The Financial Stability Oversight Council, the super-group of financial regulators created by the Dodd-Frank financial regulation reform law to monitor the financial system as a whole, identified the biggest potential emerging threats it sees in its annual report released Wednesday.
Regulators such as Treasury Secretary Jack Lew and Federal Reserve chair Janet Yellen say that they have made progress implementing Dodd-Frank and addressing the problem of “too big to fail” banks. But one of the major emerging threats listed by the FSOC, which comprises the heads of all the major regulatory agencies, is that the experience of past bailouts will lead big, interconnected banks to engage in risky behavior because of the expectation that they will get bailed out in case of a future failure.
“When market participants ... expect institutions to receive support, they will not correctly price risk when lending to and transacting with these institutions,” the document states, adding that the mispricing of risk “will incentivize large institutions to take on excessive risk, and put pressure on competing firms to do likewise.”
While claiming that the Dodd-Frank law is reducing the size and interconnectedness of big banks, the document acknowledges that there is some evidence that markets still expect government intervention in the case of financial distress.
Another key risk, from the report: Runs in the shadow banking sector.
Top officials in the regulatory agencies have said in recent months that the financial system remains prone to runs among “shadow banks” — that is, financial institutions that are not covered by the existing “safety net” of government insurance in the case of a panic.
One specific concern raised in the FSOC report is that there could be a run similar to the one that followed the collapse of the investment bank Lehman Brothers in 2008. Then, one money market mutual fund exposed to Lehman debt, Reserve Primary Fund, almost failed. Like other similar financial institutions, Reserve Primary depended on short-term debt to finance its activities, and as a result it found itself quickly cut off from funding, and verged on a collapse that could have brought down the system before the feds stepped in.
FSOC is concerned that a similar “fire sale” dynamic could play out again in the short-term funding markets, because there’s no system of insurance in place and no one regulator in charge.
The FSOC also drew attention to the problem of cybersecurity, and that breaches like the theft of customer information at the retailer Target in December could cause a system-wide problem.
“The financial sector is increasingly dependent on many other industry sectors, including energy, transportation, and telecommunications,” the report states. “As a result, a cyber event that disrupts or destroys any critical infrastructure organizations in these areas could have significant spillover effects on the financial sector.”
The Fed's zero-percent interest rate policies are another potential source of destabilization, according to the FSOC. By keeping rates near zero for five years and counting, the Fed may have led investors to "search for yield" by betting money on riskier investments. Raising rates, too, could put stress on the system. The FSOC noted that "a sharp increase in interest rate volatility still poses some potentially important threats to financial stability."
The FSOC identified other emerging threats, too, including risky new lines of business, interest rate volatility, and the possibility that distress in emerging market economies could spill over to U.S. banks.
Separately, Federal Deposit Insurance Corporation Vice Chair Thomas Hoenig, not a member of the FSOC, warned in a speech Wednesday that the eight biggest U.S. banks have gotten larger since the financial crisis. They now control assets equivalent to almost two-thirds of U.S. economic output, versus 59 percent in 2008.
Hoenig, known as a critic of U.S. banking practices and regulation, pushed for regulators to force big banks to write “living wills” that would specify ahead of time how they would pay out creditors in an orderly fashion, without causing a panic, in the case of a failure. The Dodd-Frank law gave regulators the power to require firms to write living wills.