XBRL to save the U.S. financial system

The recent financial crisis exposed the information asymmetry between regulators and financial institutions, and revealed the dangers of a systemic risk. (systemic risk is the possibility of collapse to the entire financial system and not just the failure of an individual entity). While everybody agrees that a reform is needed, there is much to discuss over how to implement a stronger regulatory framework that will underpin the financial economic system.

XBRL is maybe an important part of this solution. By defining a systemic risk taxonomy and giving regulators the ability to extend their analysis of a financial institution’s balance sheet, will provide a window for identifying large exposures across firms and markets, leverage and counterparty risks (counterparty risk takes place when a financial institution has a contract with a trading partner, such as a loan, through collateral or unrealized gains).

It is true that in the past financial institutions undertook excessive risks and leverage and regulators could not react because they could not follow and understand the complexity of the financial systems. So this information gap between regulators and financial institutions paralyzed the fed’s reaction during the financial crisis and they were not able to protect investors efficiently and effectively.

Financial institutions need more standardized reporting of corporate risk. Regulators also need a more holistic view of the financial system, which requires more data and the capability to aggregate and assess linkages of risk. Regulators still have very limited visibility of counterparty risk with the existing data reporting requirements. So additional information is needed to improve their visibility and eliminate the risk of a future financial crisis. More specifically, they need further information on derivative positions such as swaps, options and forward contracts. Once regulators collect data using XBRL, they will have the capability to map the risks associated with a financial institution and make a better decision making in the future.