be durable, it must evolve with the development of new institutions and instruments. A main purpose of this paper is to begin a dialogue on an intellectual framework for the analysis of systemic risk data collection. In particular, I discuss how to best construct a macro-micro database that links our knowledge of sectoral financial assets, liabilities, and flows to underlying micro-databases with data on individual instruments and the holdings and liabilities of economic actors (households, firms, states).
In the 2007-2009 financial crisis, financial regulators were surprised both by the size of the potential losses and by the types of institutions that were affected. Regulators moved to protect investment banks, insurance companies, mutual funds, and government-sponsored enterprises, as well as traditional depository institutions. More detailed knowledge of the risks of financial instruments and the holders of these risks might have permitted regulators to move more aggressively in advance of the crisis and would have made regulators better informed once the crisis was at hand. I examine some of the risks that arose in the recent crisis and how we could have known more about them as they were arising.
The proposed database is intended to be of substantial use to supervisors in identifying risk at regulated institutions and also to help them know when financial risks are being held by unregulated financial institutions, generating new systemic risks. U.S. and European regulators are already taking steps to improve data availability. Eichner et al. (2010) argue that while macro data may be useful for discerning trends in financial risks, it is desirable to have more specialized information to further illuminate them. My framework would take a step toward facilitating this side-by-side use of macro and more specialized data.
In this paper I set forth a framework in which a U.S. systemic regulator could be the central data-keeper for information on U.S.-originated financial instruments and could be active in making the data available to academic researchers as well as economists from regulatory agencies. The systemic regulator would actively share research results on the risks of specific financial instruments with other financial regulators (both within and outside the U.S.) and with risk managers within financial institutions. It would thus strengthen the ability of financial 3 institutions to recognize and manage their own risk, conceivably reducing the burden on regulation.
In the absence of such a systemic regulator, the framework I contemplate would also be useful for the existing set of regulators to use, either individually or collectively.
II. A Macro-Micro Financial Instrument Database for Regulation What is meant by such a macro-micro financial instrument database? The macro side of the database should have summary aggregate data on the nominal quantities of financial instruments and both the debtors or issuers and the current asset holders, by broad sector. The micro side of the database should have microdata samples of individual instruments and economic actors. The two sides of the database should be interconnected so that the microdata can be interpreted as a weighted sample of portions of the aggregates and that the two halves provide multiple views of the same data. Consider the totality of financial transactions, the economic actors who make them, and the stock of assets and liabilities for each actor that continually change as their transactions take place. The macro-micro database should capture key features of the totality so that potential systemic risks may be detected, understood, and mitigated.
The macro side of the database helps regulators know, for example, which set of financial institutions is holding the risks of a given nonfinancial instrument. The micro side could then help trace more precisely which institutions are holding that instrument. Different micro databases might provide alternative views of the instrument obligors. If mortgage data on first and second mortgages are not collected so as to reveal the combined loan-to-house-value ratios, it is possible that estimates can be derived from credit bureau data on individuals.
Because the totality of such transactions is so vast and variegated, it is vital to have an intellectual framework for organizing and aggregating them. I argue that the Flow of Funds is such an intellectual framework.
It is also important to have a cost-effective means of collecting and organizing the microdata, that is, the individual financial instruments, so that the evolution of the underlying risks can be followed. For this reason, we need to consider how to best use and improve existing databases, as well as perhaps how to develop new ones. Just as the Flow of Funds permits us to observe at the aggregate level which sectors own and owe which instruments, so we need links across the micro databases that help us observe which sorts of individuals, firms, and agencies own and owe which individual instruments so that we can understand the risks as they affect individuals and institutions.
How can we use the Flow of Funds as a framework for the envisioned database? Most fundamentally, the Flow of Funds provides an accounting framework that includes all the assets and liabilities of nonfinancial and financial institutions.
