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The OFR Annual Report: RAGs to Riches

The OFR's annual report on the state of the financial system is an interesting read that contains a variety of financial information and metrics about the industry.

Government reports, particularly mandatory ones, can be rather dull reading, but the recently-released Annual Report of the Office of Financial Research (OFR) of the U.S. Department of the Treasury bucks the trend. The 2010 Dodd-Frank Act requires the OFR to report annually to Congress on the state of the U.S. financial system, including an analysis of any potential threats to financial stability. The OFR not only does this, but toward this goal also describes their attempts to model the interconnected financial system and to play a central role in developing and promoting financial data standards.

So on that question of financial stability, how are we doing? Here is my short summary of that part of the document, but as always I encourage you to go to the source. (The glossary alone is worth it, just to see official definitions of terms such as "repo run" and "fire sale.")

The OFR has developed a Financial Stability Monitor that tracks five categories of financial system distress (their term, not mine), using a mix of economic indicators, market indexes, and calculated measurements. The categories include:

  • Macroeconomic risk
  • Market risk
  • Credit risk
  • Funding and liquidity risk
  • Contagion risk

The first four are probably familiar to you. The last one, contagion risk, is defined as "the vulnerability of the financial system to sudden shocks that may spread through seemingly unrelated parts of the financial system." In other words, it is an acknowledgment that we are dealing with a complex system which can behave in unpredictable ways. (I am using "complex system" in its technical sense, as a system that consists of interconnected parts in which the behavior of the overall requires understanding not just the parts but the connections.) This initial tool is a starting point, which is expected to be enhanced over time. For example, all of the risks are evaluated, but not all of them are quantifiable at present.

The results are provided in a classic heat map or RAG (red-amber-green) report:

OFR's annual report on the health of the financial industry includes a classic heat map.
OFR's annual report includes a classic heat map.

The results are a pretty good summary of all of our hopes and fears, and track well with what the headlines tell us. I did not expect to see an increase in corporate sector risk for 2013. The OFR explains, "The quality of bonds and loans issued has declined, with evidence of increased risk-taking in the leveraged loan sector and reduced compensation for risk."

For me, the most interesting measures are the ones found under the "Contagion" category. Next time, I'll provide a summary of what the report says about that concept, how it relates to interconnectedness, and where the OFR research on network analysis is leading. And then I will conclude this three-part series with the OFR's progress and outlook on promoting data standards.

Jennifer L. Costley, Ph.D. is a scientifically-trained technologist with broad multidisciplinary experience in enterprise architecture, software development, line management and infrastructure operations, primarily (although not exclusively) in capital markets. She is also a ... View Full Bio
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KBurger
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KBurger,
User Rank: Author
1/9/2014 | 4:36:57 PM
re: The OFR Annual Report: RAGs to Riches
It's kind of like the parable of the blind men describing an elephant (each one defines the elephant -- incorrectly -- based , I guess. Thanks for the feedback, Jennifer.
Jennifer Costley
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Jennifer Costley,
User Rank: Apprentice
1/8/2014 | 10:22:26 PM
re: The OFR Annual Report: RAGs to Riches
Your statement is an interesting observation that applies to many complex systems - the interactions contribute to both stability and to instability, depending upon the external conditions and the state of the system itself. The role of regulation is more controversial - our approaches to regulating behavior of a complex, coupled system often backfire because we try to manage the "parts." That's one reason why the OFR's work on interconnectivity is so important; it is a recognition that we need to think more holistically.
IvySchmerken
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IvySchmerken,
User Rank: Author
1/8/2014 | 9:04:25 PM
re: The OFR Annual Report: RAGs to Riches
Asset market interdependence moved from red in 2012 to orange in 2013, so the global financial system is (was) safer in that regard. Of course, this could change.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Apprentice
1/8/2014 | 4:54:51 PM
re: The OFR Annual Report: RAGs to Riches
I wonder why interest rate risk moved into the 'high risk' category in 2013? Just simple market dynamics and/or uncertainty?
KBurger
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KBurger,
User Rank: Author
1/7/2014 | 5:10:37 PM
re: The OFR Annual Report: RAGs to Riches
I guess the good news in the contagion area is that there has been a reduction in risk in the past year, at least according to OFR. But you are right that the interconnectedness and interdependencies of the financial system create raise some serious concerns and challenges. However, in some ways that is the strength of the financial system, too, or at least what makes it work. There's no going back on that, so I guess it becomes a matter of holding all the players to the same (and higher) standards -- which is what regulation is all about.
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