OFR Report Finds Threats to Financial Stability Are Increasing
Commentary by Steven Lofchie
Threats to the stability of the U.S. financial system have grown over the past year, according to the first Financial Stability Report by the Office of Financial Research (OFR).
The report details a number of major risks to the financial markets. They include the following: (i) elevated and rising credit risks, as borrowing fueled by highly accommodative credit and underwriting standards continues to expand, with defaults rising in lower-rated debt issuers and in the energy and commodity markets; (ii) possible financial stability risks imposed by macroeconomic conditions, including lower global economic growth; and (iii) new [vulnerabilities that] have emerged in the financial system; e.g., [i]nterconnections among financial firms [that] are evolving in ways not fully understood, for example, in the growing use of central clearing.
The report supplements and precedes the 2015 Annual Report to Congress, which will be published by the OFR in January.
Commentary
This is a substantial report. The tone of the report is moderately negative. One of the report's underlying themes is "the potential unintended consequences of financial regulation and financial stability policies" (at 1). This theme amounts to a reluctant admission by the regulators that certain policies were either ill-considered or pushed too far.
The mandate to force derivatives into central counterparties ("CCPs") is the most obvious example of new regulatory requirements that may have increased systemic risks (and certainly increased the risks created by interconnectedness.) For example, at the bottom of page 55, the OFR notes that "CME Clearing clears most U.S. futures, options on futures, and commodity options. . . ." The chart on page 56 illustrates the manner in which forced central clearing has resulted in increased interconnectedness. In Section 5 of the report, the OFR discusses some of the specific risks of central clearing. While it is good that the regulators acknowledged these risks, it seems that they do so reluctantly. For example, the OFR asserts that "clearing through CCPs has allowed previously opaque markets to become more transparent. . . . It has also improved accounting for positions previously considered illiquid. . . . " Since the only swaps that do or ever will trade through CCPs are very liquid swaps, such as rate swaps, it seems a stretch to describe these swaps as ever having been opaque or illiquid.
Another area noted in the report in which regulators might be creating risks is excessive capital regulation (at page 44). Various capital regulations could have the effect of creating a rapid downturn if banks were forced to sell off assets in order to prevent the breach of one capital ratio or another. This could cause a downturn in market prices, which could force other banks to sell off, and so on. In a market in which every bank is constrained severely by capital rules, it is not clear who the buyers will be.
OFR reports clearly are valuable. While it is encouraging to see regulators exercise self-criticism, it is also apparent that the process of risk assessment would benefit from a wider range of views and, perhaps, from greater separation between those who make policy and those who evaluate it.