Simon Johnson calls for ideas to 'strengthen' the Office of Financial Research

In his Bloomberg column, MIT professor Simon Johnson explains why he thinks the Office of Financial Research is important and calls for ideas to strengthen it.

Regular readers know that the Office of Financial Research is at the top of the list of the parts of the Dodd-Frank Act that should be repealed.

Put simply, the Office of Financial Research is where transparency, which is the foundation of our capital markets and economic system, goes to die.

From his column,

A more difficult task is to measure and comprehend system risks before they become debilitating. That’s what the Office of Financial Research is supposed to do. 

It shouldn’t just report on current credit conditions in a generic fashion; it should coordinate the release of timely information from all parts of the financial system.

The reason that transparency dies at the hands of the Office of Financial Research is that its does not have the mandate to release timely information.  It only has the right to report on current conditions.

These two should not be confused.

Releasing timely information implies that market participants can access and independently assess the raw data.  Market participants can subsequently adjust both the price and amount of their exposures based on this analysis.  The result is that systemic risk is minimized.

Reporting on current conditions implies that the staff of OFR has assessed the raw data and provided its conclusions.  Market participants are dependent on the staff of the OFR both correctly assessing the raw data and accurately conveying these findings.  A dependency that insures regulators continue to be a single point of catastrophic failure in the financial system (our current crisis is an example of this).

The banking lobby understood this distinction and that is why it supported creating OFR with only the capacity to report the findings of its staff.  The opacity protection team understood how easy it is to prevent disclosure to all market participants by saying the banks were already providing disclosure to the regulators.

Your humble bloggers knows one of the individuals who lead the charge to create OFR and was integral to shepherding it through Congress.  After Dodd-Frank passed, he called me up to apologize.

The apology began with his telling me I was right that OFR was where transparency would go to die.  He observed that no matter how large the egos of the economists who support or staff OFR are, they would never be able to replace the analytical ability of the financial markets (each economist learned in Econ 101 and has probably forgotten that it is the collective wisdom of the market that produces the best result).

In short, he understood that the bank lobby had used him and the many Nobel-prize winning economists who supported OFR to protect opacity in the financial system and kill transparency.

There may be alternatives to building up a strong and independent-minded OFR, but I don’t see them. I don’t see any chance that the Federal Reserve or other regulators will share the data needed to anticipate risks....

The fact that Professor Johnson doesn't see them, doesn't mean they don't exist.

There is one obvious alternative to a strong and independent-minded OFR.  That alternative is to bring transparency into all the opaque corners of the financial system so that all market participants have access to all the useful, relevant information in an appropriate, timely manner.

For example, banks should be required to provide ultra transparency and disclose to all market participants on an on-going basis their current asset, liability and off-balance sheet exposure details.

For example, structured finance securities should be required to provide observable event based reporting and disclose to investors before the next business day any activity that occurs with the underlying collateral.  This includes, but is not limited to, a payment, delinquency, default, modification or bankruptcy filing.

Our ability to ensure financial stability is only as good as the available data. I’m concerned that, when the next financial crisis hits, the OFR will be the weakest official link.

Please re-read the highlighted text as it is exactly the point your humble blogger has been making both about the need for transparency in the financial system and that OFR is going to be a source of catastrophic failure.

Thinking about how to strengthen that office is an important priority for anyone who cares about systemic risk. If you have specific ideas, send them along.

Since you asked,

Dear Professor Johnson:

As the recognized leading global expert in transparency and its role in managing systemic risk and preventing a systemic financial crisis, I recommend that the Office of Financial Research acknowledge that it is a major contributor to systemic risk.

As a result, it should request that Congress take one of two courses of action before the end of the current legislative session:

• Either abolish OFR completely; or 

• Change its mandate so that OFR funds the creation of the 'Mother of All Financial Databases', allows all market participants to access this data and is officially prohibited from ever delivering a public comment on the financial system based on its assessment of this data.  The Mother of All Financial Databases would include the data banks provide under ultra transparency and structured finance securities report under observable event based reporting.

Should you have any questions, please do not hesitate to contact me.  You already have my contact information.

Richard Field