As Prepared for Delivery
We meet today at a time of great change. It is a time of transition in political power that will likely affect the course of policy at home and abroad. In the area of financial policy, much is at stake. We are just over six years into the implementation of a wide-ranging set of regulatory reforms adopted in response to a financial crisis that crippled our economy. These reforms, including the Dodd-Frank Act, have made our financial system stronger and more resilient to future crises.
Today I’d like to speak about one of the central innovations contained in Dodd-Frank: the Financial Stability Oversight Council (FSOC). FSOC exists to monitor and respond to potential risks to financial stability. It has become a critical nerve center during episodes of market volatility or stress. The Council is the one entity that casts a clear eye on the entire financial system.
But still we have seen recent legislative proposals that would curtail the Council’s authorities or impede its decision-making. When you strip away the politics and consider the merits alone, the need for FSOC is clear. FSOC provides a forum to assess system-wide risks that was missing in the crisis and that no single regulator can achieve on its own. We must resist calls to dilute or dismantle its authorities and instead build on its important progress.
At Treasury, we are providing the incoming administration with a complete view of the range of responsibilities and tools of FSOC, and its critical role in our financial regulatory system. While we will never be able precisely to predict future crises, we must reject falling into complacency or using that reality as an excuse to avoid inquiry into areas of potential risk. A safe and resilient financial system is essential to the sustainable growth of our economy.
The Role of FSOC in our Regulatory System
Historically, our regulatory architecture suffered from both duplication and blind spots. Perhaps the most obvious omission was that no single entity was responsible for considering the whole picture. No one was charged with identifying regulatory gaps across jurisdictional silos. No one looked broadly across markets and market participants to consider how developments in technology, practices, and products might affect risks at a system-wide level. And no one was assigned the dedicated mission, nor possessed the requisite field of vision, to monitor potential threats to financial stability.
In the lead-up to the Great Recession, risks began to take root in the cracks of our system, but were obscured through financial engineering and opacity. As we know now, the risks grew large enough to topple the entire system, leading to the worst financial crisis since the Depression.
With the memory of the crisis fresh in mind, Congress established the FSOC in the very first title of the Dodd-Frank Wall Street Reform and Consumer Protection Act. And over the past six years, the FSOC has become an essential pillar of our regulatory architecture. The Council convenes the regulators for our markets, our banks, insurers, credit unions, broker-dealers, and commodities traders. Since its founding, FSOC has met 64 times, including 20 meetings open to the public. In this way, and through hundreds of additional staff-level working sessions, FSOC has institutionalized interagency dialogue and collaboration in a number of challenging, cross-cutting areas.
Our U.S. financial system is complex, and the regulatory structure for oversight of the system is fragmented. We have three federal prudential banking regulators, two federal market regulators, and a state regulatory system for insurance, banking and securities. FSOC brings together the individual regulators and allows policymakers to act with the benefit of a more comprehensive view.
The Council’s duty is to scan far and wide for emerging risks to stability. Its scope is intentionally broad, covering areas as diverse as bank prudential standards, clearinghouse risk management, global macro risks, and the structure of capital markets. FSOC’s mission is inherently forward-looking, and its authorities flexible, in order to keep pace with markets, products, and institutions that are dynamic and constantly evolving.
FSOC in Action
FSOC is best known for its authority to designate certain nonbank financial companies, including some that were at the heart of the crisis. FSOC has exercised this authority with care, designating four institutions. This action has brought these firms under more appropriate levels of oversight through enhanced supervision by the Federal Reserve. And FSOC recently de-designated one of the four nonbanks after substantial de-risking by that firm. Importantly, FSOC also designated eight financial market utilities, placing them under heightened standards and oversight.
Beyond designation, FSOC carries out many other important functions to promote the strength and stability of our financial system. One of FSOC’s most critical roles is its collective analysis and policy consideration. In its strongest form, FSOC can take formal steps, such as issuing a recommendation for agency action. At other times, it can draw attention to areas of risk and prompt action by an individual agency or highlight an emerging issue in its annual report to Congress. Equally important, the Council’s work is a living process, with increasing or decreasing focus on areas of potential risk as conditions change and markets evolve.
