An Eye on the Big Picture: Five Key Takeaways from FSOC’s Annual Report to Congress
June 28, 2015
July 21 marks the five-year anniversary of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the establishment of the Federal Stability Oversight Council, or FSOC. This new body, a who’s who of the financial regulatory community, was created as a forum for regulators to keep an eye on the big picture of the U.S. financial system, identify potential risks, and address those threats before they materialize in a new global financial crisis.
By Yana Kaplun, C’18, W’18
On June 17, Treasury Secretary Jack Lew (also the chair of FSOC) delivered the Annual FSOC Report in a hearing before the House Committee on Financial Services. The report, largely overlooked by the media, sheds light on the collective views of the regulatory community regarding potential risks to our financial system. While complex, the document and Secretary Lew’s testimony should not be ignored. Below are five forward-looking takeaways from FSOC’s 2015 report.
1. Market structure is evolving and regulations are not keeping up.
Technology, competition, and regulations have contributed to a quickly evolving financial market structure in the U.S. As regulations have tightened in recent years, there has been a migration of financial activity from more regulated to less regulated areas of the market. For example, trades of volatility products, or derivatives specifically tied to the volatility of a reference asset, have moved from regulated exchanges to over the counter (OTC) operations, whose risk is difficult to measure and even harder to regulate. Meanwhile, regulations placed on loan quality have caused a rise in risky lending by nonbank mortgage servicers. These institutions are not subject to the same capital and liquidity standards as banks, and thus pose a risk of collapse in the event of an economic downturn.
2. The low yield environment incentivizes financial institutions to conduct risky business.
Incredibly low interest rates are making it difficult for investors to make a profit. As a result, banks, insurance companies, hedge funds, and pension funds across the financial system are taking on a disproportionate amount of risk to boost yields. If interest rates increase, demand for credit assets and the ability for creditors to pay back their loans could decrease, and the effect would be magnified across the financial industry. Losses by highly leveraged institutions could cause a massive sell-off of assets, putting our economy at risk of another dip.
3. Cybersecurity breaches pose a real threat to the financial services industry.
Cybersecurity has been on the minds of many Americans given the devastating attacks on both government and retail institutions in the past year. The financial services sector is not immune to cyber-attacks. High levels of data confidentiality, integrity, and availability are crucial for the safe completion of all financial transactions. Given that the financial markets rely on relatively few core systems, an attack on any of these systems could spell disaster for a multitude of financial institutions and pose a risk to the financial system as a whole. Regulators are releasing tools to help banks assess their own vulnerabilities to cyber attacks, but the FSOC and other federal regulators urge financial institutions to stay vigilant as hacking attempts become more frequent and severe.
4. Regulation of central counterparties could have a destabilizing effect on financial markets.
Following the crisis, regulators mandated that a greater proportion of financial transactions be cleared through central counterparties, or CCPs. These measures were intended to provide transparency and liquidity to the markets, but there are now concerns that CCPs could be a new source of systemic risk. In other words, CCPs are so closely connected to many systemically important financial institutions that their failures could reverberate through the entire financial system in the event of an economic downturn. The FSOC has not yet rolled out a concrete set of recommendations to address these risks, but has indicated that more stringent regulations could be necessary.
5. Housing finance reform is the missing piece in the economic recovery puzzle.
During the subprime mortgage crisis of 2008, the government took over Fannie Mae and Freddie Mac in an effort to stabilize the housing industry. Seven years later, our housing finance infrastructure remains virtually unchanged. Fannie and Freddie remain under the control of the federal government and over 70% of mortgages in America are backed by the U.S. government. This puts taxpayers at enormous risk in the event of another economic collapse. There is broad agreement in Washington on the importance of reform and on the need for Fannie and Freddie to hand off their mortgage credit risk to the private markets. However, there is disagreement about the most responsible way to approach this reform. The lack of clarity on the future of housing finance has caused uncertainty in the mortgage market, contributing to tight credit and the anemic recovery of the housing market since the crash. The FSOC report urges lawmakers to act decisively on housing finance reform.
Why should we care?
The FSOC report is 150 pages long and full of regulatory jargon that is easy to dismiss. Yet, the information it contains is relevant to current and future business leaders, not just policymakers. Like it or not, the aspiring investment bankers and hedge fund managers among us will be entering a new financial and regulatory landscape. Cybersecurity threats, changing market structure, and stringent regulations by the federal government are just a few of the challenges we will face in the financial sector in the coming years. Publications like the FSOC annual report provide a rare big-picture view of our financial system and allow us to assess and mitigate risks to our businesses. Very simply, the FSOC report is a glimpse into the future of financial markets that none of us can afford to overlook.
Ackerman, Andrew. “Regulators Sound Alarm on High-Frequency Trading Firms.” Wall Street
Journal, April 30, 2015. http://www.wsj.com/articles/regulators-sound-alarm-on-high-
Financial Stability Oversight Council. “2015 Annual Report: Financial Stability Oversight Council.” FSOC. Accessed June 25, 2015. http://www.treasury.gov/initiatives/fsoc/studies-reports/Documents/2015%20FSOC%20Annual%20Report.pdf.
Ian, McKendry. “Cyber Threats Pose Systemic Concerns, OCC’s Curry Says.” American Banker. Accessed June 25, 2015. http://www.americanbanker.com/news/law-regulation/cyber-threats-pose-systemic-concerns-occs-curry-says-1074680-1.html.
Nocera, Joe. “The End of Fannie and Freddie?” The New York Times, June 26, 2013.
The Annual Report of the Financial Stability Oversight Council. Washington, D.C., 2015. http://financialservices.house.gov/calendar/eventsingle.aspx?EventID=384888.
Tracy, Ryan. “Regulators Point to Risks From Rapid-Fire Trading, Clearing.” Wall Street Journal, May 19, 2015, sec. Markets. http://www.wsj.com/articles/regulators-point-to-risks-from-rapid-fire-trading-clearing-1432064436?KEYWORDS=central+counterparties.
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