Last week the Government Accountability Office (GAO) took aim at the Financial Stability Oversight Council (FSOC), the regulatory watchdog assigned to keep a vigil over our markets for their safety, in a report that examines the status of efforts by the FSOC to improve transparency, accountability and collaboration. “FSOC still lacks a comprehensive, systematic approach to identify emerging threats to financial stability,” said the GAO. “OFR’s continued work to develop indicator-driven tools to assess risks to the financial system is encouraging, but without a more systematic approach and comprehensive information, FSOC cannot be assured that it is fully informed about critical vulnerabilities in the financial system,” added the GAO, referring to data-driven tools it had recommended for adoption to the watchdog.

FSOC
FSOC

FSOC: Criticised, opposed and lacking teeth

The FSOC has also faced flak from the SEC, no less, for its procedures for examining the asset management industry for possible threats to the country’s economy. The Office of Financial Research, which provides research support to the FSOC, claimed in a report that certain practices in the asset management industry could be a source of risk to the broader economy. In April, SEC Commissioner Luis A. Aguilar protested that the report had “significant factual and analytical defects” and shouldn’t be used for decision-making.

The FSOC designated Metlife as a systemic risk to the financial system earlier this month. The insurance company, which has been resisting such a move, may ultimately go to court to get the move reversed.

On September 4, the Bipartisan Policy Center said in an article written by John C. Dugan, Peter R. Fisher and Cantwell F. Muckenfuss III: “The Act did attempt to address the issue of macro-prudential oversight in part by creating the FSOC, but it did not give the FSOC sufficient authority to carry out the duties assigned to it.”

In a speech at the Kennedy School of Government, Harvard University, Donald Kohn, former V.C. of the Fed, said “the early years of FSOC have also revealed structural issues and shortfalls in its ability to accomplish the objectives we identified for macro-prudential regulation.”

Evidently, the FSOC suffers from limitations that impair its watchdog abilities and has still a way to go before it can be said that it can effectively monitor systemic risks in the financial markets.

That’s a sobering thought, considering we live in a world awash in stimulus measures, with zero (or negative) interest rates prevailing in large swathes across the globe, and asset prices at record highs seemingly everywhere. Five years after the great financial crisis, can we say that we are protected from systemic risk?

Risks that could topple the towers of global finance

Indeed, it’s not only financial risks that we need to worry about – the scope of systemic risk is much larger.

“Slow macroeconomic recovery, the scope of unprecedented monetary policy here and in other major markets, fiscal-policy woes, too many parts of the world that remind us starkly of geopolitical risk combined with yield-chasing and market reconfiguration make it clear that time isn’t on the regulators’ side,” says Karen Shaw Petrou, Managing Partner, Federal Financial Analytics, Inc.

In her remarks to the American Banker Regulatory Symposium, Arlington, Virginia, she includes geopolitical risk, cyber risk and critical shortages of high quality assets as factors that could trigger yet another “near-death experience.”

On monetary policy, she is highly sceptical of the Fed’s proposed reverse-repo facilities for managing interest rates, “given the reliance the program posits on money-market funds that are themselves significant sources of potential systemic risk,” she cautions. “With every day bringing another estimate of the mammoth size of the reverse-repo program – with the FRB now saying the impact will be not more than $300 billion – I worry also about the program’s own complexity and the ability of the FRB, like any other financial institution, to manage it under stress.”

The avowed strategy to shift control of derivatives to central counterparties may not also work given that “trades will be increasingly concentrated in financial-market utilities for which rules are incomplete and resolution protocols non-existent.”

Depressed macroeconomic growth in the EU, and the credit bubble in China are other sources of systemic risk identified by Petrou which could impinge on the highly interconnected global financial markets.

And, risk could still creep up from the mortgage industry (the GSEs), the asset management sector and insurance – the last-named because of “the big role insurance companies now play in securities financing.”

These are the “real-world events that challenge the regulatory and resolution framework still being constructed four-plus years after the enactment of the Dodd-Frank Act,” says Petrou.