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Market Risk Intensified Over The Past Year: OFR

Although overall risks to financial stability are not particularly elevated compared to the pre-crisis period, some risks, particularly market risk, have clearly intensified over the past year, according to a recent OFR report.

The federal Office of Financial Research’s 2014 annual report to the Congress cautions that despite moderate threats to financial stability, the relatively benign current economic backdrop is no cause for complacency.

Market risk intensified

Last year OFR introduced a benchmark tool “OFR Financial Stability Monitor” to look across the financial system and spot threats wherever they arise. According to the 2014 annual report, several financial stability risks have arisen since the last year, particularly those that measure market and liquidity risks.

OFR Financial Stability Monitor Market Risk

The report notes though the overall threats are not particularly elevated compared to the peak of the 2007-09 financial crisis, a number of risks are close to those prevailing in late 2005 or early 2006.

The OFR report points out that despite market gyrations, the overall demand for risky assets has not abated:

Firming risk appetite Market Risk

OFR’s Financial Stability Monitor considers the following five categories of risk viz.: macroeconomic, market, credit, funding and liquidity and contagion. The following table maps the risk classification and examples of indicators:

Risk classification and indicators Market Risk

The following sets forth the four phases of traditional credit cycle. According to the OFR report, most nonfinancial corporate credit market indicators point to the U.S. currently somewhere between the expansion and downturn phases, while the household and banking sectors are still recovering from the financial crisis.

Four phases of credit cycle Market Risk  Market Risk

Focusing on market infrastructure risk, the OFR report notes the SEC’s Regulation National Market System (Reg NMS) and Regulation Alternative Trading Systems (Reg ATS) have increased complexity and market fragmentation. For instance, the highly segmented process by which an equity order is routed through the system has added to the complexity:

Routing practices Market Risk

Role of macroprudential policies

According to the OFR report, macroprudential policies would enhance the resilience of the financial system and address emerging vulnerabilities. The report highlights some of the initiatives taken by regulators, such as steps to shore up capital, routine stress testing and developing new tools to strengthen nonbank financial institutions and financial markets. The following diagram highlights the cyclical or structural macroprudential policies:

Macroprudential policies Market Risk

The report also highlights three types of microprudential tools that focus on activities and promote market resilience: redemption policies and regulation, limits on haircuts and collateral and risk retention rules. The following table highlights how redemption policies vary in terms of speed:

Redemption policies Market Risk

The OFR report also touches upon its fundamental research agenda. One of its projects investigates visualization techniques to support financial stability monitoring. The following visualization highlights the lead-up to the collapse of MF Global Holdings Ltd. The report notes the narrative visualizations as in the following are well suited for case studies or forensic timelines, where the sequence of individual decisions, actions and events plays a central role.

Collapse of MF Global Holdings Market Risk

The OFR report emphasizes its high priority to fill data gaps in secured funding markets and asset management. The following captures how the OFR addresses data gaps:

Data gaps Market Risk

Highlighting its agenda for the future, the OFR report points out it plans to develop a suite of additional monitors and dash boards focused on money market funds, hedge funds and credit default swap markets.