January 06, 2014

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. ...