If recent congressional hearings are any guide, lawmakers will be keen to ask Treasury Secretary Jacob Lew about the Financial Stability Oversight Council’s (FSOC) designation process and its views on emerging threats to U.S. financial stability when he testifies before the House Financial Services Committee on Wednesday at 10 a.m. about the council’s 2015 annual report. We expect questions to be raised about FSOC’s process for designating nonbanks as systemically important financial institutions (SIFIs), cybersecurity, the influence of foreign regulators on U.S. policy, and concerns about global liquidity.
Here’s what we’ll be watching for:
What parts of the annual report will Secretary Lew emphasize?
On May 19, FSOC released its 2015 annual report in accordance with the Dodd-Frank Act, which requires the council to annually report on its activities and any significant financial market or regulatory developments.1 The report is notable in part because it requires each of FSOC’s 10 voting members to attest to its contents, making it a consensus document.
The annual report is perhaps most useful as a guide to what FSOC sees as emerging threats to U.S financial stability. As we noted in an earlier post, the report singled out central clearinghouse counterparties (CCPs) and financial innovation as potential sources of risk. In the case of CCPs, FSOC is concerned they “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. FSOC is also concerned that financial innovation could be used to circumvent and undermine regulation, such as insurance companies using captive reinsurance entities to avoid capital reserve requirements or the potential migration of leveraged loan origination from banks to less-regulated or unregulated nonbanks.
Other key emerging threats and vulnerabilities mentioned in the report include cybersecurity, increased risk-taking in a low-yield environment, changes in financial market structure, financial innovation, and short-term wholesale funding, among others. In response to these issues, FSOC recommends increased information sharing between the private sector and the government, and enhanced risk management technology designed to more quickly detect erroneous trades and liquidity issues.
FSOC also reports progress made in the past year to improve financial stability—including the resiliency of the U.S financial system against several significant foreign disruptions—and on the implementation of financial reforms designed to strengthen the capital, leverage, and liquidity standards of financial institutions. Furthermore, the council notes its ongoing supervisory efforts including on improving ”living wills” that large financial institutions must submit to regulators to show how they could be safely resolved if they fail, stress tests, credit-risk retention for asset-backed securities, credit rating agency reforms, among others.
We expect Secretary Lew to elaborate on the highlights of the report during his testimony, focusing on disruptions from foreign markets and ongoing regulatory reform. The testimony may place special emphasis on emerging threats that have been in the news recently, most notably cybersecurity and international concerns.2
What will members ask Secretary Lew about?
FSOC Designation Process
House Committee on Financial Services Chairman Jeb Hensarling (R-TX) is among a number of lawmakers who have previously raised questions about FSOC’s transparency and decision-making processes for designating nonbanks as SIFIs. We expect questions to be raised about the subject at this hearing.
In February, FSOC supplemented its final rule on SIFI designations with promises to improve the transparency of the designation process. In these amendments, FSOC included more opportunities for companies under consideration for designation (or for possible “de-designation” to remove a company’s SIFI status) to communicate with FSOC representatives, and for greater transparency to the public about the process. Last week, FSOC followed up on one of its commitments by publishing further details on how it determines thresholds for companies in the first stage of being considered for designation.
In addition, legislation has been introduced to change the designation process including the Financial Regulatory Improvement Act of 2015 (S. 1484), which was passed out of the Senate Banking Committee on May 21. This legislation would further increase the transparency of the process and give companies under consideration for designation the opportunity to submit “remedial plans” to try to avoid designation.3
Members may also ask about whether FSOC plans to designate any asset management companies as SIFIs. Last year, the council directed its staff to engage in an analysis of activities and products in the asset management industry, possibly indicating a focus on those activities and practices instead of designation of individual asset managers.4 In March, however, the Financial Stability Board (FSB) and International Organization of Securities Commissions (IOSCO) published a consultation paper that included specific size thresholds for asset managers for use in determining whether they are systemically important.
In light of the recent Office of Personnel Management data breach and legislation being considered in Congress to address cybersecurity risks, we expect committee members to ask about cybersecurity concerns.5 In the annual report, FSOC recommends increased information sharing among relevant parties as well as a greater collaboration between government agencies. Furthermore, the council recommends that financial regulators issue best practices, including integrating better security practices into agreements with vendors and mapping existing regulator guidance to encourage consistency. Recently, Rep. Randy Neugebauer (R-TX) and Rep. John Carney (D-DE) introduced legislation, the Data Security Act of 2015, to address this issue.
