FSOC Approves 2016 Annual Report

The Financial Stability Oversight Council (“FSOC”) approved unanimously its 2016 Annual Report containing recommendations on central counterparties (“CCPs”), cybersecurity and market structure. In open and executive sessions, the FSOC reviewed (i) updates on market developments, (ii) the Federal Reserve’s proposed rulemaking applying to certain insurance companies, and (iii) the annual reevaluation of the designation of non-bank financial companies.

The 2016 Annual Report offered the following recommendations:

  • Cybersecurity. Financial regulators should “strongly support” efforts to implement the Cybersecurity Act of 2015 in order to establish a “robust legal framework for sharing cyber-related information.” Regulators must maintain a “common risk-based approach to assess cybersecurity and resilience,” and develop “robust sector-wide plans” for responding to significant cybersecurity incidents.
  • Liquidity and Redemption Risks. Regulators should consider implementing the following measures:
    • robust liquidity risk management practices for mutual funds, particularly with regard to preparations for stressed conditions by funds that invest in less liquid assets;
    • clear regulatory guidelines that address limits on a mutual fund’s ability to hold assets with very limited liquidity in order to prevent holdings of potentially illiquid assets from interfering with a fund’s ability to make orderly redemptions;
    • enhanced reporting and disclosures by mutual funds of their liquidity profiles and liquidity risk management practices;
    • taking steps that would allow and facilitate mutual funds’ use of tools to allocate redemption costs more directly to investors who redeem shares;
    • additional public disclosure and analysis of the external sources of financing, such as lines of credit and interfund lending, as well as events that trigger the use of external financing; and
    • measures to mitigate liquidity and redemption risks that are applicable to collective investment funds and similar pooled investment vehicles offering daily redemptions.
  • Capital Liquidity and Resolution. Regulatory agencies should review the resolution plans of large, complex bank holding companies closely in order to promote resolvability under the U.S. Bankruptcy Code and ISDA’s 2015 Universal Resolution Stay Protocol.
  • Central Counterparties. The Federal Reserve, the CFTC and the SEC should continue to coordinate and examine ways to improve the supervision of all CCPs that are designated as systemically important financial market utilities.
  • Wholesale Funding Market Reforms. Regulators must monitor general collateral finance repo transactions and assess the risks that could be posed by cash management vehicles that are not money market funds.
  • Data Quality, Collection and Sharing. Regulators should (i) develop permanent data collection programs, (ii) adopt the legal entity identifier, where appropriate, and (iii) harmonize the reporting of derivatives data.
  • Financial Stability. Regulators should expand a recent Treasury Request for Information by examining the regulatory treatment of products that have “highly correlated underlying risk drivers.” In addition, they should utilize coordinated tools, such as “trading halts,” and enhance data and information sharing among member agencies.
  • Financial Innovation. Regulators should actively monitor and evaluate the risks posed by technological advances in practices and products, such as marketplace lending and distributed ledger systems, both of which “appear poised for substantial near-term growth.”

FSOC also noted that a federal court rescinded its designation of a non-bank financial company for Federal Reserve supervision and prudential standards. The government is appealing the court’s decision and stated:

[FSOC]’s authority to designate nonbank financial companies remains a critical tool to address potential threats to financial stability, and [FSOC] will continue to defend vigorously the nonbank designations process.

 

Lofchie Comment: While the FSOC Report provides good general background on the state of various types of financial institutions; e.g., broker-dealers, credit companies and banks, as well as an overview of regulatory developments, it seems to be at least as much a political document as an analytic one. Very little is said regarding the reasons why FSOC’s designation of an insurance company as “systemically important” was rejected by the court, or of the criticisms of the SEC’s proposed rules with respect to leverage at investment companies or even the reasons why the economic data regarding hedge funds is poor (Form PF is useless). Likewise, to the extent that risks seemingly have been created by regulatory policy, those risks are glossed over; e.g., discussions of clearing house risks are focused on claimed improvements, rather than questioning the limits of the concept. It is clear that FSOC is concerned with the risk of securities lending activities, but risks that seem far greater, such as the low funding of municipal pension plans, are given relatively short shrift. With respect to the pension plans, FSOC did note that the levels of underfunding are significantly greater than the official numbers because the plans are allowed to use extremely optimistic projections of their future revenues. FSOC made no attempt to further describe or quantify the extent of the underfunding or of the over-optimism. In short, it is not unreasonable to conclude that the political nature of the annual report is influenced by the FSOC’s political and structural makeup.

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