Opinion: America’s ability to identify financial stability risks is weakening

Disclaimer: The views expressed in this article are solely mine, and do not represent the views of my employer.

As the ten year anniversary of the infamous Lehman Weekend has come and gone, it’s important to reflect on the lessons that we learnt. Or in the tragic case of the Office of Financial Research, the independent federal agency Congress set up to identify risks to America’s financial stability; lessons that we should have learnt.

Let’s take a quick trip down memory lane to July 21, 2010, as the United States reeled with the deepest economic recession since the Great Depression. A bill named after Barney Frank, a Democratic Representative, and Chris Dodd, a Democratic Senator, was signed into law by then-U.S. President Barack Obama. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111–203, H.R. 4173), more affectionately referred to as Dodd-Frank, was passed in response to the 2008 Financial Crisis and to the strong public outrage against the apparent failures of regulators, markets, and rating agencies to adequately understand the extent of leverage and maturity transformation. Dodd-Frank brought vast swathes of change to the American financial regulatory environment, including all federal financial regulatory agencies and almost every aspect of the financial services industry.

It also addressed a core failing of regulators and financial firms that became apparent during the financial crisis: data.

“Data, data, data.” The OFR cried impatiently. “I can’t make bricks without clay!”

As the financial crisis made crystal clear, neither regulators nor financial firms had the tools necessary to quickly and accurately identify and assess the outstanding exposures of failing financial institutions. As the Office of Financial Research (the “OFR”) later reported, “Financial data collected were too aggregated, too limited in scope, too out of date, or otherwise incomplete.”

Yet it was from this crucible of data deficiency, the OFR was born. Through Dodd-Frank, Congress addressed the issue of information: first, it created the Financial Stability Oversight Council (“FSOC”), consisting of all the federal financial regulatory agencies to identify threats to U.S. financial stability, and to promote market prudence; and second, it created the OFR (Section 153(a) of Dodd-Frank), an independent bureau within the U.S. Treasury, to “serve the needs of the FSOC, to collect and standardize financial data, to perform essential research, and to develop new tools for measuring and monitoring risk in the financial system.”

In a way, the OFR was meant to be an independent, beating heart of America’s new financial oversight mechanism, by identifying, monitoring, and evaluating threats to financial stability.

Figure 1: OFR’s home page, where a bounty of information on U.S. financial stability can be found.

And until the end of 2016, the OFR had been fulfilling its mandate. The OFR’s yearly Financial Stability report provides rich analysis into emerging threats such as the potential role of ETFs in generating and propagating liquidity stress, to most recently, the vulnerability of the financial system to malicious cyber threats.

But the ability of the OFR to effectively accomplish its Congressional mandate has been drastically weakened, and not by choice.

President Trump’s Agenda against Bureaucracy

With the 2016 U.S. election came the herald of President Donald Trump. During his Presidential campaign, he promised a widespread deregulatory agenda and total overhaul of U.S. bureaucracy; a promise that his administration has ambitiously pursued.

On regulations, President Trump’s Executive Order 13771 of January 30, 2017 on “Reducing Regulation and Controlling Regulatory Costs” outlined a broad and sweeping deregulatory directive (if you are interested, Brookings has an excellent deregulation tracker). Under this directive, the Trump administration has pursued everything from removing protections for the greater sage grouse, to providing exemptions to certain nonprofits from disclosing donor data in their tax filings (whether you agree or disagree with the deregulatory agenda is not within the purview of this article).

On bureaucracy, the Trump administration has taken aim at various federal agencies through hiring freezes, unfilled vacancies, and by directing agencies to negotiate tougher union contracts. Just as an example, the U.S. State Department and USAID have notoriously been gutted, with substantial budget reductions and loss of career U.S. diplomatic corps. And unfortunately, the OFR has been swept up as collateral damage.

As a result, the OFR has suffered drastic cuts to funding, staff, and support.

The OFR’s woes under Trump

Since the Trump administrations bureaucratic overhaul, the OFR has experienced 20.6% reduction in total budget, and 40.6% reduction in full-time equivalent staff — a severe cut to capacity. Here, Figure 2 shows the OFR’s total budget over time.

Figure 2 utilizes values taken from the U.S. Treasury’s annual Budget-in-Brief, which is essentially a summary of the Congressional Justification of Appropriations (“CJ”), i.e., the President’s Budget request for the U.S. Treasury. The CJ is intended to include the administration’s agency priorities, requested budget levels and performance plans (in accordance with the Government Performance and Results Act). Judging from the CJ, the Dodd-Frank financial stability mechanism is clearly not a priority for the Trump administration.

In Figure 3, it’s clear that all major aspects of the OFR’s activities have had their budgets slashed, irrespective of their statutory requirements.

Between FY 2018-2019, the OFR’s Data Center which collects, validates, and maintains all data necessary to carry out the Center’s duties, had its budget cut by 6.13%. The Technology Center, which provides mission-critical analytic services to support the OFR’s work with complex, sensitive financial data, had its budget cut by 13.92%. Similarly, the Research and Analysis Center, which conducts research and analysis on systemic risk, macroprudential policy, and financial stability, had its budget cut by 11.33%. Finally, the Operations and Support Services, which contains the activities of the Director’s Office, Operations, External Affairs, and Chief Counsel, had its budget cut by 5.36%.

Moreover, the slashing of the OFR’s budget is at completely at odds with the Trump administrations stated goal of reducing taxpayer waste. The OFR is completely funded through industry assessments — i.e., not taxpayer funds — and thus, the Trump administrations budget cuts did not save taxpayers a single dime in direct spending.

The Trump administrations cuts to staffing has similarly been devastating. Here, Figure 4 shows the precipitous decline in full-time equivalent staff.

From a peak of approximately 219 full-time equivalent staff, the OFR under the Trump administration has seen its staff decline to 130 this fiscal year — a combination of layoffs and voluntary departures. Looking at the difference in budgeting and staffing for the OFR between the two administrations, it’s clear that OFR’s Congressional mandate is under threat.

Any consequences…?

Due in large to the Trump administration’s reduction in the OFR budget, the bureau has had substantially diminished capacity. As the American Banker reported, the OFR has ceased publishing specialized reports like the Financial Markets Monitor and the general research output has dwindled compared to previous years. For example, Politico’s Victoria Guida reported in October 2018 that the OFR had posted only nine publications on the agency’s website, including reports, briefs and working papers, compared to twice as many the year before.

Furthermore, Politico also reported that the OFR’s agenda was almost entirely dictated by the U.S. Treasury, as opposed to maintaining its policy independence. Undermining the OFR’s policy independence makes it less likely to identify and thoroughly investigate emerging market vulnerabilities, information gaps, and failures in the regulatory mechanism.

As Greg Feldberg, Director of Research for the Yale Program on Financial Stability and former head of research at the Office of Financial Research states in a recent Brookings article, “identifying financial stability risks and data gaps means saying things that are unpopular […] that mission requires more independence, not less.

The combined drastic cuts to the OFR’s budget and staff have seriously hurt the bureau from carrying out its Congressional mandate. Moreover, it seems the Trump administration has yet to end its bureaucratic reform agenda. In the OFR’s Budget-in-Brief for FY 2020, it ominously states “to align with the Administration’s initiative to improve government efficiency and effectiveness, the OFR implemented an organizational realignment effort to ensure appropriate structure for maximum efficiency […] the Budget reflects continued reductions in OFR non-labor spending [...].”