Why the regulators must have a global 'risk map'

We are still in the midst of the most severe downturn since the Great Depression. But one day we will come out of these dire straits. Are we any better prepared today to avoid a repetition of such a disaster? Have the supervisory agencies in the main financial centres learnt their lesson and adjusted their policies accordingly?

Consider the insights gained during this crisis. First, supervision has to focus on containing systemic risk rather than on avoiding individual bank defaults. Second, early warning signals need to be backed up by reliable information on all financial markets, including derivatives. Both aspects have been neglected in the past and continue to be neglected today.

The prevailing minimum capital accords, Basel I and Basel II, while aiming at stabilising individual institutions, disregard system-wide risks altogether. However, even if systemic risk were on the agenda of central banks and supervisors, there would still be a profound lack of reliable data on crossborder exposure among banks and on derivative products. This severe informational gap has undermined the credibility of early warnings published by, for example, the Bank for Inter­national Settlements, well before 2007.

Setting up a solid information base capturing global financial exposures is imperative. There is a long list of exposures that are not transparent today, for example the cross-border links between large, complex financial institutions (LCFIs) and the whereabouts of credit default swaps, collateralised debt obligations and other asset-backed securities. Putting together a global "risk map" displaying financial links among LCFIs as well as the most important risk drivers, such as asset price changes and yield spread dynamics, would enable authorities to carry out financial system stress tests.

The basis for the risk map would be a global database. We have proposed that standards be defined by a task force of experienced international agencies, such as BIS, the European Central Bank, the Organisation for Economic Co-operation and Development and the International Monetary Fund, allowing the data to be aggregated by region or by product.

Data privacy conditions and capacity limits mean data collection must be defined on a discrete - for example, quarterly - basis. The risk map project could be chaired by the IMF. Data sharing could be on an aggregated level to preserve data privacy and to maintain a level playing field for international competition.

Furthermore, data analysis would focus on an early warning methodology and a general assessment of systemic risk, which in turn could feed directly into the minimum capital requirement of international banks. Such a hard-wiring of systemic risk analysis to capital standards would allow supervisors to carry out counter-cyclical policies.

The control of systemic risk could be further enhanced by the use of a global credit register, which would essentially extend the risk map to exposures of banks with regard to large corporations. Existing credit registers are basically still national. This is an anachronism at a time when companies borrow and banks lend on a global scale.

Returning to our initial questions: have central banks and supervisors taken appropriate action to establish a reliable data foundation for systemic risk assessment? The answer is, unfortunately, no. Although 18 months have elapsed since the outbreak of the financial crisis, there is still no co-ordinated initiative.

What explains the reluctance of governments to get involved in a data generation exercise? The most likely explanation draws on the competitive situation in international financial markets, with governments aiming at preserving the competitive advantage of national banking industries.

Referring to the first question in the introduction, the answer is negative as well. We are still not prepared to avoid a disastrous financial crisis like the one that started 18 months ago.

However, in the interest of improved macro-prudential super­vision, one can see at least what needs to be done. As the huge losses caused by the financial crisis forcefully show, macro-financial stability is a public good that has to be actively managed. The risk map is one element in such an endeavour, and a vital element for that matter.

The authors are members of the expert commission advising the German government on issues relating to financial crisis prevention. Their latest report, New Financial Order: Recommendations by the Issing Commission, appeared in early February

Copyright The Financial Times Limited 2009