The Influence of Foreign Regulators on U.S. Policy
We also expect questions about the FSB’s role in the U.S. financial regulatory framework. The FSB was created by the G20 to promote international financial stability as a global analogue to FSOC. Its decisions, while not legally binding on member nations, are meant to represent international consensus on financial stability issues so as to provide authority to regulatory implementations. At previous hearings, questions have been raised about the impact of FSB determinations on U.S. domestic financial policy.6 Additionally, there may be questions about the International Association of Insurance Supervisors’ (IAIS) influence on global insurance regulatory harmonization and especially pressure on U.S. states to conform to international standards.7 The recently proposed Financial Regulatory Improvement Act of 2015 includes a provision reflective of these concerns that would encourage the Federal Reserve, the Federal Insurance Office and state insurance regulators to achieve a consensus position before participating in international forums.
Global Liquidity Concerns
Concerns with liquidity are laced throughout the annual report, and increasingly by other market observers in recent months. On June 8, Richard Berner, director of the Office of Financial Research, highlighted the problem, saying that “liquidity appears to have become increasingly brittle, even in the world’s largest bond markets. Although liquidity in these markets looks adequate during normal conditions, it seems to disappear abruptly during episodes of market stress, contributing to disorderly price changes. In some markets, these episodes are occurring with greater frequency.”8 A recent International Monetary Fund report further highlights the liquidity risks arising out of market makers’ withdrawal of funds during system shocks as well as liquidity mismatch within large open-ended funds.9 Members may ask Secretary Lew how FSOC is handling the issue.
1 12 U.S. § 5322(a)(2)(N).
2 See also Peter Wallison & Daniel Gallagher, How Foreigners Became America’s Financial Regulators: The Fed and Treasury are answering to a board of the G-20 without admitting it to the American people, WALL ST. J. (Mar. 19, 2015, 7:09 PM), http://www.wsj.com/articles/peter-wallison-and-daniel-gallagher-how-foreigners-became-americas-financial-regulators-1426806547.
3 Financial Regulatory Improvement Act of 2015, S. 1484, 114th Cong. § 201 (2015).
4 Minutes of the Financial Stability Oversight Council 3-4 (July 31, 2014).
5 Data Security Act of 2015, H.R. 2205, 114th Cong. (2015).
6 See The Annual Testimony of the Secretary of the Treasury on the State of the International Financial System, Before the H. Comm. on Financial Services, 114th Cong. (Mar. 17, 2015) (Rep. Hensarling asking Secretary Lew about exemptions granted to Chinese banks from FSB nonbinding rules).
7 See supra note 3, § 403(2) (“to the extent that the Secretary of the Treasury, the Board of Governors of the Federal Reserve System, and the Director of the Federal Insurance Office take a position on an insurance proposal by a global insurance or international standard-setting regulatory or supervisory forum, the Board of Governors of the Federal Reserve System and the Director of the Federal Insurance Office should achieve consensus positions with State insurance regulators when they are participants representing the United States in negotiations on insurance issues before any international forum of financial regulators or supervisors that considers insurance regulatory issues.”)
8 See Id. (Stating “liquidity appears to have become increasingly brittle, even in the world’s largest bond markets. Although liquidity in these markets looks adequate during normal conditions, it seems to disappear abruptly during episodes of market stress”).
9 See International Monetary Fund, Global Financial Stability Report: Navigating Monetary Policy Challenges and Managing Risks 31, 99 (Apr. 2015) (Discussing the effects of the October 15, 2014 volatility spike in US Treasuries and the January 15, 2015 surge in the Swiss franc’s value’s on liquidity, and highlighting the risk inherent in open-ended funds (e.g. mutual funds) including the first mover advantage that allows shareholders to drain the liquid assets of the fund during runs).
KEYWORDS: FEDERAL RESERVE, FINANCIAL STABILITY OVERSIGHT COUNCIL (FSOC), HOUSE FINANCIAL SERVICES COMMITTEE, JEB HENSARLING, SENATE BANKING COMMITTEE, JACK LEW, RANDY NEUGEBAUER, SIFIS, OFFICE OF FINANCIAL RESEARCH, FINANCIAL STABILITY BOARD, 114TH CONGRESS, FEDERAL INSURANCE OFFICE, JOHN CARNEY