IBM Viewpoint on Systemic Risk: Transparency Key to Global Financial Reform

Shaping global financial reform has been a dominant theme in the lead up to the G20 summit.  Calls for “strong oversight,” as well as “rigorous transparency and accountability” of the financial sector have been deemed essential to avoid a repeat of the turmoil. 

The issue of improved transparency prevails among reform recommendations.  However, seeking transparency between financial institutions, across borders and in real-time is no small challenge for would-be reformers.

Reformers acknowledge that the worldwide impact of the financial crisis was exacerbated by the global interconnectivity of the financial sector.  Between 1996 and 2006, cross-border banking mergers and acquisitions grew from less than 1 per cent to 40 per cent of total M&A worldwide. 

While poor-quality mortgages fed risk into the system at the outset, it was transparency deficiencies across asset-backed securities, ratings agencies and credit networks globally that turned the problem into a crisis. 

Cross-border visibility and the exchange of risk information are now fundamental to rebuilding the resiliency of the financial system.  Clearly, a crisis in a globally integrated economy now requires a co-ordinated global solution.

History shows that after every major negative financial event, a wave of new regulations is generated.  Generally, the majority of these measures simply protect us from the past.  They do not prepare us for the future.  As markets develop, new risks will emerge that may go undetected. 

To address this challenge, investment in smarter regulatory approaches must reflect investment in new financial products.  Should regulatory mechanisms lag behind in their ability to monitor and identify issues, we will leave ourselves open to a replication of recent events.

With consensus that systemic collaboration on regulation, starting with the G20, is an essential part of economic recovery, we must also acknowledge the need to balance regulation and intervention with an environment that stimulates financial innovation.

Balancing regulation with innovation is one thing. Policy makers and decision makers must also be cognizant of the fundamental need for systemic intelligence and proactive management at all levels.  They are essential if we are to promote risk management and increase the speed of response.

Enhanced transparency and risk visibility are essential to the revitalisation of debt markets and reform of asset securitisation.  This process will need to embrace provenance tracking and monitoring to assure the quality of securities.  Active ratings services can capitalise on this enhanced transparency, enabling better understanding of securities composition.  In turn, this creates the basis for more accurate, dynamic ratings. 

Generating this level of transparency requires levels of information exchange and processing power thought unfeasible until now. 

In IBM Research, we have completed complex simulations that analyse a decade’s worth of mortgage data for the whole of the US market, to assess risk exposure and interconnected dependencies.  Previously this would have been impossible, but using latest supercomputing technology, the simulation was processed in just three hours.

Recent advances in computing and advanced analytics mean that we are now capable of creating a new generation of smarter systems.   In addition, breakthroughs in data anonymity protection technology provide the opportunity to share information across regulatory boundaries, without breaking data privacy laws or breaching confidential commercial processes and algorithmic models. 

This provides a real basis for real-time global regulatory collaboration.

Based on smarter financial systems, creation of a new global risk utility becomes an increasingly realistic prospect, even if its precise shape, form and structure are to be determined.  Such a risk utility could provide global intraday market supervision, as well as an early warning system to identify longer term systemic issues.  Further, it would allow global authorities to conduct scenario analysis; improving planning and enabling them to reach consensus ahead of co-ordinated market intervention.

A precedent for industry and governmental collaborative innovation already exists.

In response to concerns about foreign exchange risk, central banks, the wider financial industry and regulators worked together to establish a global utility that governs intraday foreign exchange settlement.

Indeed, my own company helped design and build the systems that enabled its creation.  This utility has successfully achieved its goal of eliminating settlement risk across all its trades, which now total several trillion dollars a day. 

Technology of course, is not a panacea.  We also need investment, new skills and importantly, political will on a global basis. This G20 Summit can accelerate global integration of risk assessment and transparency as part of financial system recovery.  If we learn anything from this period of crisis, it is that national banking systems are irrevocably part of an interdependent global network. 

G20 leaders have a great opportunity not only to avoid the mistakes of the past, but also to prevent new ones in the future. For this they need to ensure that the new financial world order is instrumented, not only to allow event monitoring, but also to identify the creation of bubbles, risk concentrations and systemic inter-dependencies. 

A new financial world order must also be interconnected in a way that accommodates global interdependencies. And it must be intelligent enough to provide organisations not only with a view of their risk position, but also the ability to uncover potential hazards.  Above all, it must be a smarter system that allows regulators to model responses and outcomes, and enable them to act upon them.  Globally.