GoldenSource Blog

Why Tackling Systemic Risk is More Than Just Knowing Your Enemy – Part 1

Risk typically involves a series of recognizable factors – or ‘knowns.’

See a fire? Don’t touch it. Car shuddering? Get off the road. Masked man holding an ax? Run.

In contrast, risk in financial services has typically been characterized by its unknowns.

Most institutions face this at the enterprise level: Quick – can we tally up our enterprise-wide exposure to that bank? Beats me. Can we identify whether we have assets or collateral parked with an institution? Don’t know. Is that a regulator coming? RUN.

Change is afoot. With cost pressures persisting and regulators punishing major banks for poor risk and reporting practices, the financial industry is recognizing the correlation between identification and risk – both from an enterprise and systemic perspective.

Thus, the humble identifier – likened to bar codes in the retail world – is being embraced by financial institutions as a tool to help make the unknowns known.

While identifiers for individual securities have existed for quite some time, the movement to attach identifiers to individual entities is growing in popularity. In fact, one of the cool kids of financial journalism, Gillian Tett of the Financial Times, noted that the legal entity identifier should help “make it easier for bankers and regulators to monitor the flows of finance – in much the same way that the bar codes on gum packets enable supermarkets to track stocks.

While an institution’s ability to know what is being traded and with whom is more aligned with enterprise risk, it can also have a ripple effect on the rest of the financial industry.

Institutions interconnect with one another in a complex network, sharing, matching and acting upon the information produced by identifiers. When multiple institutions have the same issues with identifying entities and securities, enterprise risk problems can be magnified into systemic risk threats.

Case in point

In spite of identifiers, a group of European repositories warned that up to 60% of derivatives trade reports entering their systems could not be matched across both counterparties, primarily because of divergent identifier standards. With this incomplete picture, little can be done to adequately address risk in the derivatives market.

Thus, from a systemic perspective, identifiers that aren’t uniformly applied do little to recognize the danger that they’re meant to prevent. In fact, they often confuse things further and make the danger more difficult to spot. Rather than acting as fire alarms, disjointed identifiers create more smoke.

Like the retail bar codes they’re compared to, identifiers will have the greatest impact if used within a “financial data supply chain” where communications standards and integration build upon the initial step of identification to achieve efficiency, automation and transparency – all key to tackling systemic risk.

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