Lessons from the Financial Crisis — Eight Years Later

The financial crisis of 2007-09 now seems distant, and the chance of a future financial disruption seems remote. So it’s not surprising that some question why we need continued vigilance over financial stability.

If nothing else, we learned in the crisis that vigilance is vital. The years of calm before the crisis bred complacency about risk. Hidden weak spots in the financial system surfaced in the crisis, with significant adverse consequences for the economy. Major gaps in our ability to measure financial activity also surfaced and limited our ability to recognize weak spots, even when they were in front of us.

The Office of Financial Research (OFR) was established to provide data and analysis that policymakers and industry need to assess and monitor coming storms. The OFR has played key roles in filling those gaps.

No other organization has the same mandate to evaluate policies affecting financial stability and challenge policymakers to improve them.

No other organization has systemwide authority to collect, standardize, and make detailed financial data appropriately available for the benefit of policymakers and the public.

And no other organization has the OFR’s mandate to look across the entire financial system.

Our autonomy and unique authorities allow us to shine light into the system’s dark corners effectively and efficiently, so we can effect policies to create the stable and resilient financial system that will support sustainable economic growth.

Since the crisis, the OFR and others have taken steps to uncover and anticipate the weak spots and improve the quality, scope, and accessibility of financial data.

Regarding weak spots, we now better understand how defaults, runs, and asset fire sales can destabilize the financial system. We also recognize that trouble in one part of the system can disrupt other parts. So at the OFR, we look for these interrelationships across the entire financial system — not just its components — to assess vulnerabilities, and we communicate them to policymakers and the public.

Regarding data, we know that high-quality data are essential for policymaking and risk management. For example, regulators require reporting of derivatives activities to create transparency that promotes price discovery and efficient markets, and facilitates risk assessment. The quality of the reporting depends on the use of data standards. The OFR has led and continues to lead the development and use of such standards in derivatives and other markets.

This progress is encouraging, but we have more work to do. The financial system is constantly changing as organizations change, new products are introduced, and new technologies become available. Tomorrow’s weak spots will be different from yesterday’s. New shocks will emerge, like those from cyber events, and crises will recur. No one can predict — much less prevent — financial crises, but accurate data and understanding of the sources of stress are essential for building resilience and for the ongoing vigilance needed to assess threats.

To carry out that work effectively, we have organized our data and analytical activities into eight programs, covering most of the OFR’s mandates. These programs focus on financial data, risks in central counterparties or CCPs, risks in financial institutions, changes in market structure, stress testing, and monitoring tools. The programs communicate clearly our objectives and plans, while demonstrating our commitment to transparency and accountability about our activities.

Collecting data describing bilateral repurchase (repo) agreements is an important example of the OFR’s essential work to improve data scope. Repo markets, a linchpin for financial system functioning, provide more than $3 trillion in daily funding for securities transactions. But those funding sources misfired in the financial crisis. Investors under stress ran from them, and funding and liquidity dried up.

Bilateral repo transactions, settled between the transacting parties, account for half the U.S. repo market. But data about bilateral repo are limited. The OFR, in collaboration with the Federal Reserve System, is filling that gap with a permanent collection of repo data. Those data will help industry to manage risk and officials to improve market resilience.

The OFR’s authority to collect data from any U.S. financial company is crucial to this initiative. The OFR is committed to collecting these and other data efficiently and appropriately. The OFR’s early engagement with industry and regulators to design, test, and implement effective methods for collecting and reporting data is crucial to reducing the regulatory reporting burden.

Creating an alternative to LIBOR is another example of essential OFR work. LIBOR, formerly the London Interbank Offered Rate, is an interest-rate benchmark used to price borrowing rates on major consumer purchases, such as homes and cars, and for $150 trillion in derivatives.

LIBOR’s central role and broad use as a reference rate mean it must be reliable. Attempts at manipulation and the decreasing relevance of the markets used to establish the rate sparked calls for alternatives. The Federal Reserve Bank of New York and the OFR are working to devise a more reliable, widely accepted alternative. Even if financial activity moves out of the range of the Federal Reserve’s collection authority, the OFR would still be able to collect the needed data.

Financial data are useless if we don’t know what they mean. So, Congress directed the OFR to improve data quality by creating an authoritative database for financial instruments. Called the financial instrument reference database, this tool will provide the foundation for systematically describing financial instruments and how they relate to each other.

Common data definitions will improve data quality, help firms to manage their risks, and assist officials in identifying gaps in the understanding of financial instruments.

The financial instrument reference database initiative will also help uncover duplication in regulatory reporting and pave the way for reducing the reporting burden. To proceed in the right way, the OFR is extensively engaging with industry and the public.

Likewise, data are useless if they aren’t reliable. The 2008 collapse of Lehman Brothers proved the importance of data quality. When Lehman failed, many market participants did not realize they were exposed to Lehman through its subsidiaries. After Lehman’s failure, the industry clamored for a system to precisely identify parties to financial transactions. The OFR delivered by leading a global effort to develop and build the Legal Entity Identifier (LEI) system.

Like bar codes at the checkout counter, LEIs make fast, error-free financial transactions possible. More than 500,000 LEIs have been issued, and expansion of the system is continuing. The OFR is helping to complete the network by promoting its use among financial regulators and pushing for broader adoption.

A key benefit of precise entity identification, like that for financial instruments, is to collect data once for multiple uses, further reducing the regulatory reporting burden.

The OFR is also working to help develop the “hierarchy” of relationships among the entities that define financial enterprises. Understanding these relationships is critical to efficiently wind down a troubled financial institution without taxpayer support.

Ongoing assessment of threats to financial stability is a critical OFR mandate. Unlike the other members of the Financial Stability Oversight Council (FSOC) that conduct threat assessments, the OFR does not make policy. This statutory independence and lack of vested interest in particular policies give the OFR a unique perspective — an objective position — to assess and monitor threats. We are free to evaluate policies and tools, as the law requires, without having to defend them. The OFR’s analytical work thus complements, rather than duplicates, that of other FSOC organizations.

The OFR has done widely recognized work on assessing the systemic importance of large, complex financial institutions and pioneered financial mapping exercises to highlight data gaps and weaknesses.

Building on those foundations, we have developed a portfolio of monitors with user-friendly dashboards to be early warning systems to detect trouble. Coverage includes or will include credit, liquidity, and market risks; hedge funds; asset price correlations; and money market mutual funds.

While some OFR monitors use data unavailable elsewhere, the U.S. Money Market Fund Monitor makes existing Securities and Exchange Commission data accessible to industry and policymakers in new ways to reveal risk. This monitor puts at users’ fingertips more than 4 million records of monthly data on the holdings of about 500 funds spanning the last five years — previously available only as separate individual filings and industry-level monthly reports.

The monitor is gaining wide acceptance in the industry, and other agencies are calling on the OFR for access to the money fund monitor and other monitors, and for help in developing similar ones.

These are only a few of the ways the OFR is working to promote the stability and resilience of the U.S. financial system, while striving to eliminate duplication and regulatory burdens.

Without the OFR, the financial system would be more risk prone and dangerous, and less transparent and efficient, with likely adverse consequences for the economy. Vigilance is vital, and vigilance is our job at the OFR.

Richard Berner is the Director of the Office of Financial Research