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Insight: U.S. early warning system for financial crises gets low marks

Richard Berner (R), Director of the Office of Financial Research for the U.S. Treasury and Brian Reid (L), Chief Economist with the Investment Company Institute, appear on the panel "Systemic Risk and the Asset Management Industry" at the Brookings Institution in Washington December 16, 2013. REUTERS/Gary Cameron

(Reuters) – In June 2009, a small group of academics sent an envoy to a Washington, D.C., think tank to pitch their vision for a research office to help the nation avoid the next financial crisis.

Richard Berner (R), Director of the Office of Financial Research for the U.S. Treasury and Brian Reid (L), Chief Economist with the Investment Company Institute, appear on the panel “Systemic Risk and the Asset Management Industry” at the Brookings Institution in Washington December 16, 2013. REUTERS/Gary Cameron

The idea was to create a premier U.S. data powerhouse that would be a National Weather Service for financial storms, with up-to-the-minute information on transactions and the analytical juice to anticipate where systemic risks were quietly growing.

Their pitch worked. The Office of Financial Research was created within the Treasury Department, part of sweeping reforms in response to the worst financial crisis in decades.

But more than three years since the passage of the 2010 Dodd-Frank law, it is struggling to stay relevant.

Its first formal study, which found possible risks posed by the activities of asset managers like BlackRock Inc and Fidelity, was panned by many as ill-informed and ripped to shreds by the industry.

The office must compete for top minds on a lower pay scale than some other agencies. And crucially, other regulators are hesitant to share data and expertise.

Even some of the office’s key backers criticized its early work. The office, or OFR, needs a turnaround to avoid becoming a second-class bureaucratic operation, succumbing to regulatory turf wars and becoming unable to spot a brewing financial crisis.

“In order to be effective, OFR must have data integrity and thorough, accurate analysis,” said U.S. Senator Jack Reed, a Rhode Island Democrat who drafted the legislative language that created the research unit.

“The office has to raise its game,” Reed said of the asset management report.

Its director, Richard Berner, a former economist at Morgan Stanley and Mellon Bank, wants time. He told Reuters the OFR is still new and recruiting top talent.

The agency has roughly 185 staff members, and Berner hopes to have 300 in 2015. Its fiscal 2013 budget, financed through fees on big banks, is about $78 million.

The office takes annual looks at simmering stability risks and, observers say, has made progress tracking financial transactions.

“Now that we are starting to get some critical mass on the research side, the data side and the technology side, the progress is coming faster,” Berner said in an interview. “The accomplishments are substantial.”

ACADEMIC THEORY

The idea for the research office took shape at a February 2009 conference on statistics in bank regulation. Participants decided regulators lacked the data to anticipate the 2007-2009 crisis and needed a research powerhouse, said Arthur Small, an economist who joined the group shortly after the conference.

“We felt a great sense of urgency,” Small said, to make sure the idea got into the Dodd-Frank law.

One member gave the 2009 presentation at the American Enterprise Institute, and the group spoke with Martin Gruenberg of the Federal Deposit Insurance Corp, Neal Wolin, then a top official at the U.S. Treasury, and others. Senator Reed of Rhode Island pushed to get the research office into the law.

Dodd-Frank gave the office two major tasks. One is to standardize financial transaction data so regulators can eventually monitor asset bubbles as they form.

The other is to support the Financial Stability Oversight Council, or FSOC, a group of regulators that watches risks. OFR studies are meant to inform the FSOC’s policy decisions.

EARLY BATTLES

The OFR’s first big project came in 2011, when the FSOC wanted to know if the activities of asset managers posed risks to financial stability.

These firms buy stocks and bonds on behalf of investors and, together, handle trillions of dollars in assets. If the FSOC dubbed a manager “systemic,” it would face costly mandates to rely less on debt and be regulated by the Federal Reserve.

At the time, the OFR was understaffed and had few in-house markets experts. The Federal Reserve Bank of Boston loaned the OFR a staffer with asset management expertise to help out, a Boston Fed spokesman said.

Economists from all of the federal regulators also agreed to participate in early-stage meetings to develop the report, except the U.S. Securities and Exchange Commission. Its economists did not respond to email invitations or attend at brainstorming sessions, even though the SEC is the industry’s main regulator, two people familiar with the matter said.

The SEC did not participate early on because it had limited resources, and officials there were also skeptical about the office’s level of experience, two other people said.

But when the OFR eventually circulated drafts, SEC lawyers tried to edit the report. They thought it showed little understanding of the industry, three people told Reuters.

The OFR toned down and shortened the final report in September 2013, several people said, but the study raised concerns about managers borrowing to boost returns or crowding into the same assets at once.

SEC officials remained unhappy and asked for public feedback on the study, a sign of criticism in regulatory circles.

The asset management industry said it was misleading and inaccurate.

Berner has since said the SEC was involved “from beginning to end.” “Their fingerprints are on the report as well,” he said at a recent event in Washington.

SEC Chair Mary Jo White asked about the kerfuffle at a November conference, said the SEC shared expertise. But “at the end of the day, it is obviously the OFR’s study,” she said.

A spokesman for the SEC declined to comment beyond White’s public comments.

Data sharing has been a wider problem.

It took the OFR nearly two years to access Federal Reserve data on overnight funding methods, or “repo” loans, that regulators think fueled the financial crisis, a person familiar with the matter said.

The Fed took so long because it wanted to ensure the data would be secure, the person added.

The Fed, which declined to comment, is notoriously careful about sharing bank data lest it accidentally become public. It requires memoranda of understanding, or MOU, detailing safeguards for sensitive data.

The OFR now is early into a similar effort to get data on annual stress tests run by the Fed. Dodd-Frank directed the OFR to weigh the efficacy of the tests, which consider how banks would fare in a crisis. But it does not have the Fed data yet.

“The OFR should do whatever it takes to gain access to the data collected by the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp to execute the Dodd-Frank mandated stress tests,” the office’s outside advisory group wrote in August.

Berner said the office would seek an MOU with the Fed to share the data, but to date it has not made a formal request.

EARLY GOING

The office is still in its early stages, and many of its supporters remain optimistic about the office’s potential.

They point to the OFR’s work on an international effort to create unique identifiers for financial institutions that would be used like barcodes to track activities.

“My analysis is that without the OFR, that probably just wouldn’t have happened,” said Small, the economist who helped push for the office. “That’s a first, critically important step in making the financial system machine-readable.”

But the OFR is also still working to staff up and, at times, struggles to compete for talent within the government.

The Fed, which has huge cachet among economists looking for government experience, launched its own research unit around the same time as the OFR. It pays better, too.

The OFR’s advisory panel said a PhD making around $200,000 a year at the Fed would get less than $120,000 at the OFR. The OFR needs to boost pay, the outside group said, or “it is doubtful that the OFR will be able to attract the talent that it needs to fulfill its research mission.”

Berner said the office’s pay practices are evolving, and it is “making the changes we need to make” to hire more.

Still, the unit needs more top-tier talent and critical data if it is to spot the next crisis before it lands.

“The OFR has a strong potential. It’s unencumbered by regulatory responsibilities. It has funding. It has access,” said Andrei Kirilenko, a former chief economist at the Commodity Futures Trading Commission who is now at the business school for the Massachusetts Institute of Technology.

“But for a variety of operational reasons, it seems to have not been able realize its potential,” he said. “I’d really like to see this office succeed and have it become a center of excellence for systemic risk.”

(Editing by Karey Van Hall, Martin Howell and Eric Walsh)

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