Several weeks ago with little fanfare and only a smattering of media attention, the Financial Stability Oversight Council released its fifth annual report, outlining what its members (the heads of all major U.S. financial regulatory agencies) see as threats to the U.S. financial system. The report offers recommendations that could shape the rulemaking process and examination priorities for years to come.

One focus, for example, is cyber-security and the threat of continued breaches. Another is whether existing rules do enough to curb the risk that central counterparties might spread credit and liquidity problems across the financial system. Perhaps foreign shocks could disrupt financial stability here, or maybe new financial products concocted in the United States will do the same. The 125-page report goes on to list many more potential concerns.

The FSOC’s principal warning is that while regulators do now collect much more data on financial markets and institutions, critical gaps remain in the scope and quality of data collected, and in agencies’ ability to share all that data effectively.

Although controversial at times (notably in its ability to designate Systematically Important Financial Institutions), FSOC does serve an important role, says Cliff Stanford, chair of the bank regulatory practice at law firm Alston & Bird. “It is akin to an enterprise risk management approach, where people sit around a table and bring perspectives about their roles and what they are responsible for overseeing,” he says. “They throw them all in the soup, stir them up, and come up with a recitation.”

“Everybody is at least talking to each other,” Stanford adds, which is a marked contrast to the uncommunicative regulatory fiefdoms that overlooked symptoms of the 2008 financial crisis. “When the FSOC meets, what they talk about is really meaningful, because they will be held accountable,” he says.

Stanford wasn’t surprised to see cyber-security concerns prominently peppered throughout the report, and says it has “potential tea leaves” of where regulators may direct more attention. 

“When the FSOC meets, what they talk about is really meaningful, because they will be held accountable.”
Cliff Stanford, Chair of the Bank Regulatory Practice, Alston & Bird

“One I looked for is the emergence of peer-to-peer lending platforms, and if they pose risk either from a consumer perspective from a banking perspective, or from a securitization perspective,” he says. “Who is buying this stuff, where does it end up? Does it end up being bad debt that is folded into a bunch of securitized platforms down the line? It is in there, in the context of financial innovation and how it impacts the financial system.” That same section posits high-frequency trading as a potential threat to market stability.

Another risk factor Stanford expected to see, and did, covers non-bank mortgage servicers, some of whom “hold gigantic books of mortgages and many compliance concerns.”

The FSOC also makes the case in its annual report that no matter what progress has been made, regulatory agencies must do more to collect, analyze, and share quality data. “The house they are building here in terms of their assessment of risks could fall down if they have bad data,” Stanford says.

Among the recommendations in the FSOC report:

Financial regulators should expand efforts to map existing regulatory guidance to the NIST Cyber-Security Framework, and encourage consistency across regulatory regimes for cyber-security.

The Treasury Department’s Federal Insurance Office and state insurance regulators should continue to monitor and assess the growing risks that insurers have been taking by extending the duration of their portfolios, and by investing in lower-quality or less liquid assets.

The expansion of electronic trading beyond equities and futures markets should be assessed for potential vulnerabilities. Risk management and technology systems should be equipped to detect and mitigate issues that may arise from erroneous trades or disruptive strategies.

As U.S. regulators and their foreign counterparts expand clearing requirements for additional derivatives products, the role of central counterparties as risk management hubs will increase; regulatory scrutiny must be commensurate with this increased role.

Regulators and supervisors should seek to attain greater visibility into certain sectors of the financial system. The FSOC recommends that the Securities and Exchange Commission continue its work to address data gaps in the asset management industry.

The Risk of FSOC Itself

Regulators are increasingly encouraging or requiring use of Legal Entity Identifiers, but broader adoption is needed. Agencies should support the adoption and use of standards in mortgage data, particularly the Consumer Financial Protection Bureau’s efforts to develop a unique loan identifier, and the use of the LEI in mortgage data collections.