In its brief history, FSOC has consistently demonstrated a commitment to thoughtful and fact-based analysis and an understanding that an effective policy response must be tailored to the nature of the risk at hand. The Council’s work on asset management, LIBOR, and money market funds illustrates the range of potential policy response.
While asset management firms did not feature prominently in the financial crisis, the sector is a large and rapidly growing part of our financial system and serves as a critical channel between savings and investment. In particular, assets in less-liquid funds have seen exponential growth. Fixed income funds grew from $1.5 trillion in AUM at the end of 2008 to $3.6 trillion at the end of 2015, and alternative strategy funds grew from $365 million in AUM at the end of 2005 to approximately $310 billion at the end of 2015.
From the outset, FSOC took a consultative approach to its review. In May 2014, FSOC hosted a public conference with market participants, academics, and other stakeholders to discuss a range of risk management topics. As the Council carried out its analysis of industry-wide products and activities, FSOC issued a public request for comment. Following expert analysis across its member agencies, FSOC in April of this year issued a statement conveying its views on areas of potential risk and next steps for policy makers. These views focused on risks in open-ended vehicles invested in less-liquid asset classes, as well as leverage in hedge funds.
And as FSOC marshaled interagency expertise to develop its collective thinking on financial stability, the SEC as primary regulator initiated a number of rule-making efforts to modernize and enhance the regulatory framework for asset management. The SEC recently finalized new rules to ensure that mutual funds will have robust programs to manage liquidity risk and meet redemptions, and to enhance data collection. The SEC has also proposed, but not yet finalized, important rules on registered funds’ use of derivatives and on business continuity and transition planning for investment advisors.
In its public meeting earlier this month, FSOC discussed progress by the newly formed hedge fund working group. The hedge fund industry is today 15 percent larger than it was prior to the crisis. History has shown us the serious risks that can arise in this largely unregulated sector, the best example being the collapse of Long Term Capital Management (LTCM) in 1998. Could another highly leveraged fund, or set of similarly situated funds, again pose a threat to stability? The working group’s analysis found that leverage tends to be concentrated in the largest firms. At the same time, it recognized that the relationship between leverage and risk, and any potential financial stability implications, is a complex question.
One could argue that hedge fund risk has been mitigated since the time of LTCM. Prime brokers have reined in fund leverage, and Dodd-Frank mandated central clearing for standardized derivatives and margin for uncleared derivatives. And the introduction of Form PF provided important data that was previously unavailable. But it is still the case that no single regulator has the information necessary to assess the potential financial stability risks that may be posed by hedge fund leverage.
Through the FSOC, regulators are now sharing data and building a more coherent picture of potential risks. And, most critically in the case of a dynamic sector with shifting participants and strategies, regulators can refresh this picture on an ongoing basis and consider what actions, if any, should be taken. As a result of these efforts, we have learned more about the nature of the largest funds, their use of leverage, and their interconnections with the rest of the financial system. And the working group has proposed enhancements to data collection that would permit an even fuller picture. Along with other elements of the asset management review, this important work must be carried forward.
Another area of ongoing focus is the interagency effort to promote a gradual market transition from LIBOR to a more reliable benchmark. In its 2013 annual report, FSOC highlighted the vulnerabilities associated with the financial markets’ reliance on certain types of reference rates and called for collective action to reform the system of financial benchmarks.
LIBOR’s construction made it vulnerable to the types of manipulation witnessed during the financial crisis. Significant reforms to better ground LIBOR in underlying transactions have been completed, and more are underway. Despite these efforts, the decline in short-term unsecured funding for banks has reduced LIBOR’s transaction base. In fact, today, banks rely on “expert judgement” for roughly 70% of LIBOR submissions, which makes it subjective and vulnerable. Consistent with FSOC recommendations, the Federal Reserve convened the Alternative Reference Rates Committee in 2014 and has led efforts to analyze alternatives to LIBOR and develop plans for a transition.
This transition will be complex and deliberate. As you are all aware, LIBOR is widely used across the financial system—for interest payments on roughly $350 trillion (notional amount) in derivatives and $10 trillion in loans. It also serves as a gauge of market confidence or stress. LIBOR indirectly touches nearly every participant in the real economy—from consumers and small businesses through our largest financial institutions. In addition, multiple regulators oversee the range of market participants and financial instruments that reference LIBOR. Collective action across regulators, and of course by market participants, will be essential to reach a successful outcome.
