Seeking to manage, or at least measure, financial and systemic risk by a closer inspection, analysis, and even simulation, of financial contracts and counterparties at a more precise level of detail and frequency is a significant departure from many traditional risk management and supervision practices.
The results of more detailed contractual and counterparty analysis — which, taken together to reach the level of the enterprise from the bottom up — offers far better insights into the risk dimensions of both a firm, as well as the financial system, than practices in the form of large-brush composite risk measures and coefficients applied to balance sheets from the top down. The latter greatly reduces the burdens of compliance and regulatory reporting, but it is also much less informative and accurate.
The goals and objectives of accounting practices and methodologies are generally to provide an accurate view of the financial condition and activity of a firm as a going concern, to the extent that one-time events are noted as exceptions, and the effects of other transactions such as capital investment, revenue recognition, and depreciation are spread across a wider horizon of ‘useful life’.
When accounting methodologies aimed generally at showing a longer-term view of a firm’s ‘trailing average’, or smoothed-out, behavior are applied to risk management, artifacts can arise that obscure or mask risk, and the one-time events which accounting practice seeks to footnote should in all likelihood be headline topics for risk analysis such as stress testing.
Some fundamental premises of how best to respond, as a firm and as an industry, to regulatory requests for more detailed contractual and counterparty information:
1) Individual firms should seek to turn what is traditionally viewed as a non-productive overhead cost of regulatory reporting and compliance — in light of the new mandate to provide more detailed financial information — as an opportunity to map contract-level financial positions into a financial data repository that spans the entire balance sheet (and off-balance-sheet) of the firm and allows across-the-board analysis and stress testing using level-playing-field scenarios and assumptions.
Currently, most firm’s product divisions are isolated in operational silos with proprietary systems-of-record formats and potentially incompatible risk management methodologies and assumptions. Implementing this approach will result in risk measurement and management practices which are more timely, more comprehensive, and based on higher-resolution detailed data — a ‘win’ for the firm.
Firms should not view the proposal to create and populate such a database as an attempt to jack up their entire financial operations and insert a new ‘ground floor’, nor to be a replacement for internal data warehousing initiatives. Rather, the model is to allow an interface database to be populated with appropriate mappings from existing systems within the firm.
As such, such a database, though comprehensive and more detailed than traditional G/L reporting data stores, is not ‘mission critical’ , but more along the lines of decision support — and could provide a platform for productive use to that effect internally within the firm as well.
2) The industry as a whole, in conjunction with regulators, should strive to agree on a common standard to represent low-level financial positions and contracts such that each firm does not create its own proprietary version of such a data model, one which then requires further re-mapping and translation (and likely incompatibility) at the level of systemic oversight.
Having the financial industry and the public regulators agree on a common data model, with requisite standardized reference data, will be a “win” for the public good as well, as it will greatly reduce the cost and complexity of making sense of more detailed financial information for purposes of analysis at the systemic level in the Office of Financial Research.
Finally, by implementing a form of distributed reporting repository, if you will, each institution can make the database available on a secure basis to not only regulators but also to internal staff as well as vendors who can supply value-added reporting and analysis tools predicated on the standard model. This is yet a third win for economic efficiencies that would make available better risk management practices to a wider range of institutions who otherwise would not choose or be able to develop such tools.
The increased regulatory requirements mandated by the recent passage of the Dodd Frank Act are no doubt not a welcome development for financial institutions, and the challenges to fulfill the specific functions of the Office of Financial Research as delineated therein would be formidable even with full cooperation from the industry. However, given that the work needs to be done, and time and effort expended, it clearly is in the best interests of the financial industry and the public if the projects can be pursued in a manner that will produce substantial long-term benefits to offset the additional costs incurred.