Resurrecting the OFR.

• Author: Allen, Hilary J.
• Position: Office of Financial Research expertise

1. INTRODUCTION 2 II. THE OFFICE OF FINANCIAL RESEARCH: FROM INCEPTION TO 2020 5 A. The Creation of the OFR 5 B. The OFR Under the Obama Administration 8 C. The OFR Under the Trump Administration 10 III. NEW CHALLENGES IN FINANCIAL STABILITY REGULATION 12 A. Climate Change 13 B. Fintech 17 C. Data Problems 21 IV. REBUILDING THE OFR 23 A. Structure. 26 B. Data 27 C. Funding 29 D. Staffing 30 E. Interagency Collaboration 33 F. Culture 38 i. Addressing Modelling Limitations and Automation Bias 38 ii. Questioning Financial Stability Orthodoxy 41 iii. Encouraging Innovation 43 V. CONCLUSION 46 I. INTRODUCTION

   Threats to the stability of our financial system are evolving, and financial regulation needs to evolve with them. Financial regulators need more than just economic, legal, and accounting expertise to grapple with issues like climate change and the rise of fintech; at the very least, they need to employ climate science, complexity science, data science, and software engineering experts. Scattering this kind of expertise throughout the United States' fractured financial regulatory architecture would keep that expertise fragmented, cut off from the cross-sectoral collaboration needed to comprehend and respond to systemic risks. Financial stability will benefit if these types of scientific and technological expertise are instead concentrated in an interdisciplinary research hub, and the Office of Financial Research (OFR) is the most obvious agency to serve as that hub. While the OFR was decimated under the Trump Administration, this Article highlights a silver lining: the Biden Administration now has an opportunity to resurrect the OFR as an agency with a broader focus on the new types of vulnerabilities that are emerging in the financial system.

   The OFR was created in the aftermath of the 2008 financial crisis as a type of early warning system for emerging systemic risks. Gaps in data availability and analysis had hampered governmental authorities as they tried to grapple with the events of 2008, and so the OFR's initial focus was on the collection and analysis of transactional and institutional data. This Article argues, however, that the OFR should pursue a broader, more interdisciplinary conception of "financial research." Financial research can involve many things, including studying the climate risks that the financial system is increasingly exposed to and the new technologies that the financial industry is adopting. Financial research can also involve experimenting with regulator-driven technological innovations designed to mitigate emerging problems--technological experimentation may also improve the OFR's core data collection and analysis functions.

   Finance is becoming inextricably intertwined with new technologies, and so financial regulators must grapple with those technologies in order to discharge their regulatory functions. In particular, financial stability regulators--who are charged with figuring out how the different parts of the financial system operate together--face a daunting learning curve. They will increasingly need to be able to assess threats posed by machine learning and distributed ledger technologies, for example. Without expertise in these new technologies, threats to financial stability may go unnoticed by the regulatory community. (1) Financial stability is also threatened by climate change. Extreme weather events and other lasting environmental changes (like rising seas) could undermine the value of loans and investments made by banks and overwhelm insurers. Extreme weather events could also compromise vital financial infrastructure needed to process payments and other transactions. Less obviously, policy steps taken to reduce carbon emissions will likely entail a reallocation of capital from emission-heavy businesses to newer greener industries, and this transition could have significant consequences for any financial institutions that are significantly exposed to the former. (2) Again, without an understanding of climate science, financial stability regulators will be unable to properly discharge their functions. A rebuilt interdisciplinary OFR can help fill this lacuna.

   To be clear, the OFR cannot succeed in isolation; the reform efforts advocated for in this Article should be part of a full-court press to revitalize our financial regulatory architecture. In particular, the Biden Administration must rehabilitate the Financial Stability Oversight Council (FSOC), which was hobbled during the Trump Administration. (3) The FSOC is charged with responding to any emerging threats that are identified by the OFR's research, (4) and so if we want to maximize the impact of the OFR, the FSOC needs more power and resources of its own. A number of proposals have been made to this end, including a bill introduced in 2020 titled the "Systemic Risk Mitigation Act." (5) But the OFR should be more than just the research arm of the FSOC--ideally, it would make important contributions through its relationship with other financial regulatory agencies as well. While this Article's recommendations are strongly oriented towards promoting financial stability, they also have relevance for other types of financial regulation relating to capital intermediation and investor and consumer protection.

   Unfortunately, even during the Obama Administration, the OFR occasionally faced pushback from other financial regulatory agencies (as well as strong opposition from Republican lawmakers). (6) In addition, the OFR was never as independent from the Treasury Department as its progenitors would have liked. (7) Structural reforms can help address some of these concerns--this Article advocates for moving the OFR out of the Treasury Department, amongst other things. More important, though, are the resource and cultural reforms necessary to allow the OFR to achieve its potential. The fact that the OFR was decimated during the Trump Administration (in terms of both personnel and budget) provides something of a clean slate for rebuilding the agency with significant science and technology expertise, as well as the usual economic and legal expertise. Significant hiring of new types of experts will automatically reorient the focus of the OFR to some extent, but other affirmative steps will also be needed to ensure that the OFR develops a culture that is open to assessing the new types of threats to financial stability that will inevitably emerge in the future.

   First, steps should be taken to guard against capture in the rebuilt agency, particularly to ensure that OFR personnel are not too deferential to the next generation of risk models adopted by the financial industry. The OFR will also need to encourage a certain level of humility and critical thinking with regard to model output in general--including the output of its own models. This critical, humble approach should also be applied to conventional wisdom about how financial crises spread. While crises have historically been transmitted through contractual relationships and market panics, "whatever can go wrong will go wrong faster and bigger when computers are involved." (8) As financial technology becomes more sophisticated (and extreme weather events and other environmental changes threaten physical infrastructure), it increases the possibilities for operational risks to generate and transmit problems through the financial system. However, while we want to encourage a healthy skepticism of technological outputs, we also want the OFR to harness the best of financial technologies in support of its financial stability mission. This will require a culture that supports innovation by the regulators and extends grace for the failures that are an inevitable part of the innovation process. This Article will provide recommendations for steps designed to further all of these cultural imperatives.

   The remainder of this Article will proceed as follows. Part II sets out a brief history of the OFR from its inception, examining its trajectory under the Obama and Trump administrations. Part II also highlights some of the criticisms that have been leveled at the OFR during its existence. Part III demonstrates that the financial landscape has shifted even since the OFR's creation in 2010, which means that financial stability regulation now faces additional challenges that were not contemplated when the OFR was first created. In particular, financial stability regulators now need to engage with the realities of climate change, as well as the innovative technologies that have been adopted as part of the fintech revolution. Perennial challenges in data collection and analysis persist too, and Part III also considers technology's role in addressing these. Part IV provides a blueprint for how the OFR might be resurrected in a way that not only allows it to better fulfill the ambitions of its original proponents, but also to help address the difficulties that financial regulators face when confronting new challenges. Part V concludes.

2. THE OFFICE OF FINANCIAL RESEARCH: FROM INCEPTION TO 2020

   1. The Creation of the OFR

      The financial crisis of 2008 had many causes, but it was clearly exacerbated by a lack of understanding about where risks had developed, and about how those risks might be transmitted from one part of the financial system to another. While banks were subject to regular oversight by prudential regulators, financial regulators and other government officials knew much less about other types of financial institutions and their activities. (9) They also had limited understanding of the relationships amongst the different financial institutions that could transmit shocks from one institution to another. (10) For example, if a financial institution defaulted on its contractual obligations, then the ripple effects could be significant--but regulators and government authorities had limited data with which to gauge how large such ripples would be. (11) There was also...