FSOC Identifies Threats Facing Financial System

WASHINGTON — The Financial Stability Oversight Council on Thursday identified several significant areas of concern that policymakers need to address in order to contain threats to the U.S. financial system.

The council, an interagency body comprised of financial regulators, outlined seven broad priorities that they said would set the agenda for the group for the coming year. Those included targeting reliance on wholesale funding that is vulnerable to runs, making progress on housing finance reform, weighing alternative to reference rates like Libor, and watching the impact of low interest-rate risk.

Treasury Secretary Jacob Lew said the report would serve as an "important tool" for regulators on the remaining work left ahead to done, while drawing regulators' attention to those areas.

"We have made important strides over the last year, and our financial system is stronger," said Lew at the council's public meeting. "But, as everyone here knows, much work still remains."

The council, which is headed by Lew, unanimously approved the annual report at a public meeting and all 15 members of the council personally signed it in an earlier-closed session.

Lew pointed to progress made by regulators since the passage of the Dodd-Frank Act, including the Federal Reserve Board's proposed package of rules to supervise the largest financial institutions, new mortgage regulations, and additional work by the Federal Deposit Insurance Corp. on its orderly liquidation authority.

He was echoed by Fed Chairman Ben Bernanke, who stressed further effort was required by policymakers on wholesale funding as well as tri-party repo market reforms. He noted that U.S. regulators should also cooperate with international counterparts in transitioning to a new benchmark rate following the Libor scandal.

Particularly, Bernanke and others noted the need to address the susceptibility of runs on money market mutual funds, which could trigger a fire sale of assets, impair the flow of short-term financing, and put strains across the financial system.

"The report also makes clear much work needs to be done," said Bernanke at the meeting. "In particular, wholesale funding markets remain vulnerable to runs that could in turn trigger destabilizing fire sales. To address such concerns, the council recommends that the SEC consider regulatory action to improve the loss absorption capacity of money market funds and mitigate run risk associated with those funds."

In November, the FSOC released three proposed recommendations to reform the industry utilizing its authority under Dodd-Frank. The move by the council, which was supported by then Chairman Mary Schapiro, was intended to break through a logjam at the SEC, after Schapiro had been unable to win board approval to move forward with the agency's own reform plan.

Mary Jo White, who was attending her first FSOC meeting as the new chairman of the Securities and Exchange Commission, said the agency was currently reviewing the comment letters and has been considering the council's recommendations to ensure they get it right as they also consider further regulatory action.

As it did last year, the council noted its continued concerns on the tri-party repo market's vulnerabilities and noted a lack of progress in addressing them. They found that there was still continued reliance by market participants on intraday credit extension from the clearing banks and weakness in the credit and liquidity risk management practices of many market participants.

One new area given far greater attention in this year's report was operational risks facing the financial system, including cyberattacks that cause denial of service on bank's web sites and the impact from natural disasters like Superstorm Sandy.

Comptroller of the Currency Tom Curry, who has repeatedly emphasized operational risks in recent speeches, said he was pleased that this year's report highlighted them as an area of focus.

"Operational weaknesses have been the root cause of many of the high-profile events that have occurred with in the banking industry over the last several years, ranging from faulty execution of novelty strategies, inadequate controls of mortgage servicing operations, and serious lapses in control during money laundering activities," said Curry.

On housing reform, the council stressed the importance of reducing Fannie Mae and Freddie Mac's systemic footprint and drawing in private mortgage market activity.

"The housing finance system continues to draw on significant federal government support," according to the report. "Increasing the presence of private capital in assuming credit risk in housing finance remains a priority."

As it did last year, the council stressed it continues to monitor the threats to financial stability posed by a low-interest rate environment as some market participants "reach for yield."

Additionally, during the closed session, the council discussed its ongoing analysis of nonbank financial companies.

"It is critically important that the council take the time to get the analysis right, and we expect to vote on designations of an initial set of nonbank financial companies soon," said Lew.

Under the regulatory reform law, FSOC was given the authority to designate nonbank financial institutions that could pose a risk to the financial system. Many expect American International Group, for example, to be among the first SIFI designations. AIG has previously said it meets the thresholds set by the council to decide which firms require further review.