Addressing a future risk that is visible on the horizon but has not yet materialized is an inherent challenge. This is exactly why the FSOC exists and why its call to action can be so meaningful.
Money market mutual funds
At times, a particular problem has called for more concrete proposals from FSOC to help cut a path forward. We saw in the financial crisis that money market mutual funds (MMFs), a $3.8 trillion industry at the time, were subject to destabilizing runs. At the height of the crisis in September 2008, the Reserve Primary Fund “broke the buck” and investors began redeeming MMFs more broadly. With financial institutions and many other firms dependent on short-term commercial paper purchased by MMFs, these strains quickly propagated and exacerbated market stress, threatening the broader economy. In the end, a government backstop became necessary to stem the panic.
In light of these widely-recognized structural vulnerabilities, FSOC from its inception was focused on ways to mitigate financial stability risks with MMFs and issued recommendations in its 2011 and 2012 annual reports. Having passing initial reforms in 2010, the SEC was also hard at work on the structural concerns. But the Commission ultimately appeared unable to move forward with further proposed rules.
FSOC, therefore, issued for comment a proposed “Section 120 recommendation,” a tool provided by Dodd-Frank that allows the Council to recommend actions to a primary regulator when it determines that there is a risk to U.S. financial markets. The proposal laid out several alternatives for the SEC to consider in proceeding with the necessary structural reforms. The proposal, however, was never finalized because the SEC moved forward with rule-making in 2013. FSOC welcomed those efforts and continues to monitor their impact. The changes took effect in October, requiring prime funds to use a floating net asset value and allowing them to impose redemption fees and gates in periods of stress.
Dialogue and Coordination
Finally, the benefits of fostering dialogue and maintaining focus on risks cannot be overemphasized. FSOC has institutionalized the convening of regulators at the highest level, as well as frequent staff-level interaction through multiple subject-matter committees. This regular process helps forge working relationships at many levels across a fragmented regulatory system. And it facilitates communication and coordination when inevitable periods of market stress arise. We have already seen the benefits, for example when FSOC members swiftly convened to monitor market functioning following Superstorm Sandy, or met to assess market reaction to the Brexit referendum.
The FSOC also assures that the United States maintains its position in leading, rather than following, the international regulatory dialogue. Financial markets are increasingly global in nature. Treasury and other regulators participate in key international fora such as the G20 and the Financial Stability Board to discuss risk and regulatory issues from a global perspective. Importantly, these groups provide an opportunity for U.S. authorities to press for strong standards and a level playing field for our institutions abroad.
For all the issues FSOC tackles, it necessarily draws upon the expertise of its member agencies. FSOC is not a primary regulator and does not replace the role of the expert agencies responsible for oversight and regulation of institutions and markets. It is the embodiment of a collective responsibility to consider the stability of the system as a whole.
Sometimes this responsibility warrants a collective step, such as a designation or a Section 120 recommendation. But more often the work to address potential risks occurs as agencies, better attuned to issues raised by FSOC, carry out their responsibilities as primary regulators. The work of FSOC on financial stability complements the efforts of its member agencies. In this case, the whole is greater than the sum of its parts.
Our financial system is the most vibrant and dynamic in the world. Our regulatory framework strives to ensure that the system remains strong, and that its vibrancy and dynamism serve their fundamental objective, which is to support the health of the U.S. economy. An essential element of this framework includes the ability to look across the entire system and consider potential risks to the whole. We lacked that capability prior to the crisis, and this contributed to the build-up of risks that brought such lasting damage to our economy.
The Council has greatly improved regulators’ ability to share information, collaborate, and take a collective view of risk. The work does not presume outcomes or the conclusion that action will be required. Instead, it ensures that we as a regulatory community do not become complacent when faced with emerging risks or stagnant in our silos as a dynamic financial market evolves around us.
For all it has accomplished, FSOC remains a young institution. As such, it requires strong commitment from all its members to continue the work. We must stand united and resist calls to dilute the Council’s authorities, slow down its decision-making, or dismiss its findings. No entity can predict the precise extent or timing of the next financial crisis. But this is no excuse for inaction or a reversal of course. To the contrary, we must preserve this critical forum, as we seek to maintain the strength and vibrancy of our financial system and its ability to support the real economy for decades to come.