About | HeinOnline Law Journal Library | HeinOnline Law Journal Library | HeinOnline
LOG IN
LOG IN

1 1 (January 13, 2022)

handle is hein.crs/govegls0001 and id is 1 raw text is: ItoCongressional Research Service Informfing Ih legisIlive cI bat £since 1914 Introduction to Financial Services: Systemic Risk Recent Episodes of Financial Instability 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, could also trigger financial instability in theory. 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. Updated January 13, 2022 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 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. Major changes included the following: 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

What Is HeinOnline?

HeinOnline is a subscription-based resource containing thousands of academic and legal journals from inception; complete coverage of government documents such as U.S. Statutes at Large, U.S. Code, Federal Register, Code of Federal Regulations, U.S. Reports, and much more. Documents are image-based, fully searchable PDFs with the authority of print combined with the accessibility of a user-friendly and powerful database. For more information, request a quote or trial for your organization below.



Short-term subscription options include 24 hours, 48 hours, or 1 week to HeinOnline.

Purchase Access

Already a HeinOnline Subscriber?

Log In

profiles profiles most