FSOC Issues 2014 Annual Report

The Financial Stability Oversight Council (“FSOC”) issued its 2014 Annual Report, which describes significant financial market and regulatory developments identified by FSOC, analyzes emerging potential threats and makes certain recommendations. 

The report discussed:

  • vulnerability to runs in wholesale funding markets, including tri-party repo and money market mutual funds, which can lead to destabilizing fire sales;
  • developments in financial products and new business practices and in the migration of certain financial activities outside of the regulatory perimeter;
  • the potential risk-taking incentives of large, complex and interconnected financial institutions;
  • reliance on reference rates that may be susceptible to manipulation, such as LIBOR and foreign exchange rate benchmarks;
  • the need for financial institutions and market participants to remain vigilant in relation to potential interest rate volatility;
  • cyberthreats and the increase of trading-related operational outages and incidents that could cause disruptions to markets and the financial system;
  • potential risks to U.S. financial stability and economic activity from financial developments abroad;
  • the importance of closing financial data gaps and improving financial data quality; and
  • the need for significant reform in the housing finance system, including increased private capital, a reduction in the footprint of government-sponsored enterprises and improvements in mortgage finance market infrastructure.

Lofchie Comment: One of the criticisms made of FSOC is that, unlike most of the financial regulatory agencies, its membership is drawn entirely from a single party rather than both.  FSOC’s annual report gives evidence as to why the criticism is justified, and why it is detrimental to an organization that is supposed to assess systemic risk to draw its members solely from one party, thereby not affording any opportunity for its conclusions to be challenged by the other.  That is, there is tremendous incentive for the organization to conclude that the policies of the governing party are wise and to downplay the risk that those policies may create.

In the case of this annual report, the primary example of this is the discussion of central clearing of derivatives.  While there are many who believe that mandatory central clearing decreases systemic risk, there are also some who disagree with the idea that forcing so much credit risk, not to mention operational risk, into only a few conduits increases systemic risk.  Even those who believe that central clearing results in a net diminution of systemic risk generally would concede that it also carries its own material systemic risks.  Yet there is almost nothing about this in FSOC’s annual report.

Similarly, the annual report raises concerns about the risks created by the fact that broker-dealers do not have access to the same sources of liquidity as banks, including deposits and the Fed Window.  This concern ought to highlight one of the most worrisome problems created by Dodd-Frank.  The business of dealing in derivatives is essentially a credit activity and, like most credit activities, is most logically conducted in banks.  That Dodd-Frank is going to push derivatives dealing out of banks and onto broker-dealers and other institutions that will not be able to access liquidity as easily as banks is a major systemic risk and one that should not be ignored.  Yet the annual report makes no mention of this, which shows that the value of the report is reduced by the fact that, ultimately, it is a partisan document.

See: FSOC 2014 Annual Report.

 

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