Introduction to Financial Services: Systemic Risk

Recent Episodes of Financial Instability

Systemic risk is financial market risk that poses a threat to financial stability. The 2007-2009 financial crisis was characterized by system-wide financial instability. Overtaken by panic, market participants became unwilling to engage in even routine transactions at the height of the crisis. Distress at large financial firms was central to the crisis. Financial stability was not restored until large-scale financial intervention by the Federal Reserve (Fed) and Congress helped stabilize markets and provided assistance to financial firms. The result was a sharp and long-lasting contraction in credit and economic activity.

The COVID-19 pandemic also caused significant financial market turmoil in spring 2020, as investors were faced with uncertainty and unprecedented disruptions to economic activity. But this time, financial stability was quickly restored, albeit again through large-scale financial intervention by the Fed and the CARES Act (P.L. 116-136). Unlike the previous crisis, distress at large financial firms was not central to the instability. Both episodes suggest that financial markets remain inherently fragile under periods of stress, and federal interventions are likely in future episodes of instability. This raises questions of whether further reforms are merited to mitigate systemic risk and whether federal interventions are acceptable.

Sources of Systemic Risk

The financial crisis highlighted that systemic risk can emanate from financial firms, markets, or products. It can be caused by the failure of a large firm (hence the moniker "too big to fail"), or it can be caused by correlated losses among many small market participants. Although historical financial crises have centered on banks, nonbank financial firms were also a source of instability in the financial crisis and the pandemic. Boom and bust cycles in asset values or credit availability can often be the underlying cause of crises, with the bursting of the housing bubble in the financial crisis a notable example. Other events unrelated to asset values, such as a successful cyberattack on a critical market, in theory could also trigger financial instability. Daniel Tarullo, a former Fed governor, identified four categories of systemic risk:

• 1. Domino or spillover effects—for example, when one firm's failure imposes debilitating losses on its counterparties.
• 2. Feedback loops—for example, when fire sales of assets depress market prices, thereby imposing losses on all investors holding the same asset class. Another example is deleveraging—when credit is cut in response to financial losses, resulting in further losses.
• 3. Contagion effects—for example, a run in which depositors or investors suddenly withdraw their funds from a class of institutions or assets, such as banks or money market funds (MMFs).
• 4. Disruptions to critical functions—for example, when a market can no longer operate because of a breakdown in market infrastructure.

Policy Response to the Financial Crisis

In the aftermath of the financial crisis, one priority for policymakers was to contain systemic risk. In other words, how might threats to financial stability be identified and neutralized? Systemic risk (also called macroprudential) regulation seeks to prevent both future financial crises and modest breakdowns in the smooth functioning of specific financial markets or sectors. It can be contrasted with the traditional microprudential regulatory focus on an individual institution's solvency.

Critiques of inadequate systemic risk regulation in the run-up to the crisis can be placed into two categories: (1) insufficient regulatory authority to identify or mitigate systemic risk, partly because of financial market opacity; and (2) shortcomings of the regulatory structure that made it unlikely for regulators to successfully identify or respond to systemic risks. Critics argued that in the fragmented U.S. regulatory system, no regulator was responsible for financial stability or focused on the bigger picture, and their narrow mandates meant there were gaps in oversight.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA; P.L. 111-203) sought to enhance regulatory authority to address specific weaknesses revealed by the crisis (e.g., derivatives markets); reduce opacity in certain markets (e.g., new reporting requirements for hedge funds and derivatives); and modify the regulatory structure to make it forward-looking and nimble enough to respond to emerging threats.

Financial Stability Oversight Council (FSOC). DFA created FSOC, headed by the Treasury Secretary and composed of the financial regulators and other financial officials. FSOC was tasked with identifying risks to financial stability, promoting market discipline by eliminating expectations that the government will prevent firms from failing, and responding to emerging threats to financial stability. DFA also created the Office of Financial Research (OFR) in Treasury to support FSOC.

Generally speaking, FSOC does not have rulemaking authority to intervene when it identifies emerging threats to stability. When one of its members has the requisite authority, FSOC can recommend—but not require—the member to intervene. Otherwise, it can recommend a legislative change to Congress. It is required to produce an annual report (on which the chair testifies) to Congress, where it catalogs emerging threats and recommendations. FSOC's and OFR's budgets, which are proposed by the Treasury Secretary and not subject to congressional appropriations, decreased in nominal terms by 27% and 38%, respectively, from 2016 to 2019 and increased by a proposed 157% and 48%, respectively, from 2020 to 2023.

