The May 19, 2015 Fifth Annual Report, issued by the Financial Stability Oversight Council (FSOC), established under the Dodd-Frank Wall Street Reform and Consumer Protection Act to oversee risks to the U.S. financial system, highlighted several issues relating to financial institution activities and regulations.

Increased risk taking in a low-yield environment

FSOC indicated its concern that historical low-yields in investments have caused greater risk-taking for only incremental gains, citing, as an example, federal banking agencies’ findings that there are serious deficiencies in underwriting standards for leveraged loans. Low returns also are making it difficult for retirement funds to meet their liabilities to their investors, which have led such funds to seek out lower quality, higher yield assets to boost returns. FSOC expressed concern that such risk-taking might lead to large losses or disruptions in the market in the event of a sudden rise in interest rates.

FSOC recommended that regulators and the industry continue to monitor and assess these heightened risks resulting from the search for greater yields and the risks from potential severe interest rate shocks.

Changes in financial market structure and implications for financial stability

FSOC believes that while changes in market structure such as the ability to trade at higher speeds and the diversity of trading venues have increased competition and reduced transaction costs, regulators need to be attentive to vulnerabilities and to the consequences of the expansion of electronic trading beyond the equities and futures markets:

  • Risk management and technology systems must be able to quickly detect and mitigate issues arising from error trades or disruptive strategies
  • Given the fact that markets are now highly complex and interlinked, liquidity provisions and pricing may adjust quickly and unexpectedly even in the absence of significant market events

FSOC also highlighted the market structure reforms undertaken by the CFTC and SEC over the past five years but recommended that:

  • Regulators remain vigilant to the factors that will drive changes in market structure and how those changes will impact the functioning of the markets, the provision of liquidity and the potential implications for financial stability
  • Regulators should collaborate to better understand linkages between and across markets, both regulated and unregulated, and improve data collection efforts and data sharing arrangements
  • Regulators should develop enhanced tools to better understand currently unregulated firms that may act like intermediaries and determine whether appropriate recommendations should be made to Congress to regulate such firms

Financial innovation and migration of activities

FSOC noted the continuing technology innovation that is reshaping the financial system and expressed concern about how these new products might present potential risks to the US financial system. Of particular concern are nonbank mortgage servicing companies, which now comprise a significant portion of that market. These companies generally are subject to regulations issued by the Consumer Financial Protection Bureau at the federal level and prudential standards at the state level.

FSOC recommended that industry and regulators remain vigilant to potential financial stability risks that may arise from financial innovation, business practices and migration of activities to unregulated or less-regulated market participants. FSOC also recommended that state and federal regulators continue to monitor nonbank mortgage servicers and collaborate with the industry on further development of prudential standards and corporate governance standards for these nonbank companies.

Short-term wholesale funding

On an optimistic note, FSOC commented favorably on both a decrease banking entities’ reliance on short term wholesale funding and progress in addressing structural vulnerabilities in the tri-party repo market and the reforms to money market funds that included a floating net asset value for institutional money market funds.

FSOC recommended that:

  • Market participants continue to make progress toward extending improvements in the settlement process for tri-party repo transactions to the GCF market, which is an interdealer repo market in which the Fixed Income Clearing Corporation acts as intraday central counterparty
  • There continues to be coordination between market participants and financial regulators to address the risk of post-default fire sales of assets by repo investors
  • Regulators review the risks posed by other types of cash management vehicles to determine if changes are needed to address regulatory gaps

Risk-taking incentives of large, complex, interconnected financial institutions

FSOC noted that even though enhanced prudential standards have been promulgated for the largest, most interconnected financial institutions, with the prospect of an orderly liquidation authority if needed, it expressed concern that that there still is the lingering notion in the market that federal government support would back up a struggling financial institution.

FSOC recommended that:

  • Federal banking agencies continue to promote forward-looking capital and liquidity planning at large bank holding companies, US branches and agencies of non-US banks and other banks
  • Agencies promulgate regulations to address structural liquidity needs for the largest banking organizations
  • The US work with international regulators to finalize a standard on total loss-absorbing capacity for the world’s largest and most systemically important banking organizations
  • The Federal Reserve Board propose regulations regarding maintenance of minimum amounts of long-term debt by the largest most complex US bank holding companies
  • Federal banking agencies take appropriate steps to promulgate the November 2014 International Swaps and Derivatives Association protocol to contractually recognize the cross-border application of certain special resolution regimes and work with market participants on addressing similar risks in other financial contracts governed by standard market documentation

Housing finance reform

FSOC noted favorably the recovery in the housing market since the recent financial crisis. While noting that Fannie Mae and Freddie Mac have been able to reduce their overall mortgage credit risk, FSOC nonetheless expressed concern over their continued US government conservatorship.

The FSOC recommended that:

  • Agencies work with Congress and the industry to reform the housing finance system and support financial stability to reinvigorate private capital’s role in supporting provision of access to creditworthy borrowers while adequately protecting taxpayers
  • Comprehensive legislation be enacted to address the conservatorship of Fannie Mae and Freddie Mac and clarify the federal and state governments’ role in mortgage markets
  • Fannie Mae and Freddie Mac further reduce their retained asset portfolios in ways that do not disrupt the stability of mortgage markets or access to credit for creditworthy borrowers
  • Regulators work on reform of Fannie Mae and Freddie Mac’s representations and warranties policies to increase transparency and certainty and standardization for both mortgage investors and mortgage originators
  • Efforts be made to enhance efficiencies in the secondary mortgage market and allow for their integration into a new common securitization platform for Fannie Mae and Freddie Mac

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