Technical Capabilities Necessary for Regulation of Systemic Financial Risk

Summary of a Workshop

Robert F. Engle, New York University

Scott T. Weidman, National Research Council

Rapporteurs

NATIONAL RESEARCH COUNCIL OF THE NATIONAL ACADEMIES

THE NATIONAL ACADEMIES PRESS

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Technical Capabilities Necessary for Regulation of Systemic Financial Risk Summary of a Workshop Robert F. Engle, New York University Scott T. Weidman, National Research Council Rapporteurs

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THE NATIONAL ACADEMIES PRESS 500 Fifth Street, N.W. Washington, DC 20001 NOTICE: The project that is the subject of this report was approved by the Governing Board of the National Research Council, whose members are drawn from the councils of the National Academy of Sciences, the National Academy of Engineering, and the Institute of Medicine. This study was supported by a grant from the Alfred P. Sloan Foundation. The views expressed in this publication are those of the authors and do not necessarily reflect the views of the Alfred P. Sloan Foundation. International Standard Book Number-13: 978-0-309-14960-0 International Standard Book Number-10: 0-309-14960-6 Copies of this report are available from the National Academies Press, 500 Fifth Street, N.W., Lockbox 285, Washington, DC 20055; (800) 624-6242 or (202) 334-3313 (in the Washington metropolitan area); Internet, http://www.nap.edu. Copyright 2010 by the National Academy of Sciences. All rights reserved. Printed in the United States of America

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The National Academy of Sciences is a private, nonprofit, self-perpetuating society of distinguished scholars engaged in scientific and engineering research, dedicated to the furtherance of science and technology and to their use for the general welfare. Upon the authority of the charter granted to it by the Congress in 1863, the Academy has a mandate that requires it to advise the federal government on scientific and technical matters. Dr. Ralph J. Cicerone is president of the National Academy of Sciences. The National Academy of Engineering was established in 1964, under the charter of the National Academy of Sciences, as a parallel organization of outstanding engineers. It is autonomous in its administration and in the selection of its members, sharing with the National Academy of Sciences the responsibility for advising the federal government. The National Academy of Engineering also sponsors engineering programs aimed at meeting national needs, encourages education and research, and recognizes the superior achievements of engineers. Dr. Charles M. Vest is president of the National Academy of Engineering. The Institute of Medicine was established in 1970 by the National Academy of Sciences to secure the services of eminent members of appropriate professions in the examination of policy matters pertaining to the health of the public. The Institute acts under the responsibility given to the National Academy of Sciences by its congressional charter to be an adviser to the federal government and, upon its own initiative, to identify issues of medical care, research, and education. Dr. Harvey V. Fineberg is president of the Institute of Medicine. The National Research Council was organized by the National Academy of Sciences in 1916 to associate the broad community of science and technology with the Academy’s purposes of furthering knowledge and advising the federal government. Functioning in accordance with general policies determined by the Academy, the Council has become the principal operating agency of both the National Academy of Sciences and the National Academy of Engineering in providing services to the government, the public, and the scientific and engineering communities. The Council is administered jointly by both Academies and the Institute of Medicine. Dr. Ralph J. Cicerone and Dr. Charles M. Vest are chair and vice chair, respectively, of the National Research Council. www.national-academies.org .

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Board on Mathematical Sciences and Their Applications C. DAVID LEVERMORE, University of Maryland, Chair TANYA STYBLO BEDER, SBCC Group PHILIP A. BERNSTEIN, Microsoft Corporation PATRICIA FLATLEY BRENNAN, University of Wisconsin-Madison EMERY N. BROWN, Massachusetts General Hospital GERALD G. BROWN, U.S. Naval Postgraduate School RICARDO J. CABALLERO, Massachusetts Institute of Technology GUNNAR E. CARLSSON, Stanford University BRENDA L. DIETRICH, IBM Thomas J. Watson Research Center DEBRA ELKINS, Allstate Insurance Company SUSAN J. FRIEDLANDER, University of Southern California PETER WILCOX JONES, Yale University KENNETH L. JUDD, Hoover Institution CHARLES M. LUCAS, Osprey Point Consulting VIJAYAN N. NAIR, University of Michigan CLAUDIA M. NEUHAUSER, University of Minnesota J. TINSLEY ODEN, University of Texas at Austin DONALD G. SAARI, University of California at Irvine J.B. SILVERS, Case Western Reserve University GEORGE SUGIHARA, University of California at San Diego Staff SCOTT T. WEIDMAN, Director NEAL D. GLASSMAN, Senior Program Officer BARBARA W. WRIGHT, Administrative Assistant For more information on BMSA, see its Web site at http://sites.nationalacademies.org/ DEPS/BMSA/index.htm, write to BMSA, National Research Council, 500 Fifth Street, N.W., Washington, DC 20001, or call (202) 334-2421. iv

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Acknowledgments Sincere appreciation is extended to the Alfred P. Sloan Foundation for sponsoring the workshop that is summarized in this report and the preparation of this document. This report has been reviewed in draft form by individuals chosen for their diverse perspectives and technical expertise, in accordance with procedures approved by the National Research Council’s Report Review Committee. The purpose of this independent review is to provide candid and critical comments that will assist the institution in making its published report as sound as possible and to ensure that the report meets institutional standards for objectivity, evidence, and responsiveness to the study charge. The review comments and draft manuscript remain confidential to protect the integrity of the deliberative process. We wish to thank the following individuals for their review of this report: Christine Cumming, Federal Reserve Bank of New York, Darrell Duffie, Stanford University, Andrew Haldane, Bank of England, Arvind Krishnamurthy, Northwestern University, David Rowe, SunGard, Charles Taylor, The Pew Charitable Trusts. Although the reviewers listed above have provided many constructive comments and suggestions, they were not asked to endorse the conclusions or recommendations, nor did they see the final draft of the report before its release. The review of this report was overseen by Peter Bickel of the University of California at Berkeley. Appointed by the National Research Council, he was responsible for making certain that an independent examination of this report was carried out in accordance with institutional procedures and that all review comments were carefully considered. Responsibility for the final content of this report rests entirely with the rapporteurs and the institution. v

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Contents 1 INTRODUCTION AND MAJOR OUTCOMES OF THE WORKSHOP 1 Goals of the Workshop, 1 Some Underlying Observations, 1 Major Points for Policy Makers, 2 2 MAJOR THEMES OF THE WORKSHOP DISCUSSIONS 4 Need for a Common Language for All Securities and Financial Contracts, 4 Data Needed for the Regulation of Systemic Financial Risk, 5 Some Signals That a Systemic Regulator Might Monitor, 7 Monitoring Networks of Counterparty Risks and Exposures, 8 Regulators Need New Analysis Tools, 10 Privacy and Other Issues That Limit the Regulatory Use of Data Already Collected, 10 Which Data Should Be Public Information? 11 The Need for Stronger Training in Financial Risk Management, 12 Incorporating an Understanding of Human Behavior into Systemic Risk Regulation, 12 3 OBSERVATIONS FROM THE WORKSHOP’S KEYNOTE PRESENTATIONS 14 APPENDIXES A Letter from Senator Jack Reed to Ralph Cicerone, National Academy of Sciences President 17 B Workshop Participants 20 vii

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