Alert August 02, 2011

Financial Stability Oversight Council Issues its First Annual Report; Finds that U.S. Financial Stability improved, but U.S. Still Faces Challenges to Recovery

The Financial Stability Oversight Council (the “FSOC”) published its first Annual Report (the “Report”), which covers the year ended December 31, 2011.  After discussing the current macroeconomic environment, the Report focuses on three other topics: financial developments since the financial crisis, the progress of regulatory reform and potential emerging threats to U.S. financial stability.

Financial Developments

During the crisis, the FSOC states, the U.S. government took many dramatic steps to support financial markets.  Private funding has replaced many of the government’s support programs, but private funding has not returned to the private securitized mortgage market.  The banking sector and many other financial institutions have experienced increased profitability since the crisis, but smaller banks have struggled to recover and are still failing at increased rates.  Despite the overall improvement, banks are still hesitant to expand direct lending activity.  In addition, the FSOC states, insured depository institutions have seen more asset growth than other financial institutions since the recession, and concentration and globalization have also increased in the banking industry since that time.  The overall financial system is less leveraged than before the recession.  Also, the credit risk transfer markets that contributed to the crisis have shrunk considerably.  Short-term wholesale funding markets, which provide needed liquidity for financial institutions, continue to experience dramatically decreased activity since before the crisis.  Additionally, risk pricing in important markets is about average, while prices for commodities and agricultural land have risen significantly.  Financial institutions, states the Report, have also begun to reform compensation practices, which they have acknowledged contributed to the crisis.  Assets in mutual funds, hedge funds and defined contribution plans have recovered, the FSOC notes, although some state and local government pension plans are on track to eventually face funding shortfalls.  Last, regulatory reforms have led to increased efficiency and transparency in financial markets, and regulators are also working to address many risks identified during the crisis. 

Progress of Regulatory Reform

The Report states that the Dodd-Frank Act has closed many gaps in the regulation of financial institutions, strengthening standards in areas such as supervision, risk management and disclosure.  The new Basel III international standards for banks have also imposed increased requirements for holding capital globally, a new liquidity standard for banks and new accounting rules.  In addition, information on trading in swaps will become available through trade repositories, and standardized derivatives will need to be centrally cleared and traded on regulated trading platforms.  Also, the FSOC has defined characteristics for designation of systemically important financial market utilities to receive enhanced supervision, and it is working on defining characteristics for designation of nonbank financial institutions to be supervised by the FRB.  Meanwhile, the FRB will establish stricter supervisory guidelines for large financial institutions, and regulators are also working on new reporting and disclosure requirements that would apply to designated nonbank financial companies.  Moreover, the Dodd-Frank Act established a new framework for resolving large complex financial institutions, which includes a requirement for designated nonbank companies and large bank holding companies to maintain detailed resolution plans.  Finally, U.S. regulators are making an effort to work with their international counterparts to achieve consistency in global regulatory reform.

Potential Emerging Threats to U.S. Financial Stability

The FSOC states that globalization and technological innovation, while positive in many ways, can also negatively impact financial stability because of the increased links across global economies and the addition of complexity to financial systems.  Development of new financial products can increase risk by increasing complexity and changing business models.  Electronic trading has led to higher trading volumes and more market liquidity, but the “flash crash” demonstrated that this liquidity can diminish under stress.  New technology has helped to create more flexible, efficient and effective systems, but events such as hacking attacks serve as reminders that technology must be constantly monitored and upgraded.  The Report notes that U.S. financial market can also be impacted by foreign markets.  Market uncertainty in Greece, Ireland and Portugal could potentially cause negative effects in the U.S., even though the U.S. has limited direct exposure to those countries.  Supervisory agencies have been working with U.S. financial institutions to increase resiliency in the face of foreign market troubles, and the FSOC will also carefully monitor European markets.  Some risks are also posed by money market funds and the tri‑party repo market, which have exhibited structural vulnerabilities.  Money market funds are an important source of certain types of funding for some major European banks, and their vulnerabilities contributed in part to the financial crisis.  There are also significant risks due to real estate-related exposures.  There have, however, states the FSOC, been overall improvements in capital throughout the financial system, which will help prevent additional declines in real estate prices.  Additionally, monetary policy normalization has been delayed and uncertainty surrounding the pace of this normalization as well as fiscal consolidation may cause shocks.  Risk planning and diversification should be employed to prevent such shocks.  Also, with very limited exception, it appears that U.S. market participants are not “reaching for yield” at this time.  Further, many large U.S. financial institutions are still receiving the highest credit rating for short-term funding, and many large banking institutions were found by the FRB to have weaknesses in their capital planning processes.  In order to increase financial stability in the U.S., the FSOC concludes, lessons must be learned from the financial crisis – much progress has been made, but many challenges still remain.