The federal Office of Financial Research was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The Director of the OFR, Richard Berner, recently spoke to a meeting of actuaries, and provided some interesting insights into the OFR’s take on risk and the current state of the U.S. economy.

In his speech, Berner focused on credit risks as his biggest worry today: “…overall threats to financial stability remain at a medium level. As depicted in the Financial Stability Monitor, macroeconomic, market, credit, and funding and liquidity risks are not excessive, though a number of risks within those categories have increased.

Credit risks are now prominent. The combination of leverage, the sharp drop in commodity and energy prices, and the slowdown in growth in emerging markets have exposed elevated credit risks at home and abroad. Valuations in both equity and debt markets remain well above historical averages, and exposures are high. Liquidity risks appear to have risen in major bond markets, which can amplify shocks. And certain financial activities continue to migrate to presumably less-regulated and less-transparent areas of the financial system.”

Financial Stability Risks

Financial stability “stress tests” for the insurance industry

In his comments, Berner highlighted the importance of stress tests as a part of the regulatory process. “In my view, a robust stress-testing regime is one of the best tools for evaluating the adequacy of reserves and capital, probing potential weaknesses outside the regulatory perimeter, strengthening firms’ risk management, and assessing potential system vulnerabilities. To evaluate stress tests, we are engaged in dialogue with the Federal Reserve about methodology and about obtaining access to relevant data. We are suggesting ways to conduct systemwide stress tests. To that end, we are exploring how stress tests can include runs and contagion.”

Related to this, Berner also brought up the topic of the insurance industry’s effort to get a better handle on the risks involved in their operations results with the new own-risk and solvency assessment (ORSA) program, where insurers undertake self-analyses of risks in their groups. He notes that ORSA is designed as an internal risk management process to determine an insurer’s ability to meet policyholder obligations, and the data is to be shared with insurance regulators.

Berner went on to pose a few rhetorical questions about ORSA and stress tests from the perspective of a regulator:

“Could stress tests benefit from including some uniform market-wide scenarios beyond interest rates? For example, the European Insurance and Occupational Pensions Authority
has required some standardized market scenarios for European life and property casualty insurers in its 2014 sector-wide stress test, developed by the European Central Bank.

Could an approach with some common scenarios facilitate understanding of possible sector-wide vulnerabilities?

Banks and insurers have sharp differences in their businesses and in the risks they manage. Stress testing for banks and insurers should reflect those differences. However, the bank stress tests have provided valuable improvements in data quality and in banks’ risk models; in turn, these have helped strengthen banks’ capacity to manage risks. Are there analogous improvements for insurance?”

Regulation of shadow banking

Berner also addressed the topic of shadow banking in his comments. He noted “progress in addressing risks outside banking includes ongoing work to assess risks in so-called shadow banking and to develop tools to limit them.”

He noted that minimum floors on haircuts can strengthen secured, short-term wholesale funding markets. He also pointed out that regulations to strengthen derivatives markets and improve transparency have also been implemented. Beyond this, weaknesses in the supervision of asset management activities are being addressed. Berner emphasizes that these regulatory initiatives “cut across the financial system”, which means that close collaboration among federal and state financial regulators is essential for their successful implementation.

See full remarks of Richard Berner below.