WASHINGTON — Financial innovation, including distributed ledger technology and marketplace lending, has emerged as a new source of risk to the U.S. financial system, according to a report issued Tuesday by the Financial Stability Oversight Council.
In its annual report, the interagency council assessed the various threats facing banks and other institutions. It concluded that regulatory efforts had greatly mitigated the risk to the economy posed by a failing megabank, but it reiterated warnings about cybersecurity vulnerabilities and the role of central counterparties in financial markets.
But the council struck a new tone in its characterization of fintech market players, noting both its promise and its perils. Marketplace lending "is an emerging way to extend credit using algorithmic underwriting which has not been tested during a business cycle," which creates a risk that the industry might not endure a credit crunch, the report said. It also warns that underwriting standards and loan administration standards in the industry could "deteriorate [in an effort] to spur volumes," affecting other market players.
Distributed ledgers also came under new scrutiny. Though the council acknowledged the technology's ability to "reduce concentrated risk exposures" and improve the efficiency of settlement systems, it warned that it could "pose certain risks and uncertainties."
The technology, by decentralizing parts of the financial system, could also create a more complex environment for supervisors, the council said. "Since the set of market participants which make use of a distributed ledger system may well span regulatory jurisdictions or national boundaries, a considerable degree of coordination among regulators may be required," the report said.
Cybersecurity also remains a major risk for the financial system, the council found. It advised regulators and financial institutions to develop common plans for information sharing, responses for a significant cybersecurity incident and a "risk-based approach to assess cybersecurity and resilience" in the firms beyond the National Institute of Standards and Technology's framework. The FSOC also urged the Treasury Department and law enforcement agencies to support the implementation of the Cybersecurity Act of 2015, a bill passed in December that incentivizes the sharing of information on data hacks within the private sector.
"This year's annual report shows that issues like market structure and cybersecurity have been raised on the [council's] radar," Treasury Secretary Jacob Lew said at an FSOC meeting before the release of the report. He added that several other issues had emerged as well.
"It is a process where if everything changed it would be unnerving," and if everything remained the same, "it would be equally unnerving."
Central clearing markets remained a big concern as well. Dodd-Frank mandated the use of central clearing platforms to centralize certain over-the-counter derivatives, but regulators in recent years have worried that these entities, many of which are regulated as financial market utilities, are themselves pooling risks within the financial markets. Though the report did not offer new proposals to address this, it renewed calls for inserting low-risk swaps into the platforms and develop failure-response mechanisms.
The FSOC also criticized the quality and extent of financial data made available by financial institutions. "In particular, important gaps remain in wholesale funding markets, asset management activities, and banking and market making taking place outside the regulatory perimeter," the council found.
In a May report, the Office of Financial Research, an independent Treasury Department office, found that public information released on large banks' living wills this year did not provide enough information for conclusive findings on their resolvability.
On a positive note, the FSOC found that the resolvability of the largest banks had improved significantly in recent years, citing measures such as the Federal Reserve and Federal Deposit Insurance Corp.'s responses to large banks' living wills. The council also hailed the Fed's total loss-absorbing capacity rule and recent enhancements in the International Swaps and Derivatives Association protocol.
Such steps "can be expected to make the largest, most interconnected financial institutions more resilient, improve regulators 'and firm managers' ability to manage potential distress at such institutions, and reduce the impact of contagion that may arise from interconnections among firms and markets," the report said. However, the FSOC found that large bank holding companies are still being buffeted by the "relatively flat yield curve" and by credit risk — particularly in relation to energy and commercial real estate exposure — calling for them to be "robustly monitored."
In its report, the council referred to a March ruling that struck down its designation of MetLife as "systemically important," saying its power to designate nonbanks is essential to its mission. "The council's authority to designate nonbank financial companies remains a critical tool to address potential threats to financial stability, and the council will continue to defend vigorously the nonbank designations process," it said. The FSOC is appealing the decision in the U.S. District Court of Appeals.