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The Financial Crisis and Information Needs for Financial Surveillance. Christopher Towe Deputy Director Monetary and Capital Markets Department International Monetary Fund. Lessons from the Crisis. Information gaps were extreme: Limited data on risk exposures

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The Financial Crisis and Information Needs for Financial Surveillance

Christopher Towe

Deputy Director

Monetary and Capital Markets Department

International Monetary Fund

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Lessons from the Crisis Surveillance

  • 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

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Key gaps—Financial Innovation Surveillance

  • 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

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Key Gaps—Major Banks Surveillance

  • 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

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Key Gaps—Asset Valuation Techniques and Risk Modeling Surveillance

  • 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

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Key Gaps—OTC Instruments Surveillance

  • 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

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Key Gaps—Non-Banks Surveillance

  • 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

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Key Gaps—Information Content Surveillance

  • 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

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Initiatives Are Underway Surveillance

  • 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)

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But there is more to be done… Surveillance

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.

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R1: Systemically Important Institutions Surveillance

  • 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.

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R2: Reprioritized/Expanded FSIs Surveillance

  • 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

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R3: Systemic Analysis Surveillance

  • 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

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R4: Transparency of Risk Assessments Surveillance

  • 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

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R5: Transparency of OTC Derivative Markets Surveillance

  • 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

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The task ahead… Surveillance

  • 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