What to Watch for: FSOC’s January 21 Meeting

The Financial Stability Oversight Council (FSOC) will meet on Wednesday, January 21 in both closed and open sessions. The preliminary agenda includes an open discussion of the FSOC’s process for considering companies for potential designation as systemically important financial institutions (SIFIs), including potential reforms identified in meetings with key stakeholders in recent months. FSOC members will also be briefed on the council’s work on strengthening the governance and integrity of financial rate benchmarks, such as the London Interbank Offered Rate (LIBOR). During the closed session, the FSOC will be briefed on systemic risks posed by leveraged lending, which has recently accelerated in Europe while it has slowed in the United States. The council will also discuss FSOC’s next annual report, which highlights emerging threats to the financial system. Finally, the council may discuss recent changes in the prices of oil and the Swiss franc that have the potential to destabilize the financial system.

Here’s what we’ll be watching for:  

Will the FSOC announce reforms to improve its transparency, communications and processes?

After conducting an outreach campaign to solicit ideas from market participants and other stakeholders on ways to improve the SIFI designation process, FSOC staff could use the open discussion session to brief council members on the findings of their listening tour. The FSOC’s process for evaluating non-bank financial companies for potential SIFI designation has faced a barrage of criticism. The FSOC’s critics have charged that the process for designating SIFIs is unclear and insufficiently transparent, that it needs to be improved and that a moratorium on further designations may be necessary until it is. The FSOC’s process for re-evaluating existing SIFIs with the possibility of removing their SIFI designations (“de-designation”) has been criticized as well both for its lack of transparency and concerns that it has not received the careful consideration it deserves.

More than a dozen sources, including financial industry groups, regulatory reform advocates and think tanks (including the Bipartisan Policy Center (BPC)) have issued recommendations on how to improve the FSOC. There were also five legislative proposals introduced during the 113^th Congress. BPC has analyzed and summarized a range of these proposals that have been offered by individuals and groups on the left and right. A breakdown and comparison of those proposals can be found here.

The FSOC has responded to its critics. At the council’s October 6, 2014 meeting, FSOC Chairman and Treasury Secretary Jacob J. Lew publicly announced that the council “is committed to improving its effectiveness and engaging with the public” and that it “had asked council staff to continue its outreach to stakeholders and to report back to the council in the coming months so that the council can consider possible changes to its [designation] process.”¹ On November 12, the FSOC’s Deputies Committee hosted a series of panel discussions with experts from industry and consumer advocacy groups, and with think tanks—including the BPC—on how the council could improve its public transparency, its engagement with companies during the designation process, and the de-designation process.² Although it enacted a new transparency policy last May, the FSOC has not yet announced any actions based on ideas arising from these recent meetings.

On Wednesday, FSOC staff could present reform ideas it is considering to improve the SIFI designation process. We will be watching to see what proposals are presented, how they compare with previous public proposals that have been made and whether the Council acts on them now or continues discussion in a future meeting.

What progress has been made on addressing systemic risk from leveraged lending and benchmark rates, and how do recent changes in the prices of oil and the Swiss franc affect systemic risk?

The FSOC is expected to receive briefings on efforts to address systemic risk posed in two areas of concern: leveraged lending and market confidence in key financial benchmark rates. The FSOC may also discuss last week’s sudden removal by the Swiss National Bank of Switzerland’s exchange rate cap.

In 2013, the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve and the Office of the Comptroller of the Currency (OCC) released their final guidance on leveraged lending,³ loans that are made by banks to entities with relatively low credit ratings and are often used to finance the purchase of companies. In early 2014, Federal Reserve Governor Daniel Tarullo stated his concerns that the investor appetite for yield was feeding the growth of leveraged loan funds alongside lower underwriting standards.⁴ Later in 2014, the FSOC’s annual report cited “material widespread weaknesses in underwriting practices, including excessive leverage, inability to amortize debt over a reasonable period and lack of meaningful financial covenants” in leveraged loans,⁵ risks that would be exacerbated if accompanied by a sharp rise in short-term interest rates.⁶ In 2014, the FDIC, Fed and OCC increased their oversight of leveraged lending due to a belief that industry participants had largely ignored their guidance.⁷ Examinations reportedly identified problems with about one-third of $767 billion in loans that the agencies reviewed.⁸ On November 7, 2014, the three agencies attempted to address these concerns in part by issuing answers to a series of questions they had been asked by banks on how to comply with the 2013 guidance.⁹ While leveraged lending had increased by 34 percent to $800 billion since 2008, recent evidence suggests that pressure from regulators may be working, as issuance of such loans to U.S. companies dropped in the fourth quarter of 2014,¹⁰ and is expected to drop again in 2015.¹¹

One specific concern for the FSOC may be the sudden fall in oil prices making it more difficult for energy companies to raise new funds through leveraged loans and to meet covenants on existing loans.¹² The council may also be concerned about a recent rise in leveraged loan activity in Europe,¹³ which remains in the throes of weak economic growth and faces risks from rising opposition to continued austerity policies and the potential exit of Greece from the Eurozone.