Here, I set forth the relationship between the existing U.S. Flow of Funds and the envisioned database. The Flow of Funds (a part of the system of national accounts that is compiled by the Federal Reserve System) establishes a framework that accounts for the financial assets and liabilities of all U.S. parties (including households, nonprofits, firms, governments, and the rest-of-the-world). 1 The Flow of Funds has a fluid conceptual framework that can be expanded to reflect derivative and synthetic instruments. The U.S. Flow of Funds relates to the system of U.S. national accounts; individual agents and sectors borrow and lend as part of the national, sectoral, and individual imbalances between savings and investment. To the extent that financial instrument risk is tied to agents, sectors, and markets, this framework facilitates the economic analysis of risk. The Flow of Funds framework can, like the national income accounts, accommodate a series of satellite accounts to extend the value of the framework. These, some of which are discussed below, could include mark-to-market or mark-to-model pricing, agents behind the scenes (such as exchanges and rating agencies), and measures of risk. Finally, the micro-databases and statistics that underlie the aggregate measures could be associated with the Flow of Funds as a linked library, in which the aggregate categories of the Flow of Funds organize the microdata as a set of reference headings.
The U.S. Flow of Funds is an aggregate data set; the monitoring system or systems would combine aggregate data, microdata sets, and estimates of risk by instrument. A single joint monitoring system could be administered jointly on behalf of, and made available to, all financial regulators, which would make the system most efficient. Currently, different agencies and groups within the agencies are separately developing monitoring systems, and much of the development is haphazard. I argue that individual agencies, even in the absence of a single joint database, will likely find it useful to use the Flow of Funds framework to meld and clarify their data resources.
The U.S. Flow of Funds has two intimately related parts. One part is a set of flows, net new borrowing and lending, and the other is a set of outstanding stocks, assets, and liabilities.
(The quarterly net flows are defined to be the difference in the quarterly level of outstanding stocks.) 2 These are presented as aggregates by sector (lenders and borrowers, such as banks, households, governments, corporations) and by instrument (equity, mortgages, loans, commercial paper, consumer credit, securities). The Flow of Funds reflects the financial assets and liabilities and financial activities of both financial and nonfinancial entities in the U.S. It
thus provides a natural framework from which a systemic regulator could observe the types of risks distributed across the financial system.
The first column in Table 1 shows the credit market borrowing by nonfinancial sectors in 2008, taken from the Flow of Funds, Annual Flows, as published June 11, 2009. In this table, they are organized by instrument, such as commercial paper and home mortgages, and by sector, such as household sector and nonfinancial corporate business. It also shows borrowings by foreigners. The second and third columns show the debt levels owed by the nonfinancial sectors for the same instruments and sectors at year-end 2007 and 2008. Adding column one to column two gives column three; the net borrowing flow during 2008 added to the level of debt at the end of 2007 gives the level of debt at the end of 2008. Other summary tables in the Flow of Funds, not presented here, show financial sector borrowing and total liabilities and their relationship to total financial assets. Yet others relate the Flow of Funds to national savings and investment and the national income accounts.
Through its ties to the national income and accounts, the Flow of Funds obtains a benchmark measure of the total borrowing and lending by a given sector necessary to balance net cash flows. This provides an indirect estimate of the completeness of direct measures of total borrowing and lending.
The efficiency of the borrowing and lending of the nonfinancial sector provides a prime economic rationale for the activities of the financial sector. An important rationale for systemic regulation is to ensure this two-way flow of financial transactions. It is of fundamental importance that the financial transactions of the nonfinancial sector come under the scrutiny of the systemic regulator. Table 1 presents a compact view of the total borrowing of the nonfinancial sector from the Flow of Funds, year-end 2007 and 2008.
Less aggregated tables in the Flow of Funds – there are 31 sector tables and 31 instrument tables – show holdings of instruments by different sectors. In short, the Flow of Funds relates instruments to the assets and liabilities of institutions. The assets and liabilities of each individual agent are naturally organized within this Flow of Funds framework. Moreover, the databases in which samples or the universe of agent outstandings or flows are captured naturally map into this framework as well. For example, if an agency is using samples of a credit bureau’s data on individuals and households, this database can be mapped into and benchmarked with the household balance sheet from the Flow of Funds.
What the Existing U.S. Flow of Funds Lacks
However, the table on Issuers of Asset-Backed Securities (L.125) has their assets as $4.5 trillion (including credit cards, commercial mortgages and agency and GSE-backed securities) and liabilities divided into commercial paper ($0.6 trillion) and corporate bonds ($3.9 trillion).