WASHINGTON - The U.S. financial system has weathered several external threats in the past year, but significant hazards remain, including the potential for cyberattacks and excessive concentration of risk in central counterparties, according to a report by the Financial Stability Oversight Council.
The interagency council's annual report, released Tuesday, noted that the system has not suffered lasting effects from a precipitous drop in oil prices or ongoing crises in the Ukraine and the Middle East.
But as those threats recede, others pose significant risks to financial stability and demand greater attention from policymakers, said Treasury Secretary Jack Lew.
"There have been a host of technological, competitive, and regulatory changes that continue to reverberate and create potential new stresses to the system," Lew said. "Cybersecurity is a primary focus of multiple agencies today. Central counterparties have grown in importance to financial stability and market resiliency. Market structures are evolving, and this had led to financial innovation and some migration of activities away from traditional players."
Cyber threats topped the list of concerns outlined in the report. It said cyberattacks are "creating a growing operational risk to the financial sector" and reiterated past calls for Congress to pass "comprehensive legislation on cybersecurity issues, including information sharing and data breach notifications." FSOC also encouraged continued work by the Federal Financial Institutions Examination Council to coordinate responses and information sharing where possible within the banking sector and called on all financial market stakeholders to collaborate with the Financial and Banking Information Infrastructure Committee to communicate threats and data breaches.
The report also recommended that greater emphasis be placed on having third party vendors meet certain cybersecurity minimum standards; placing additional security protocols on administrative access for financial institutions; and enhance firms' ability to recover in the case of an inevitable attack.
The report's emphasis on cybersecurity comes as lawmakers struggle to address some of the most core elements of a cybersecurity bill, including scope, enforcement and whether such a law should supersede state cybersecurity laws. The House Financial Services Committee held a hearing on the subject last week and again on Wednesday.
The report also for the first time made specific note of the potential systemic threats posed by the failure of central counterparties, or CCPs. The Dodd-Frank Act mandated that certain over-the-counter derivatives, or swaps, be routed through a CCP before they are executed. FSOC already declared many CCPs in the U.S. as financial market utilities, or FMUs, in 2012, thus subjecting them to enhanced regulatory scrutiny because of their systemically important status.
The purpose of the reform is to reduce the potential systemic fallout if one party to a transaction fails, but the report said that the existing safeguards that are in place to ensure that the CCP itself does not fail may not be adequate, given the size of the risk and the growing move toward clearing in the U.S. and worldwide.
"The increasing importance of CCPs has heightened public and regulatory focus on risk management practices at CCPs and the potential threat to financial stability in the event of a CCP failure," the report said. "The Council also encourages regulators to review the adequacy of margining, stress testing, enhanced transparency and disclosures, and cyber resilience."
FSOC's interest in CCPs comes as the Office of Financial Research earlier this month released a pair of academic papers suggesting that clearinghouses were inadequately capitalized for the scope of their risks. Federal Reserve Gov. Daniel Tarullo also said in a speech in January that the existing global margin requirements for CCPs may be based on an unrealistically mild worst-case scenario and suggested that further analysis is warranted.
The report added that the prolonged low interest rate environment has spurred a growth in reach-for-yield activities by financial firms, which could pose a threat if not kept in check. As central banks around the world begin to lower interest rates amid concerns about employment and price stability, institutions will likely take on longer-duration assets, lower lending standards and otherwise take on risks they may not otherwise assume because of a lack of more traditional means of boosting returns. That could pose a risk to financial stability if the interest rate market suddenly become more volatile, the report said.
FSOC also held a closed meeting Wednesday in which the council discussed resolution plans - one of the touchstones of the Dodd-Frank Act -- which requires the world's largest institutions to outline how to dissolve themselves without collapsing the world economy. The report said that the U.S. is still setting up its resolution process, including the completion of total loss absorbing capacity and liquidity ratio rules. But other countries are still catching up, and how the resolution of a large U.S. firm would play out abroad remains unclear.
The Federal Deposit Insurance Corp. and Federal Reserve are set to review the latest iterations of those largest banks' so-called "living wills" later this summer. Fed Chair Janet Yellen said in February that this year's living wills would be subject to heightened scrutiny after the FDIC voted last year to deem many banks' plans "not credible", while the Fed opted instead to approve the banks anyway. The FSOC report recommended that FDIC and the Fed "review and assess the upcoming resolution plans and take appropriate action to foster resolvability."