FSOC Annual Report Highlights New Emerging Threats

On Tuesday, the Financial Stability Oversight Council (FSOC) approved and released its 2015 annual report. The key feature of the annual report is FSOC’s assessment of emerging threats to financial stability. At a lengthy 143 pages, the annual report is no beach read. It does, however, offer an interesting window into the issues captivating the nation’s financial regulators. Among the emerging threats highlighted by FSOC as warranting further attention by regulators over the upcoming year were central counterparties and financial innovation. Here are the highlights:

Central Clearinghouse Parties

The first entities FSOC ever designated as systemically important financial institutions (SIFIs) were eight Central Clearinghouse Parties (CCPs). Despite now being subject to Federal Reserve (Fed) oversight FSOC is concerned that “CCPs could transmit significant liquidity or credit problems among financial institutions or markets” in periods of market stress or volatility if CCPs do not put aside sufficient pre-funded resources or their risk management or other practices are inadequate. Such issues could result in losses to investors who use CCPs. FSOC recommends that the Fed, the Commodity Futures Trading Commission, and Securities and Exchange Commission coordinate their monitoring of these issues and pay special attention to CCP credit, default and liquidity risk management; bank-CCP risk management; and CCP recovery and resolution planning.

Our take: The Fed has the authority to consider enhanced regulations on CCPs under its authority granted in Title VIII of Dodd-Frank. The Fed may consider such enhanced regulations if it sees growing risk from CCPs. It is important to note that Dodd-Frank dealt with CCPs and enhanced Fed oversight in Title VIII as opposed to until Title I, where other nonbank SIFI regulatory standards apply.

Financial Innovation

FSOC sees the potential for future innovation to undermine regulation as another potential risk area. Innovation and changing market conditions have always posed challenges for financial regulator to regularly adapt their oversight of markets and institutions. FSOC specifically mentions that its members are monitoring risks from innovations that include:

• captive reinsurance entities being used to avoid capital reserve requirements;
• the growth of exchange-traded funds and bond mutual funds that could present fire-sale, liquidity, and redemption risks during periods of market stress;
• the potential migration of leveraged loan origination from banks to less-regulated or unregulated nonbanks; and
• the potential of digital currencies to skirt certain regulations.

The 2015 report also spends more space highlighting the potential threat from increased risk-taking in a prolonged low-interest-rate environment. Searching too aggressively for opportunities to boost investment yield can lead to lower underwriting standards—something regulators have identified for some leveraged loans, which FSOC still sees as problematic despite outflows from high-yield and leveraged loan funds over the past year— holding more illiquid assets, or other risky activities.

Our take: There has been a significant amount of debate since the crisis on whether financial innovation is generally good or harmful to society, or whether it is more mixed. BPC’s 2014 report on the costs and benefits of big banks assessed some of the issues regarding financial innovation, particularly as they relate to banks and broker dealers.

Threats Remain

Several of the emerging threats outlined in the 2014 annual report remain in the 2015 edition, including reliance on short-term wholesale funding; risk-taking incentives of large, complex, and interconnected financial institutions; the quality of financial data; and reliance on reference rates like the London Interbank Offered Rate (LIBOR). Cybersecurity was also featured in both reports, in 2015 mentioning more specific vulnerabilities the US financial sector to cyber-attacks, and identifying best practices for addressing cyber risks.

Our take: Threats from cyber-attacks seem likely to continue to rise as consumers and businesses become increasingly dependent on digital technologies. The Treasury Department and financial regulators—both individually and through the Federal Financial Institutions Examination Council—have focused aggressively on cybersecurity issues. FSOC continues to emphasize collaboration and data sharing among member agencies and with financial institutions.