Tom Curry

The Financial Stability Oversight Council (FSOC) released its 2020 Annual Report on Dec. 3. The FSOC, which was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act, aims to (1) identify risks to the country’s financial stability arising from financial distress or the failure of bank holding companies and nonbank financial companies, (2) promote market discipline by mitigating shareholder expectations regarding government intervention in the event of losses and (3) respond to emerging threats to the stability of the U.S. financial system. The FSOC is chaired by the secretary of the treasury and members include the heads of the federal financial regulatory agencies and certain nonvoting state insurance and securities regulators. 

The report is the FSOC’s most current forecast of potential or emerging systemic economic threats. It focuses primarily on the impact of the COVID-19 pandemic on the U.S. economy and makes recommendations based on particular issues faced by the financial sector in light of the COVID-19 pandemic and associated economic downturn. 

Corporate Credit 

The report notes that, despite a temporary decline in activity at the beginning of the COVID downturn in March, swift government intervention has caused debt financing to bounce back.  

Notwithstanding this positive news, the report also highlights the potential risks associated with the COVID downturn to the corporate credit market, including borrowers’ ability to service their obligations, the ability of market participants to absorb market losses from defaults and downgrades resulting from the COVID downturn, the willingness of market participants to continue to provide intermediation, and the potential strain that bankruptcies would place on certain nonfinancial institutions, such as the U.S. judicial system.  

The FSOC recommends that agencies continue to monitor levels of nonfinancial business leverage and asset valuation trends, and assess the impact of fluctuation in the corporate credit market on the health and soundness of the broader financial market. 

Armand J. Santaniello

Fintech and Financial Innovation 

Consistent with previous FSOC recommendations, the report acknowledges that financial innovation can offer substantial benefits to consumers and businesses. The COVID downturn accelerated the need for these benefits, as institutions are more frequently utilizing third parties to support remote work capabilities and maintain operational levels.  

While relationships with third-party providers may allow institutions to leverage technology (including fintech), reduce costs and increase efficiency, new risks and vulnerabilities must be acknowledged. For example, concentration risk – reliance by many institutions on a single vendor – could result in disruption in access to financial data and could impair the flow of financial transactions.  

The report encourages agencies to monitor and analyze the effects of new financial products and services on consumers, regulated entities, and financial markets, and evaluate potential effects on financial stability. The report also stresses continued coordination among financial regulators to support responsible financial innovation and competitiveness yet promote consistent regulatory approaches that identify and address potential risks.  

Commercial Real Estate: 

The COVID downturn has left the commercial real estate sector vulnerable. The governmental implementation of lockdown orders and restrictions have heavily impacted certain segments of the CRE market, including hotels, restaurants, retail and offices. Distress in CRE properties makes creditor banks vulnerable to losses and write-downs, which threatens to tighten credit and dampen economic recovery.  

Because of the large proportion of CRE loans held on banks’ portfolios – especially small and mid-sized banks – volatility and uncertainty in the CRE market could have a significant impact on the financial system as a whole.   

The report recommends that regulators continue to closely monitor the volatility occurring in the CRE market, and to encourage banks to continue to boost loss-absorption capacity by strengthening capital and liquidity barriers to sustain potential losses in CRE portfolios. 

Cybersecurity 

The report also discusses the pandemic’s impact on cybersecurity, as increasingly remote working environments have left financial services companies open to cyberattacks. Additionally, increased reliance on interconnected third-party technology increases the risk of systemic disruption. The report notes that a destabilizing cybersecurity incident has the potential to cause a disruption of irreplaceable key financial services, to cause market participants to lose confidence in the financial system, leading to withdrawal of funds or decreased activity, or to compromise the integrity of crucial data.  

The FSOC recommends that federal and state agencies monitor these cybersecurity risks, continue to implement examinations of financial infrastructures to ensure that they are prepared to sustain the risks inherent in an increasingly digital-dependent market, and work closely with private third-party technology providers to monitor cybersecurity risks. 

The report is a useful summary of the COVID downturn’s impact on the financial markets to date and will give incoming Treasury Secretary Janet Yellen a snapshot of financial stability risks. However, as discussed in our Nov. 22 Banker & Tradesman column, the Biden administration will have the opportunity to change many of the FSOC’s members and shift its focus to additional financial stability risks such as climate change. Yellen may also use a more robust FSOC as a vehicle to tackle other structural weaknesses and financial threats brought to light by the COVID-19 pandemic.  

Thomas J. Curry is a partner in Nutter’s corporate and transactions department. Kate Henry and Armand J. Santaniello are associates in Nutter’s corporate and transactions department. Curry is former U.S. comptroller of the currency and all are members of the firm’s banking and financial services group.