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From Banking and Finance Law Daily, December 3, 2014

Excessive risk-taking remains area of concern, says OFR report

By Stephanie K. Mann, J.D.

The Office of Financial Research has submitted its 2014 Annual Report to Congress, citing threats to the stability of the U.S. financial system that have risen in the last year.

The annual report, issued five years after the end of the financial crisis of 2007-09, highlights three specific areas of concern:

  1. excessive risk-taking during an extended period of low-interest rates and low volatility;

  2. an increase in market fragility resulting in declining market liquidity and persistent risks of asset fire sales and runs; and

  3. the migration of financial activity away from banks toward less-regulated parts of the financial system where threats could be significant, but are more difficult to assess.

“Threats to financial stability are moderate, our tools for spotting them are better, and the financial system in many ways is more resilient compared with just before the financial crisis,” said OFR Director Richard Berner. “But as the financial system evolves and innovates, we must be especially watchful for important new vulnerabilities that are emerging in dynamic financial companies and markets.”

The report notes that, in addition to new vulnerabilities, gaps remain in the analysis, data, and policy tools aimed at spotting and addressing them, despite progress in narrowing those gaps. Moreover, many new policy tools designed to make the financial system stronger and more transparent are still largely untested and may have unintended side effects. The report also found that the development and implementation of other policy tools to respond to threats to U.S. financial stability remains incomplete.

Annual report. Highlights of the OFR 2014 Annual Report include:

  • A discussion of “Analyzing and Monitoring Threats to Financial Stability,” with the OFR’s Financial Stability Monitor as the centerpiece. The monitor displays the state of financial stability and the buildup of vulnerabilities across five broad categories of risk based on a set of models, surveys, financial data, and other indicators.

  • A discussion of the benefits and challenges of new policies to enhance financial stability, most of which focus on the largest, most complex banks or nonbank financial firms designated for enhanced supervision.

  • A summary of three significant OFR research initiatives, including a project that uses agent-based models to simulate the spread of fire sales in financial markets during crises. In a second project, OFR researchers explore effective and innovative visualization techniques that reveal key patterns and connections in complex financial data. A third project uses data available to the OFR from the $26 trillion credit default swap market to analyze the role of information flows on the pricing of derivatives and to explore how transaction sizes affect prices and liquidity under different market conditions.

  • An assessment of progress and challenges in developing and implementing financial data standards, which are essential to providing high-quality data for the benefit of policymakers and industry participants. To assure data quality, the OFR continues to call on regulators to require the use of data standards in regulatory reporting.

  • A description of OFR progress in filling gaps in data needed to monitor and analyze threats to financial stability, especially those arising in market-based activities—so-called shadow banking activities.

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