Will XBRL Save the U.S. Financial System?
Closing the information gap between regulators and financial institutions will require data standards and risk reporting. Here’s how XBRL can help.
September 2, 2010
Financial regulatory reform was recently signed into law by President Obama, as the United States continues to emerge from one of the most devastating financial crisis in its history. While reform was needed, there is much debate over how to implement a stronger regulatory framework that will underpin the financial eco-system. The recent crisis exposed the information asymmetry between regulators and financial institutions and revealed the dangers of systemic risk. Systemic risk is the possibility of collapse to the entire financial system, not just the failure of an individual entity.
For regulators to be able to assess systemic risk there is a need for more stringent data standards, increased risk reporting from financial institutions, standardized methods for data transfer and smarter computing and analytics for risk management. Extensible Business Reporting Language (XBRL) can help define systemic risk taxonomy and giving regulators the ability to extend their analysis of a financial institution’s balance sheet. This will provide them with a window for identifying large exposures across firms and markets, increasing leverage and counterparty risks. XBRL-driven collection of risk data can help regulators monitor and act more decisively during periods of financial distress. Stronger information standards and data aggregation will help regulators move to into a state of situational governance (Exhibit 1) in which they can manage too-important-to-fail scenarios more effectively.
This article examines the problem of systemic risk and how more stringent data standards and XBRL can close existing information gaps between regulators and financial institutions.
Increased transparency and better information are imperative for regulators and financial institutions to mitigate financial risks that are undertaken during rapid economic growth and magnified during economic deceleration.
Regulation and Systemic Risk
Regulation and supervision faltered during the recent financial crisis. Financial institutions undertook excessive risk and leverage during the economic boom, and regulators did not understand the complexities of the financial system and the underlying systemic nature of risk between institutions (i.e. AIG, Lehman Brothers.). Moreover, financial engineering outweighed enterprise risk management practices and corporate governance within the boardroom. In a global economy, the interconnected nature of institutions and markets multiplied the effects of the downturn.
Systemic risk is commonly viewed as the possibility of collapse to the broader financial system or market, not just the failure of an individual entity. It is characterized by negative spillover or contagion effects that propagate throughout the system. During the financial crisis, the prudential framework was not equipped to properly manage systemic risk. The information gap between regulators and financial institutions paralyzed the federal government’s reaction during the crisis, and the regulators’ lack of understanding of risk and the inability to measure it in a timely manner contributed to the inability to react efficiently and effectively. This was especially evident during the Lehman Brothers’ collapse and the AIG rescue.
So where are we now?
Regulators should be developing the ability to identify the domino before it falls and creates a negative chain reaction throughout the system. Unfortunately, the lack of systemic intelligence continues to be the challenge. The regulatory framework still needs to be rebuilt to properly oversee the complexity of the financial system to nurture end goals of systemic health, safety, and confidence (Exhibit 2).
Financial institutions need more standardized and granular reporting of enterprise risk to corporate boards. Regulators need a more holistic view of the financial system, which requires more data collection and the capability to aggregate and assess linkages of risk.
Currently, regulators collect very little information on systemic interactions between financial institutions. Quarterly reporting to the U.S. Securities and Exchange Commission (SEC), call data and the Reports of Condition and Income provide insight into the individual condition of a financial institution, but lacks critical information on institution interactions.
The risk between institutions is known as counterparty risk. Counterparty risk takes place when one institution has a financial contract (i.e. loans, credit) with a trading partner, through collateral or unrealized gains (Exhibit 3).
The risk of default between trading partners creates counterparty risk and can be one of the severest forms of systemic exposure. Regulators have very limited visibility of counterparty risk with existing data reporting requirements. The lack of transparency over counterparty risk remains one of the most common information gaps that limit government insight into potential systemic events and cascades to the broader economy. Given these factors, how can regulators close the information gap and move to a situational governance model where they can act and react in a period of crisis? XBRL-based data governance is the answer.
XBRL is a proven standard for financial reporting and can be extended for risk management in the new regulatory environment. Regulators are already key participants in the business-reporting supply chain. Once regulators define data standards and collect granular risk data using XBRL, they will have the capability to map the buildup of risk in the financial system through simulations and what-if scenarios (i.e. too big to fail). Significant advantages to XBRL-driven transparency are that it provides a seamless exchange of information and provides an automated format that can be used to deliver near real-time insight into large exposures across the system. During periods of crisis, regulators must react in a quick manner, so the accessibility, uniformity and method of information exchange are integral to the effectiveness of oversight.
The current financial crisis has exposed flaws in the U.S. financial regulatory framework, which compounded during the last 20 years of economic growth. The dynamic nature of financial markets and the information asymmetry between regulators and financial institutions require improved transparency to achieve systemic health. XBRL should be extended to collect the risk data necessary to monitor the system so that regulators will have the data they need to make informed decisions. XBRL-driven transparency will enable granular and standardized collection of risk data that will allow regulators to aggregate and link risk across the system.
In an upcoming article, we will reveal how XBRL, computing and analytics can be used as an integrated function that provides near real-time insight into systemic risk.
Marlon Attiken, CPA, is a manager in IBM Global Business Services, Financial Management practice. Santosh Nair, is a senior IT specialist in IBM Global Business Services, Systems Integration practice.