The Financial Stability Oversight Council (FSOC) will meet Wednesday, March 11 in closed session. The preliminary agenda includes a discussion on central counterparties (CCPs) and a report from the Federal Reserve Board on the initial results of annual stress tests for 31 so-called “bank SIFIs” with assets more than $50 billion. The agenda also includes an update on FSOC’s 2015 annual report, which highlights emerging risks to the financial system and is typically released in the spring. Finally, the council may discuss additional matters such as recent statements by the Financial Stability Board (FSB) on asset managers.
Here’s what we’ll be watching for:
Do this year’s stress tests show improvements in financial stability?
After the Federal Reserve’s initial stress tests in early 2009 helped to calm markets, lawmakers codified the exams into an annual practice required by the Dodd-Frank Act.1 On March 5, the Federal Reserve Board announced that the 31 financial institutions subjected to the 2015 Dodd-Frank Stress Test (DFAST) passed the test, meaning that they would be able to maintain a minimum 5 percent capital level if they were subjected to a set of macroeconomic shocks simulated in the test’s “severely adverse” scenario.2 The results also showed that the 31 financial institutions were projected to lose $490 billion over nine quarters under the same scenario, a modest improvement over their ability to weather a severe economic crisis from the prior year.3
The Federal Reserve is also undertaking two additional annual stress tests as part of the Comprehensive Capital Analysis and Review (CCAR) process, which includes both a quantitative and qualitative review of the capital adequacy, capital adequacy process, and planned distributions. The results of these two tests are expected to be released this Wednesday. If a bank holding company fails a CCAR test it can lead to the Federal Reserve requiring the institution to augment its capital or adjust its internal processes or capital payout plans to come into compliance.
We expect FSOC to discuss what these results mean for financial stability and whether improvements can be made in their methodology. Institutions subject to CCAR have expressed concern that the metrics used are insufficiently transparent or predictable, making it difficult for the institutions to comply. However, a report released last week by the Office of Financial Research concludes that the quantitative CCAR test is becoming more predictable.4
Will the changes FSOC made in February to its designation and annual review processes work well and be enough for Congress?
In February, FSOC adopted a number of measures designed to strengthen its process for evaluating and potentially designating SIFIs and improving its communication with firms under consideration for designation and with the general public. We applauded those changes as real progress while noting that the reforms did not go as far as we would have liked and were unlikely to please all stakeholders. Nonetheless, concerns remain about the processes for designating and “de-designating,”—that is, removing a SIFI designation if FSOC decides a SIFI is no longer systemically important—nonbanks, as do questions about FSOC transparency. The Senate Banking Committee plans to hold hearings on both FSOC transparency and accountability and whether to change the threshold at which bank holding companies automatically become subject to more stringent prudential standards (the so-called “bank SIFI” threshold). In the House, several bills have recently been released to reform FSOC and its processes, including a bipartisan effort by Rep. Luetkemeyer (R-MO).
Meanwhile, during a February hearing, Federal Reserve Board Chair Janet Yellen received several questions from House members that indicated continued concerns about the SIFI designation process and the annual review process by which SIFIs could potentially be de-designated.5 While we do not expect the council to propose or implement additional reforms on Wednesday, we expect the minutes detailing the adoption of those changes to become public. We will be interested if there are any additional comments or discussion shedding light on FSOC’s decision making process in adopting these reforms. Going forward, we will be watching to see whether the changes they already implemented will be enough to satisfy enough members of Congress to head off legislation to force FSOC to go further.
Will FSOC discuss the FSB’s latest release on asset managers?
On March 4, the FSB and the International Organization of Securities Commissions (IOSCO) released an updated consultative document that stated that an asset manager could “cause or amplify significant disruption to the global financial system and economic activity.” It also set out a “materiality threshold” above which asset managers might be considered systemically significant, suggesting these as more than $100 billion in balance sheet total assets and more than $1 trillion in assets under management.6 Such thresholds are viewed warily by some in the asset management industry who view size as a mostly irrelevant indication of the systemic risk posed by an asset manager. The document includes several additional quantitative and qualitative indicators for assessing the systemic importance of asset managers, such as interconnectedness, leverage ratio, guarantees and other off-balance sheet exposures, and complexity.7 These specific criteria appear to front-run or run counter to where FSOC’s more activities-based approach to asset managers.