The FSOC has similarly been focused on ways to reduce systemic risk by improving market confidence in financial benchmark rates, such as LIBOR, Euro Interbank Offered Rate (EURIBOR) and some foreign exchange (FX) rate benchmarks. In 2012, investigations revealed that industry participants had been manipulating LIBOR and EURIBOR,¹⁴ rates that serve as reference rates for many mortgages, government and corporate bonds, credit cards and derivatives. Manipulation of such rates is a serious problem that directly harms of consumers and investors and more broadly erodes confidence in the market. The FSOC has sought to improve governance to ensure the integrity of such benchmark rates, including working with foreign regulators, developing international principles and making greater use of risk-free rates.¹⁵ Those efforts have been complicated by differing European and U.S. views of how to oversee such benchmarks, but a key European Parliament source recently suggested that concerns expressed by the U.S. Treasury and Commodity Futures Trading Commission have been addressed.¹⁶

We will be watching to see whether the council believes that enough progress is being made to address these two areas and whether they are presented with or discuss specific recommendations for further action.

Since the last FSOC meeting in December, the price of oil has continued its sharp decline, dropping below $50 a barrel. Last week, markets were further disrupted by the Swiss National Bank’s surprise move to remove Switzerland’s exchange rate cap. As a result the Swiss franc jumped 17 percent in value over the euro in a single day.¹⁷ The potential exists for these types of “black swan” events—significant unexpected shocks to the market—to cause financial instability. Assuming the FSOC discusses these market-moving events and their implications on Wednesday it will likely do so in closed session.

We will be watching to see if the FSOC comments publicly about these changes, and whether the FSOC’s minutes from its December meeting, expected to be released in conjunction with the January meeting, contain any detail about their discussion on falling oil prices.

What will be the focus of the FSOC’s 2015 annual report?

The agenda also includes a discussion of the FSOC’s next annual report, which the council uses to give its assessment of changes to the macroeconomic environment, financial developments and emerging threats to financial stability, and to make recommendations for reform. The annual report plays an important role in promoting regulatory coordination since it requires that the FSOC’s member agencies agree on a common set of threats to the financial system. Although the annual report is generally released in the spring, it is unlikely that the council is close to finalizing its content. However, we will be watching to get a sense of what the FSOC believes are the major developments and emerging threats to financial stability in 2015.

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¹ Financial Stability Oversight Council, Minutes, October 6, 2014, p.6.

² See: U.S. Treasury Department Office of Public Affairs release, “Financial Stability Oversight Council Stakeholder Engagement Through November 12,” November 12, 2014.

³ U.S. Department of the Treasury Office of the Comptroller of the Currency, Federal Reserve System, and Federal Deposit Insurance Corporation, “Interagency Guidance on Leveraged Lending,” March 11, 2013.

⁴ Daniel K. Tarullo, speech at the 30^th Annual National Association for Business Economics and Economic Policy Conference, February 25, 2014.

⁵ Financial Stability Oversight Council, 2014 Annual Report, May 7, 2014, p. 40.

⁶ Ibid., p. 119.

⁷ Craig Torres, Kristen Haunss and Christine Idzelis, “Fed Scrutiny of Leveraged Loans Grows Along With Bubble Concern,” Bloomberg, October 1, 2014.

⁸ Ryan Tracy and Gillian Tan, “Regulators Fault Banks on Leveraged Loans,” The Wall Street Journal, November 7, 2014.

⁹ Board of Governors of the Federal Reserve System, FDIC, and OCC, “Frequently Asked Questions (FAQ) for Implementing March 2013 Interagency Guidance on Leveraged Lending,” November 7, 2014.

¹⁰ Lynn Adler, “TRLPC: U.S. regulators’ leveraged loan policies starting to bite,” Reuters, December 17, 2014.

¹¹ Christine Idzelis, “Loan Pinch Seen Lasting in ’15 Amid Fed Scrutiny: Credit Markets,” January 2, 2015.

¹² Jonathan Schwarzberg, “TRLPC-Loan costs rise for leveraged US energy companies,” Reuters, December 4, 2014.

¹³ Julie Miecamp, “Private Equity Deals Seen Spurring Leveraged Loan Surge,” Bloomberg, January 7, 2015.

¹⁴ For greater detail on the rate-manipulation scandal, see, for example: The New York Times Dealbook, “Understanding the Rate-Fixing Inquiry,” July 28, 2014.

¹⁵ FSOC 2014 Annual Report, Ibid., p. 118.

¹⁶ Jim Brunsden, “U.S. Objections to EU Financial Benchmark Bill Addressed,” January 9, 2015.

¹⁷ Matt O’Brien, “Why Switzerland’s currency is going historically crazy,” The Washington Post, January 15, 2015.