Immediately upon announcement of his idea, Bernanke’s almost purely academic concept of macroprudential[1] systemic risk early warning became massively political with US senators and congressmen laying oily Washington paws all over Bernanke’s sketch book model. In the spring of ’09, the Fed was ‘wide open’ to criticism as having failed totally at supervision, a quite un-fair criticism really since the US supervisory landscape is actually really fragmented with many layers of institutions having responsibility in that space, partial responsibility, in fact much like the EU where in fact the Directorate General ECFIN does actually do some macroprudential functions only it doesn’t really take on that responsibility. Think of Eurostat and its relation to DG ECFIN.

In the US, Senator Barney Frank’s House Financial Services Committee had to write the legislation[2]. Of course the main point is that all of the developed western economies were actively considering this type of response to the Crisis in early 2009; the US, the UK & in the old days we would have considered Germany but as a committed European the Germans allowed Cion to do that consideration with the Bundesfinanzministerium bending its ear. In France the spectacularly independent Banque de France took the view (some would say quite rightly) that it did not need any assistance with macroprudential analytics, it was quite good at that itself, the Swedes and the Dutch (again some would say quite rightly [me included]) much the same thing.

By early 2010, the New York Times reported that responsibility for macroprudential early warning was going to reside in the US Treasury with Geithner as Chair and the Federal Reserve chairman as deputy. Bernanke’s systemic risk authority would become a council[3];

 “The issue is one of the most fundamental in the contentious effort to overhaul regulation after the crisis”,

the NYT reported. To cut a long story short Bernanke’s Systemic Risk Council idea became wrapped up in what came to be known as the “Dodd Frank”[4] (DF) legislation process, (unfortunately) a massively political wrangle in the US in which other issues not directly related to macroprudential early warning such as concerns over TBTF; “Too Big to Fail” or Financial Institutions which became so systemic they could not be other than bailed out.

DF proposed a Financial Stability Oversight Council, made up of Expert Members: the10 federal financial regulators and an independent member and 5 nonvoting members, the Financial Stability Oversight Council will be charged with identifying and responding to emerging risks throughout the financial system. The Council will be chaired by the Treasury Secretary and include the Federal Reserve Board, SEC, CFTC, OCC, FDIC, FHFA, NCUA, the new Consumer Financial Protection Bureau (& ‘uncle Tom Cobley and all’). DF is widely despised by experts in banking supervision and those with knowledge of Monetary Economics or Macroprudential issues. Quite “Frankly” it’s a dogs’ breakfast which seems to be a racing cert when politicians get a grip on supervision.

Its probably worthwhile clarifying one more nuanced ‘private language’ code word which is subsumed under DF, given that we have placed ‘Dodd Frank’ in a context already, that is “The Volker Rule”; which requires supervisors to implement regulations for banks, their affiliates and holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds. So in essence the Volker rule is the US legislation of the Independent Commission on Banking in the UK which we have studied extensively here[5] on asymptotix. The Volker rule is simply a bringing to life of an act called “Glass Steagall”, as Andrew Ross Sorkin (who wrote the movie “TBTF”) argues in his DealBook presence in the NYT;

 ‘A meme around Glass-Steagall has been created, repeated so often that it has almost become conventional wisdom: the repeal of Glass-Steagall led to the financial crisis of 2008. And, the thinking goes, has become almost religious for some people, that if the law were reinstated, we would avoid the next crisis.’[6]

But I am getting lost in the DF labyrinth, what happened in the end to Bernanke’s Systemic risk early warning system idea?

The Financial Stability Oversight Council[7] got established under the Dodd-Frank Act;

The Financial Stability Oversight Council (FSOC) will provide, for the first time, comprehensive monitoring to ensure the stability of our nation's financial system. The Council is charged with identifying threats to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States financial system. Within the US Treasury there is an Office of Financial Research also, which is chartered to improve the quality of financial data available to policymakers and facilitate more robust and sophisticated analysis of the financial system[8]. At the beginning of this year the OFR made a significant contribution to Macroprudential Analytics in this document[9];

A Survey of Systemic Risk Analytics

Dimitrios Bisias, Mark Flood, Andrew W. Lo, Stavros Valavanis

ABSTRACT

We provide a survey of 31 quantitative measures of systemic risk in the economics and finance literature, chosen to span key themes and issues in systemic risk measurement and management. We motivate these measures from the supervisory, research, and data perspectives in the main text, and present concise definitions of each risk measure; including required inputs, expected outputs, and data requirements in an extensive appendix. To encourage experimentation and innovation among as broad an audience as possible, we have developed open-source Matlab code for most of the analytics surveyed, which can be accessed through the Office of Financial Research.

I would personally have prepared if the code would have been developed in R but hey that is another story and I can always translate it. Mark Flood is well known to asymptotix in another place and through other times and as one would expect the thinking behind Systemic Risk Macroprudential early warning is in complete alignment with the Rational Expectations (REH) approach which one would expect in this space. I strongly recommend that anyone with a real interest in this topic studies this document seriously.