In July 2014, FSOC directed its staff to “undertake a more focused analysis of industry-wide products and activities to assess potential risks associated with the asset management industry.”8 In December, FSOC followed up with a request for public comment on whether asset management products and activities may pose potential risks to U.S. financial stability. On February 4, the council extended the deadline for such comments until March 25.9 We will be watching to see how FSOC reconciles the FSB/IOSCO approach with its own approach to the potential designation of U.S.-based asset managers as SIFIs. Will FSOC continue to focus on activities and practices, as BPC has recommended, or will FSOC move toward the FSB/IOSCO’s focus on asset size and institution designation?
Will FSOC take additional measures to mitigate systemic risk posed by central counterparties?
Dodd-Frank contained provisions to reduce systemic risk by requiring much more centralized clearing and transparency for derivatives and securities transactions. However, these additional transactions increased the importance of CCPs and there is concern that concentration of credit risk in such large institutions simply transfers systemic risk from one place to another. In February, the Bank for International Settlements (BIS) and IOSCO released a peer review of how well the United States is implementing the BIS/IOSCO principles for financial market infrastructures (FMIs), which set expectations for the design and operation of important FMIs like CCPs and payment and settlement systems. CCPs assume the credit risk of buyers and sellers by becoming the counterparty to both sides in a transaction. The paper suggests that U.S. regulators have generally implemented oversight in accordance with BIS/IOSCO principles, but makes additional recommendations including that regulators adopt “more-detailed requirements or guidance in order to clarify” what they are intended to do. In addition, earlier this week, the Federal Reserve Bank of New York released a report that found that introducing a CCP to a trading market can increase or decrease risk depending on the number of dealers trading and the number of asset classes being traded. We will be watching to see if FSOC advocates that regulators, particularly the Federal Reserve, implement any of the peer review’s specific suggestions, or if FSOC advocates changes in regulator behavior based on the findings in the New York Fed’s report.
What will be emphasized in FSOC’s 2015 annual report?
The agenda also includes a discussion of 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 FSOC’s member agencies agree on a common set of threats to the financial system. The annual report is generally released in the spring. We will be watching to get a sense of what FSOC believes are the major developments and emerging threats to financial stability in 2015.
1 12 U.S.C. Section 5365 (i).
2 See: Board of Governors of the Federal Reserve System, Dodd-Frank Act Stress Test 2015: Supervisory Stress Test Methodology and Results, March 2015. Available at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20150305a1.pdf.
3 Board of Governors of the Federal Reserve System, “Federal Reserve releases results of supervisory bank stress tests,” March 5, 2015. Available at: http://www.federalreserve.gov/newsevents/press/bcreg/20150305a.htm.
4 Paul Glasserman and Gowtham Tangirala, “Are the Federal Reserve’s Stress Test Results Predictable?” Office of Financial Research, March 3, 2015. Available at: http://financialresearch.gov/working-papers/files/OFRwp-2015-02_StressTestResults.PDF.
5 Securities Industry and Financial Markets Association, summary of House Committee on Financial Services hearing “Monetary Policy and the State of the Economy,” February 25, 2015. Available at: http://www.sifma.org/members/hearings.aspx?id=8589953326.
6 Ibid., pp. 48-51.
7 Ibid., pp. 51-55.
8 Financial Stability Oversight Council, minutes, July 31, 2014. Available at: http://www.treasury.gov/initiatives/fsoc/council-meetings/Documents/July%2031,%202014.pdf.
9 See, for example: The Cadwalader Cabinet, “House Financial Services Subcommittee Chairmen Send Letter to FSB and FSOC Requesting Information on Methodologies Used to Designate G-SIFIs,” May 9, 2014. Available at: http://www.cadwalader.com/thecabinet/regulatory_updates.php?ID=7815&date_filter.