Order ‘Big Short’ for an Out-to-Lunch Congress

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May 16 (Bloomberg) -- For all the criticism of the Dodd-Frank Act, one thing the law does right is fill the informational and analytical blind spots that allowed our economy to unwittingly approach the precipice of disaster.

Little noted among the law’s 2,300 pages and 16 titles is a section creating the Office of Financial Research within the U.S. Treasury Department. The humble pie on which JPMorgan Chase & Co. chief Jamie Dimon is now feasting should be shared generously with those in Congress who would dismantle this valuable arm of government.

The OFR has the mission of collecting and analyzing data about the financial system. The results of its research will be made available to the new Financial Stability Oversight Council to help it carry out its duties monitoring systemic risks. The results of its research are also available to the public. The law banishes the willful blindness and passivity of financial regulators before the crisis.

There is a movement in Congress, however, that would bring back the not-so-good old days. And, just to prove their point, the House Financial Services Committee recently held hearings on the efficacy of the OFR a day after voting to disband the office. One representative went so far as to justify eliminating it on the basis that “everyone knew” about the looming financial crisis in 2008, so who needs an early-warning system. Order up another copy of Michael Lewis’s “The Big Short” for the good congressman.

Early Achievements

Evidence of the potential good that can come from the OFR is found in the work it has already undertaken. For example, it has reached out to experts in the academic community and in the private sector to establish best practices in risk management.

In December, the OFR, Treasury and the Financial Stability Oversight Council co-sponsored a major conference bringing together leaders from the regulatory community, academia, public-interest groups and the financial-services industry to discuss data and technology issues and analytical approaches for mitigating threats to stability. Isn’t this the kind of activity we all wish was taking place in Washington during the lead-up to the financial crisis?

But the OFR is more than a gabfest among policy wonks. The first two working papers that the OFR has produced are notable for their clarity and foresight on systemic risk.

The first paper, “A Survey of Systemic Risk Analytics,” provides a comprehensive examination of the various ways to measure systemic risk and considers the feasibility of an early-warning system for financial crises.

In an ideal world, systemic-risk monitoring would work much like the National Weather Service, providing advance notice of hurricanes so that authorities and market participants can put staff and resources in place, minimize exposure, and plan for the impending event and immediate aftermath.

Separately, the OFR and the Financial Stability Board are coordinating the development of a standardized legal-entity registry that will, for the first time, provide consistent global identification of counterparty financial transactions. It was, after all, the fear of unknown ties to unidentified counterparties that spooked investors and policy makers during the panic of 2008.

The second working paper, “Forging Best Practices in Risk Management,” lays out improvements in the way financial institutions and their regulators identify and control risk. Concluding with a helpful list of the most important areas for continued research, it serves as a virtual roadmap for modification of the role of risk management in financial firms’ business decisions.

Taking Risks

With this work in place, the OFR is poised to make a meaningful contribution on issues such as incorporating the potential for regime shifts (from low-volatility to high-volatility returns, for example); exploring the correlation between risk and executive compensation; and determining the proper relationship between regulation and internal risk management.

Finally, it’s worth remembering that hedging and risk bearing are central to the economic role of financial intermediary firms. But hedging also involves the use of leverage. As the Commodity Futures Trading Commission and the Securities and Exchange Commission bring transparency to the shadow banking system, it is important to have another set of eyes focused on economic risks that these regulatory agencies or private actors may have overlooked or chosen to ignore.

For now, it looks like the OFR will survive the misguided broadsides from some elements in Congress. Because the OFR is funded by the Federal Reserve until this July (and by levies on systemically significant firms thereafter) it is partly shielded from congressional interference.

In light of its important mission, however, the OFR deserves full support -- not just the meek endorsement of a dysfunctional political establishment. In this regard, the Senate should move forward with the confirmation of Richard Berner, President Barack Obama’s nominee to lead the OFR, and Congress should cease holding oversight hearings that are thinly disguised attempts to undermine the office’s purpose and legitimacy.

(Zvi Bodie is a professor of management at Boston University. Cornelius Hurley is director of Boston University’s Center for Finance, Law & Policy. The opinions expressed are their own.)

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To contact the writers of this article: Zvi Bodie at zbodie@bu.edu Cornelius Hurley at ckhurley@bu.edu

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net