The Committee to Establish the National Institute of Finance was founded in 2009 by a group of private citizens with the aim of building a transaction data framework to provide financial regulators with the data and analytic tools to better monitor systemic risks impacting the financial system. In a Q&A with Arthur Small, CE-NIF member and associate professor at Penn State University, he explains how the objectives of the CE-NIF have been formally proposed in the Senate Bill and will hopefully be retained in the converged bill that is expected to be passed into law later this year.
Q. What is included in the Senate Bill that supports the CE-NIF’s objectives?
Just to give some background first. Last February Sen. Jack Reed (D-RI) introduced the National Institute of Finance Act of 2010. This bill incorporated many of the proposals put forward by the the Committee to Establish the National Institute of Finance. This bill was then folded into the larger architecture for financial regulatory reform that Sen. Christopher Dodd put together in the Senate Banking Committee. The Senate’s Restoring American Financial Stability Act was then passed in the Senate and is currently being converged with the Wall Street Reform and Consumer Protection Act passed by the House of Representatives in December 2009.
There were a few changes made in the transition of the National Institute of Finance Act to the Senate bill. Firstly, the name of the entity has been changed from the National Institute of Finance to The Office of Financial Research (OFR). More importantly, this new entity will no longer be an independent entity because it will be structured as an office within the Department of Treasury.
Nonetheless, the Senate Bill retains for the OFR a great deal of the independence the CE-NIF was pushing for. The appointed OFR director, although formally subordinate to the secretary of the Treasury, would be effectively independent. This director would be appointed by the President, will serve a term of office of five years, and would therefore not be a political appointee that comes and goes with an administration. The OFR Director would also serve as a non-voting member of the Financial Stability Council (FSC), which is also created by the Senate bill. *
Q. What is the proposed Office of Financial Research’s function?
The Senate bill also expresses that the OFR’s role will be to serve as the technical support function to this FSC. And there are two parts of that function: data gathering and analytics.
A major purpose of the OFR will be the creation of data standards for the financial services sector and in particular, to set standards for the submission of financial data to the US government. This submission of data would include the level of detail the OFR director deems necessary, which would likely include a highly granular level of transaction data. The OFR would eventually issue and maintain two different and very important public databases via the Financial Data Center. One would be a database of the financial instrument types, and another a database of financial entities and organizations.
The other major office would be the Financial Research and Analysis Center whose mission will be to develop intelligence out of the data and to build tools that would help do analysis and map flows of financial transactions within the network of the financial system to identify emerging systemic risks. This center will also do scenario analysis and stress testing to review the consequences of a given market situation, such as the default of a big investment bank. With this center in place, one would have the analysis and intelligence at hand to be able to see what will likely happen in different market scenarios which would help regulators make decisions during times of market turmoil such as experienced in 2008. The idea is that in order to understand, monitor and manage systemic risk you have to have the data and analytics that embraces the entire financial system.
Q. What type of financial institutions will be required to submit financial data to the OFR?
This is going to be decided by the FSC and the director of the OFR. The FSC will be able to exempt certain classes of institutions if it feels this is appropriate. There has been some discussion about whether or not reporting requirements will be a burden on smaller institutions, but in fact the smaller institutions tend to use third-party providers for this type of data management, so it is not too burdensome. However, these smaller firms, such as local credit unions, are probably not as important in terms of identifying systemic risk impacting the entire financial system.
There has been some push to exempt the insurance sector entirely. And the reason for this is that currently under U.S. financial regulation, insurance companies have historically been regulated not at the federal level but within individual states. One of the insurance lobbying groups have stated that they believe the proposed bill should be changed so the insurance sector would not be covered by the OFR and would therefore not be obliged to do this type of transaction reporting. However, insurance companies are a major part of the asset management industry and therefore a substantial player in the overall financial system. The problem with exempting an entire sector of the financial system is that this exemption would create incentives for firms who do not want their transactions observed to move these transactions into the blind spots. So, we feel because Wall Street is so very creative, this initiative has to be comprehensive.
In fact, you could summarize the argument against this exemption with three letters: AIG. AIG Financial Products, a London-based subsidiary of AIG, was able to issue the credit default swaps because they were using the AAA credit rating they had as part of this large insurance conglomerate. I would be very concerned of some kind of repeat if the insurance industry was given a blanket exemption.
Q. What do global financial institutions have to do to be able to provide this information and data to the OFR?
There have been a number of efforts to demonstrate proof of concept including the underlying semantics involving efforts from the EDM Council, and also to demonstrate proof of concept in terms of where software comes from. Also, the Securities & Exchange Commission (SEC) has various initiatives for electronic reporting, so this focus on data and reporting is not exactly coming from left field. Secondly, I would note this is going to be something that occur over several years and will involve industry collaboration and input.
There are enormous benefits to the financial industry itself from standardization. Internal analysis by one major Wall St. bank shows that the firm stands to save $300 million a year in operating costs because they would be spared the expense of reformatting and cleaning all the data that they get from other financial institutions with which they transact. Also, access to the data gives greater certainty in the underlying value of transactions. So there are very large, direct benefits to the financial industry. Financial institutions will find it a lot easier to make the necessary IT investment when moving to an industry standard, knowing that other firms with which they transact will likewise be moving to adopt the same standards.
Q. What are the plans to make this initiative global?
As the legislation is currently proposed, it states the mandate of the OFR would cover all US flag financial institutions as well as foreign institutions in their US operations. However, we would hope and expect the OFR would be an important part of an emerging international data and analytics framework. There is no reason to have multiple versions of reference databases to identify financial institutions or to have more than one language for the exchange of financial data.
We would hope and expect that reference databases would be adopted on a global basis, and that other financial authorities in other jurisdictions such as the EU would be involved together with industry in the creation of some international standards that everyone would use. Ideally there would also be an exchange of analytical tools, knowledge and expertise between people working in different jurisdictions. Moreover, I think if the US does make this very large step there will arise some impetus for getting other jurisdictions to step up and to see this as a challenge to which they might choose to respond to.
The CE-NIF is already in discussions with figures in other countries including the UK, and have members from the European Central Bank working with us. That said, although we value international cooperation, our immediate focus is getting this legislation passed in the U.S. Congress.
Q. What is the next step for the CE-NIF?
Obviously, we are eager for legislation to pass as it is currently proposed and we are especially hopeful that the OFR director remains independent and that the insurance industry is not excluded in the final bill.
The CE-NIF is a citizen group: it does not have any statutory authority or official mandate. Our role all along has been educational. Once the legislation is passed, it will be up to the President to appoint an OFR director who can take charge. We hope we can provide some value to that director and the community that will form around that the OFR so they can get a jumpstart, but our help will be all advisory.
* The Financial Stability Council was created to better identify risk and emerging threats to the financial system. The FSC is composed of the heads of the major financial regulatory agencies including the US Treasury, Federal Reserve and the SEC.