“There is still a question in terms of where the rubber hits the road and how these recommendations will get implemented,” Stanford says. “It is going to be interesting to see how this annual report, as a reflection of the FSOC’s collective views, influences Congress. If there really is an effective feedback loop, it could help set the agenda for the Senate Banking Committee. The same risks may not apply to every institution given their idiosyncratic nature, but I think chief risk officers, especially at banks, would be very interested in these recommendations.”


The following, from the Financial Stability Oversight Council’s annual report, address the use of data by regulators.
Regulators took several steps in 2014 to improve the scope, comparability, and transparency of existing data collections. Promoting transparency in the over-the-counter derivatives markets is a major priority for the Council and international regulators, given the market’s role in the financial crisis, its decentralized nature, and evolving infrastructure.
The global Legal Entity Identifier (LEI) project progressed in 2014. In the United States, more regulatory reporting forms are requiring the use of the LEI. Also, in 2014, the Commodity Futures Trading Commission and Office of Financial Research entered into a cooperative effort to enhance the quality, types, and formats of data collected from CFTC-registered swap data repositories (SDRs). Although regulators now collect significantly more data on financial markets and institutions, critical gaps remain in the scope and quality of available data.
The Council recommends that the SEC continue its work to address data gaps for the asset management industry and that the appropriate member agencies continue to improve data collection on bilateral repo and securities lending activities. The Council also recommends that the state insurance regulators and the National Association of Insurance Commissioners (NAIC) continue to work to improve the public availability of data, including financial statements relating to captive reinsurance activity.
The Council recommends that members and member agencies continue moving to adopt the LEI in reporting requirements and rulemakings, where appropriate.
For derivatives markets, swaps must now be reported to new entities known as SDRs and security-based swap data repositories (SBSDRs). It is important that these data be sufficiently standardized for effective analysis by regulators and with appropriate aggregation and protection for public dissemination.
The Council recommends that members and member agencies work with international regulators to promote high standards in derivatives data reporting and recommends that impediments to U.S. authorities’ access to data stored at repositories be resolved.
Source: Financial Stability Oversight Council.

A less generous view of the FSOC and its risk assessments comes from Felicia Smith, vice president and senior counsel for regulatory affairs at the Financial Services Roundtable—the organization that has repeatedly slammed the FSOC for a lack of transparency in its SIFI designations.

Smith’s concern is that the FSOC is seeking bank-like regulatory solutions for capital markets and largely ignoring the role of Federal Reserve monetary policy as a possible cause of systemic risk. “They talk about issues associated with what they describe as runs, because people are moving into long-dated exposures that are riskier,” she says. “What they don’t do is talk about why people are moving into riskier assets. For the last several years we have had interest rates held by monetary policy by the central bank to practically zero.”

FSOC’s concerns about insurance company stability are also related to that macro-economic problem, Smith says. “They have obligations they are going to have to pay down the line 20 years from now,” she explains. “They can’t afford to rack up year-after-year-after-year of very low interest rates, because they need to follow through on the commitment they made with policies. So they are moving into classes of assets where there is higher risk, but there is also the potential for higher reward. Maybe they wouldn’t do so at all if there was a more ‘normal’ interest rate environment.”

Smith’s concern with the FSOC is that it wants “to get rid of the capital markets and replace everything with bank-like regulation.”

“These are not bank-like markets,” she says. “Capital markets necessarily involve the allocation of risk with the expectation of the corresponding reward. They seem to have a problem, even in their money market fund approach, of not recognizing that people are sometimes seeking risk, not running from it.”

“The only kind of regulation that matters is prudential regulation, and they ignore the fact that the capital markets are being adequately regulated by the SEC,” she adds.

Those same concerns have been a frequent lament of SEC Commissioner Michael Piwowar. “Perhaps, if the Fed and other banking regulators were experts on capital markets, they would see the folly of ‘prudential market regulation,’ ” he said recently. “But it is clear that the Fed and the others not only are not experts; they do not even understand the basics. The Fed may be risk averse and suspicious of those motivated by profits, but risk taking and profit seeking are the cornerstones of the capital markets.”