Financial system more resilient, risks moderate – but vulnerabilities remain, report states

Risks to stability of the nation’s financial system remain moderate, as the structure is more resilient than it was 10 years ago at the start of the financial crisis; however, new vulnerabilities have emerged, a federal financial watchdog reported Tuesday.

In its 2017 Annual Report to Congress, the Treasury’s Office of Financial Research (OFR) said that market risk and cybersecurity vulnerabilities are concerns. “Market risk — the potential for sudden changes in asset prices that could disrupt economic growth — remains elevated, particularly in the stock markets and bond markets,” the report states.

The report notes three aspects of structural changes in markets and industry which pose threats:

  • lack of substitutability, or the inability to replace essential services if a provider fails or drops that line of business;
  • fragmentation of trading activities through multiple channels and products; and,
  • the chance that the transition to a new reference rate to replace the London Interbank Offered Rate, or LIBOR, could be difficult.

For cybersecurity vulnerabilities, the report states that a large-scale cyberattack or other cybersecurity incident could “disrupt the operations of one or more financial companies and markets and spread through financial networks and operational connections to the entire system, threatening financial stability and the broader economy.”

The report also notes that obstacles remain to resolving failing systemically important financial institutions. “There are two paths for the resolution of a failing systemically important financial institution that is not an insured depository institution,” the report states. “Both paths have shortcomings for handling the failure of the largest and most complex bank holding companies, known as global systemically important banks.”

The OFR was established by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which also mandated the annual report to Congress. The report, according to OFR, is designed to assess the state of the U.S. financial system, including analysis of threats to financial stability; key findings from OFR’s research and analysis of the financial system; and, status of the efforts of the OFR in meeting its mission, including how the OFR supports the Financial Stability Oversight Council, or FSOC, and other key stakeholders

In a release, OFR said that among its key finders are:

  • Network analysis combined with maps of the financial system populated by real-world data may help identify potential systemic vulnerabilities to cybersecurity and operational threats.
  • Examples cited by industry about duplicative, conflicting, and inconsistent regulatory reporting requirements merit further exploration.
  • Alternatives to LIBOR are needed, as well as a smooth transition to achieve the alternatives – including development of active derivatives markets that use the new/alternative rate.
  • Strategic regulatory mandating of the Legal Entity Identifier (LEI), a financial data standard, is required, which would help precisely identify parties to financial transactions.
  • A multifactor approach capturing several dimensions of risk in assessing systemic importance of banks is superior to using asset size alone, which could subject some large U.S. banks with traditional business models to costs for complying with regulations that are unaligned to their risks.
  • FSOC and its member agencies could increase efficiency by adopting initiatives to facilitate appropriate data sharing and reduce the costs of financial data acquisition

Office of Financial Research Reports on Risks to Financial Stability