FSOC Releases 2015 Annual Report (with Lofchie Comment)
The Financial Stability Oversight Council ("FSOC") released its 2015 Annual Report (the "Report") pursuant to Section 112 of the Dodd-Frank Act.
The Report summarizes developments over the past year in the broader economy (in Section 4), as well as in various financial markets (in Section 5). The Report describes recent activities by FSOC and significant rulemakings by other financial regulatory agencies (in Section 6), makes recommendations to address structural weaknesses in the U.S. regulatory regime (in Section 3) and discusses emerging threats to the global economy that could necessitate further regulatory action (in Section 7).
In particular, the Report discusses and makes recommendations concerning the following topics (among others):
- Central Counterparties ("CCPs") – Although regulators have taken "significant steps" to promote strong risk management at systemically important CCPs, existing rules should be evaluated carefully to ensure that potential credit and liquidity risks associated with CCPs during periods of market stress are minimized.
- Market Structure – Owing to technology, regulators should continue to monitor changes in market structure, regulation and competition, and how they affect the provision of liquidity and operational risks.
- Interest Rates – Historically, the low-yield environment in the United States has encouraged risk-taking across the financial system. In particular, regulators should monitor underwriting standards and risk management practices in the leveraged loan market, which have deteriorated over the past year.
- Cybersecurity – The Treasury should continue to utilize the Financial Sector Information Sharing and Analysis Center ("FS-ISAC") to facilitate information sharing between the public and private sectors "in a manner that respects civil liberties and protects the privacy of customers." In addition, regulators should enforce cybersecurity best practices modeled on the National Institute of Standards and Technology's Framework for Improving Critical Infrastructure Cybersecurity (the "NIST Framework").
- Data Collection – Regulators should seek to attain greater transparency in certain sectors of the financial system, such as the asset management industry, securities lending and bilateral repo markets. In addition, all member agencies should adopt legal entity identifiers ("LEIs") in rulemakings, where appropriate.
- Repo – The settlement of General Collateral Finance repo transactions should be made consistent with previous reforms to the tri-party repo market to reduce reliance on intraday credit.
- Housing Finance – Congress should pass legislation addressing the conservatorship of Fannie Mae and Freddie Mac and clarifying the future role of the public sector in mortgage markets.
Lofchie Comment: FSOC's Annual Report reads a bit like a self-advertisement – "financial reform progress included further strengthening of capital, leverage and liquidity standards"; "the Council continued to fulfill its mandate" (at 87). This self-promotional tendency diminishes the value of the Report as an objective assessment of the current state of the market. Since the report highlights the benefits of government policies, it might be worth mentioning some of the negatives for the sake of balance, even if that seems like nitpicking: The "historically low-yield environment" results in investors accepting "disproportionate amounts of risk" and is "making it difficult for pension and retirement funds to meet their long-term liabilities"; "a sharp increase in interest rates could lead to fire sales." Various factors, including "regulation" (i.e., Reg. NMS), have contributed to the fragmentation of the securities markets. The "risk appetite of traditional broker-dealers [has] changed, with some broker-dealers reducing their securities inventories and, in some cases, exiting certain markets." To put it differently, higher government capital and other requirements have resulted in reduced liquidity in the financial markets (which is not good in the event of the fire sales referenced above) in tandem with decreased competition as firms with smaller shares in any market give up entirely on that market. Central counterparties are no longer magical cure-alls; they are now "potential threats to financial stability." (It would be better for the government to admit that the big clearinghouses are too big to fail and go on from there.) Financial activities are moving out of regulated institutions (no surprise there). Broker-dealers hold less corporate debt and more government debt. (That is, capital rules decrease liquidity in the corporate markets and strongly encourage lending to the government.)In short, it is possible to be as optimistic as a banker or as negative as a lawyer about the FSOC Report. Notwithstanding all the criticisms mentioned above, a more balanced Report should (at least) acknowledge that: (1) very low interest rates are making it impossible for retirement funds, particularly government retirement funds, to be able to meet their future obligations, and (2) any quick rise in interest rates could lead to fire sales in markets where broker-dealers will have no incentive or ability to provide any liquidity. That raises a real challenge for monetary policy: keep interest rates low, and pension plans fail; raise in interest rates, and markets may crash.