Red flags worrying lawmakers 11 years after financial crisis

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WASHINGTON — With the financial crisis reaching its 11th anniversary this month, House lawmakers on Wednesday highlighted trouble spots in the financial system that still keep them awake at night.

Among the top issues cited by members of the House Financial Services Committee were leveraged lending, cybersecurity and the upcoming transition to a new interest-rate benchmark.

“We are entering a period that may prove a test for the new regulatory framework put in place following the financial crisis,” said Rep. Gregory Meeks, D-N.Y., the chairman of the subcommittee on consumer protection and financial institutions. “I fear that some actors in the economy and even some in government suffer from a worrisome form of amnesia or selective memory.”

While the Republicans on the subcommittee struck a different tone and praised regulatory relief measures under the Trump administration, several still raised alarm about building risks. They implored the two witnesses, Federal Reserve Gov. Lael Brainard and Office of Financial Research Director Dino Falaschetti, to take action to safeguard certain elements of the financial system.

Here were lawmakers' list of top concerns:

Leveraged lending

At the beginning of the summer, the Fed indicated that it was keeping a close watch on leveraged lending, finding that corporate debt has increased since the end of the financial crisis and that the least creditworthy borrowers account for most of that growth.

In a speech in June, Fed Chairman Jerome Powell said that the risk in leveraged loans was outside the banking system, making those highly-leveraged loans difficult to track and supervise.

“While leveraged loans have traditionally had important investor protections, covenants for leveraged loans issued in the past few years have weakened dramatically, and they often include features that increase opacity and risk,” said Brainard in her written testimony to the subcommittee.

Lawmakers on the panel linked concerns about leveraged loans with those about shadow banks in general.

Rep. Jesus Garcia, D-Ill., admonished the Financial Stability Oversight Council for de-designating nonbanks as “systemically important financial institutions.”

“The 2008 financial crisis was a painful reminder that it is not just commercial banks that can make risky choices, threatening the stability of our entire financial system,” he said. “Hedge funds, insurance giants, and asset managers are all closely connected to basic financial stability.”

Brainard appeared to agree, telling the committee that today’s leveraged loans have features that make them much more opaque compared to leveraged loans of the past.

“What’s important I think going forward is to be able to have as much visibility as we can into those [collaterized loan obligation] structures and who is holding those loans through those structures,” she said. “We look at banking systemic exposures, but of course there’s a very large component which is non-bank that I think bears attention.”

However, Rep. Andy Barr, R-Ky., pushed back on the idea that leveraged loans could pose a systemic risk to the financial system.

“Just because a product is risky does not mean it’s a contagion that will spread to other parts of the system and bring down our economy. That’s what systemic risk is,” he said. “Leveraged loans are of course not without risk, but that’s the idea. Risk is how investors earn returns and how businesses access credit to finance their operations.”

Cybersecurity

The Capital One data breach in July was also fresh in the minds of lawmakers, which they said underlined the ongoing cyber threat.

“I still believe that the most dangerous, the most important issue facing our nation’s economic system is cybersecurity and it seems to be something that doesn’t always rise to the top of the list of concerns,” said Rep. Barry Loudermilk, R-Ga.

OFR is particularly concerned about how much data is shared between service providers, said Falaschetti.

“What we’re really worried about here are the interconnections,” he said. “Our researchers are developing a network analysis that would help bring transparency to understand that, okay, if this particular organization finds itself in difficulty from a cyber attack, who else is downstream?”

Rep. Bill Foster, D-Ill., specifically asked if the Fed had explored “requiring major financial firms to connect to more than one cloud provider so they can fail over to the second one” if one of the cloud providers were disrupted.

“Certainly there’s work internationally where we’re thinking about precisely this question that you raise about the ability to fail over,” said Brainard. “I think there’s some technologies that are out there or are developing that would provide mechanisms for being able to do so.”

A heightened focus on potential risks from companies using third-party cloud providers is likely just beginning, Brainard added.

“I think we do recognize that migrating to the cloud mitigates some risks, adds other risks, and so we need to hold our institutions accountable for making that risk assessment in a very well-informed way and taking that migration very seriously,” she said.

Libor transition

Regulators are preparing to replace the London interbank offered rate with a new benchmark known as the secured overnight financing rate as early as 2021. Although officials have urged banks to switch over as soon as possible, concerns remain that financial institutions are ill-prepared for the transition.

“I think that this poses one of the greatest potential disruptions to our financial system ever, and this is why—uncertainty,” said Rep. David Scott, D-Ga. “It has a large part to play in how smoothly this transition plays out.”

Brainard defended the move to SOFR, telling Scott that Libor “was shown to be subject to manipulation and is becoming increasingly fragile as fewer participants provide input into that rate.”

In 2012, the House Financial Services Committee launched an investigation into allegations that banks had submitted false information in order to manipulate Libor.

Both Brainard and Falaschetti agreed that the transition away from Libor merits attention.

“We have two years to pull the switch on this, and we’re developing fallback language…so how long does that process take place and how does that settle?” said Falaschetti. “There’s a lot of work to be done there and we’re monitoring the potential implications for systemic risk from that issue.”

Rep. Scott Tipton, R-Colo., noted that some securities tied to Libor can’t be altered without full investor consent. "That’s got to be creating real challenges for transition,” he said.

“It’s a very big issue,” said Brainard. “The more sophisticated players in this space are re-contracting, but there’s a lot of friction, and doing that, as you say, is creating risk.”

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Financial reform Cyber security Cyber attacks LIBOR SOFR Leveraged loans CLOs Lael Brainard Federal Reserve House Financial Services Committee
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