"Too Big to Fail" (TBTF). DFA sought to end TBTF and the systemic risk it posed. FSOC's primary regulatory authority is the ability to designate nonbank financial firms and payment, clearing, and settlement systems as systemically important. The former are referred to as systemically important financial institutions (SIFIs) and the latter as financial market utilities (FMUs or SIFMUs). There were previously four SIFIs and are currently zero SIFIs (see Table 1). There are currently eight FMUs.

Under DFA, designated SIFIs and all bank holding companies with more than $50 billion in assets were subject to enhanced prudential regulation by the Fed—special safety and soundness requirements (e.g., living wills and Fed-run stress tests) that do not apply to other firms. In 2018, P.L. 115-174 replaced that threshold with a graduated threshold of between $100 billion and $250 billion, reducing the number of banks subject to enhanced regulation. In addition, under Basel III (an international agreement), the very largest banks are subject to additional capital and liquidity requirements that do not apply to other firms. Collectively, these DFA and Basel III requirements aim to make it less likely that large financial firms will fail, given the systemic risk that their failures could pose.

In addition to reducing the likelihood that large firms would fail, DFA also attempted to make it less disruptive if they did fail. As an alternative to bankruptcy, DFA created a resolution regime for nonbank financial firms if their failure posed a risk to financial stability. Called Orderly Liquidation Authority (OLA), it is modeled on the Federal Deposit Insurance Corporation's (FDIC's) bank resolution regime, with key differences, and the FDIC administers it.

Policy Debate

Through the creation of FSOC and the enhanced regulation of nonbank SIFIs and large banks, the DFA put an institutional structure in place to address systemic risk. Arguably, in practice, this structure has not worked as envisioned. The DFA regime envisioned that (1) emerging threats to financial stability would be identified by FSOC and addressed by the regulators or Congress; and (2) systemic risk posed by large financial firms would be mitigated through the Fed's enhanced regulation, and their failure would be managed through OLA.

To date, FSOC has used the statutory process to recommend that member agencies address systemic risk once (Securities and Exchange Commission MMF reforms, adopted in 2014). FSOC has made informal recommendations, such as recommendations related to digital assets, government-sponsored enterprise (GSE) capital requirements, and climate risk. In addition, each annual report contains multiple recommendations to member regulators that mostly serve as an update on initiatives that they were already undertaking. The report has also included some legislative recommendations. The 2022 annual report endorsed legislation to regulate cryptocurrencies and fintech third-party service providers. Arguably, this coordination of the regulatory agenda helps avoid regulatory gaps or duplication, but it has not led to significant action on emerging threats. Further, the number of large firms subject to enhanced regulation was reduced by the de-designation of all four nonbank SIFIs and by raising the $50 billion threshold in P.L. 115-174. Since 2020, FSOC appears to have been relegated in favor of a subset of members acting outside of FSOC who have coordinated the response to systemic risk posed by stablecoins, Treasury markets, and MMFs.

In 2019 guidance, FSOC reoriented its approach away from institution-based regulation (i.e., SIFI designation) and toward activities-based regulation—regulating particular financial activities or practices to prevent them from causing financial instability—to address systemic risk for nonbanks. (These two approaches need not be mutually exclusive.) This approach requires FSOC to make policy recommendations and regulators or Congress to adopt them—although that has happened rarely to date, as noted. This guidance and MetLife's successful court challenge to its designation arguably make it more difficult for FSOC to designate a SIFI in the future. (No large financial firm has failed since 2010, so OLA has never been tested.)

Criticisms of the current regime include the following: (1) its success depends on policymakers accurately identifying and responding to emerging threats, although they failed to do so before the financial crisis; (2) it reduces the role for market discipline to discourage systemically risky behavior and may inadvertently increase perceptions that large firms are TBTF and will be bailed out; and (3) regulation imposes costs that may unduly increase the price or reduce the availability of credit. Events in spring 2020 highlighted these challenges. Foreseeing the severity of the pandemic and its effect on financial stability was unlikely, but the problems that arose were not new, and federal interventions to restore stability may encourage excessive risk-taking by market participants in the future. For example, MMFs caused instability again in the pandemic despite the 2014 reforms, and FSOC encouraged further SEC action in 2021.

CRS Resource

CRS Report R47026, Financial Regulation: Systemic Risk