One of the fundamental flaws revealed by the financial crisis is that the U.S. government lacks the tools to monitor and regulate financial institutions and markets effectively. The most significant weakness is not a lack of legal authorities; it is the absence of necessary data and analytical capability. This cardinal lapse has been largely overlooked until now because critical components of effective regulation were often "outsourced."

Some of that outsourcing enabled the creation of the toxic assets that triggered this crisis. When issued, these toxic assets were rated triple-A or double-A by private rating agencies. Rating these securities and advising issuers on how to qualify for the desired ratings was a large and profitable business for the rating agencies. These ratings received the blessing of financial regulators and made it easy for investment and commercial banks to sell many ultimately troubled assets to highly regulated financial firms (such as insured depositories, insurance companies, pension funds, Federal Home Loan banks, Fannie Mae and Freddie Mac).

Comptroller of the Currency John Dugan in a speech last year alluded to the outsourcing problem presented by the rating agencies. "In a world of risk-based supervision," he said, "supervisors pay proportionally more attention to the instruments that appear to present the greatest risk, which typically does not include triple-A-rated securities." In other words, the filter of what "appear(s) to present the greatest risk" to the regulators was determined by the rating agencies.

When the financial markets crashed and the major surviving financial firms teetered on the brink, the federal government had to determine whether these firms were adequately capitalized. Yet neither the Treasury nor the regulatory agencies were able to make such determinations because they lacked the necessary data and analytical capacity to do so. They were consequently forced to outsource the analysis to the regulated financial firms themselves. The Treasury posited a few economic stress scenarios and instructed the regulated banks to assess how their banks would fare if these scenarios were to transpire. The banks were then to report the results of their analyses back to the Treasury and their regulators.

In an ironic twist, the banks used the same models they employed to manage their exposure to risk during the run-up to this crisis to perform this analysis. The banks should have the capability to perform such analysis. It is part and parcel of competent corporate management and governance. Nevertheless, the government also should be capable of generating independent assessments of the health of the businesses it regulates.

Despite these clear weaknesses in the government's approach to financial regulation, the Treasury's solution to the financial crisis created by credit-default swaps and other unregulated derivatives has been to propose more ways for the industry to regulate itself. Specifically, the Treasury's idea is to channel as much derivative trading as possible through clearing houses. With a clearing house in the picture, the credit risk of the clearing house is interposed between the seller of a derivative contract and the buyer. The clearing house is obligated to make good on a derivative's contractual requirements. While expanding the use of clearing houses is an excellent and welcome suggestion in its own right, it cannot fully solve the problem created by inadequate regulatory capabilities.

Clearing houses themselves can create systemic risk by concentrating credit risk on their own balance sheets, a point that is not a theoretical issue. There have been several notable collapses of foreign clearing houses in recent decades. The most important domestic derivatives exchange and clearing house in the United States, the Chicago Board of Trade, was minutes from collapse in October 1987 following the U.S. stock market crash. Only an emergency loan of $400 million from Continental Illinois Bank — granted orally in a phone call — allowed the exchange to clear the preceding day's trades and made it possible to open for business. Given these risks, the federal government must be able to deploy the tools needed to regulate the clearing houses themselves.

The time has come to empower regulators with the essential tools required to effectively enforce regulation. To do this, we must create the financial equivalent of the National Institute of Health, a National Institute of Finance. The NIF would collect transaction and position data necessary to monitor systemic risk at the market and individual financial-entity level. This data is not currently collected by financial regulators and the Treasury's financial regulatory reform plan does not propose doing so. The plan does call for important changes in legal authorities, and the NIF would provide the required data and analytical capability.

The NIF would also build a major research and analysis capability so that financial engineering could be deployed to work in the public interest rather than exclusively for the benefit of private firms. When the NIF is up and running, the government will no longer have to rely on outsourcing critical elements of financial regulation.

Ensuring the government and regulators have these requisite legal, data and analytic tools is the best way to prevent the next crisis and ensure the health of our financial system.

This blog has been reprinted with permission from American Banker. Allan Mendelowitz is a former chairman of the Federal Housing Finance Board and a founding member of the Committee to Establish the National Institute of Finance.

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