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House Financial Services Subcommittee Hearing on Promoting Financial Stability

House Financial Services Subcommittee on Consumer Protection and Financial Institutions

“Promoting Financial Stability: Assessing Threats to the U.S. Financial System”

Wednesday, September 25, 2019

Key Topics & Takeaways

  • Cybersecurity: Both witnesses agreed that the risks associated with a cyber-attack present a serious challenge to the U.S. financial system. The Office of Financial Research is currently preparing analysis for the Financial Stability Oversight Council to give them greater insight as to why the financial services industry is especially susceptible to cyber/data breaches.
  • Repo Market: Referencing the Federal Reserve Bank of New York’s decision to increase the size of overnight cash loans offered through the repo market, Brainard indicated that it may be time to allow the balance sheet to grow again to supply the reserves that the short-term money markets are demanding.

Witnesses

Opening Statements  

Chairman Gregory Meeks (D-N.Y.)

In his opening statement, Meeks reflected on the financial crisis and the subsequent passage of Dodd-Frank. He referenced global challenges such as Brexit and attacks on oil supplies, amongst others, as events contributing to an environment that will test the post-crisis regulatory regime. He expressed concern over new emerging threats such as high equity valuations that appear well above fundamentals, seizures in short term funding markets, leveraged lending that burdens companies with high debts, rapid concentration of the banking structure and the disappearance of local banks and cyber-attacks. He called upon the U.S. regulators, the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR) to contribute the necessary resources to monitor, map and quantify emerging systemic risks.

Ranking Member Blaine Luetkemeyer (R-Mo.)

In his opening statement, Luetkemeyer praised the safer and more resilient U.S. financial system that now exists in the aftermath of the financial crisis. He praised the Trump administration for easing overly burdensome regulations but said that more can be done to free up additional capital. Referencing the House Financial Services Committee hearing titled “Holding Megabanks Accountable: A Review of Global Systemically Important Banks 10 Years After the Financial Crisis,” Luetkemeyer noted that banks view cyber-attacks and data security as among the most important issues facing the industry. He lamented the current state of rules and protections governing data security and breach notification and called for action to be taken to address these deficiencies. Luetkemeyer noted his concern regarding the Financial Accounting Standards Board’s (FASB) Current Expected Credit Loss (CECL) impairment standard, specifically referencing the fact that no economic impact study has been performed and that it could threaten lending behavior in times of crisis.

Testimony  

The Honorable Lael Brainard, Governor, Board of Governors of the Federal Reserve System

In her testimony, Brainard outlined the Federal Reserve’s (Fed) role in promoting financial stability and how since the financial crisis, the Fed has reinvigorated their approach to promoting financial stability citing the creating of a new Board Committee on Financial Stability and a Division of Financial Stability. She stated that as the building of financial imbalances in good economic times has the potential to lead to disruptions that can amplify downturns, and that they continually assess financial vulnerabilities as well as mitigants that build resilience. She cited the fact that a range of asset prices are high relative to historical benchmarks may make it more challenging for financial entities to obtain or extend financing. Brainard also expressed her concern with business borrowing and high levels of corporate debt. She concluded that financial system resilience must be fortified in good economic times, citing the countercyclical capital buffer (CCyB) as an effective tool to this end.

The Honorable Dino Falaschetti, Director, Office of Financial Research, U.S. Treasury Department

In his testimony, Falaschetti stated that the OFR was established to increase the likelihood that future warnings of systemic risk are viewed as credible due to their grounding in economic fundamentals, high-quality data and careful research. He outlined the OFR’s latest annual report to Congress that determined financial stability risk to be in the medium range while there are relatively high market and cybersecurity risks. He noted that while these risks can change rapidly, credit risk appears to be moderate with funding and liquidity risk remaining low overall. Falaschetti specifically noted that cybersecurity risk is an area of concern and focus for the OFR.

Question & Answer

CECL

Reps. Barry Loudermilk (R-Ga.) and Luetkemeyer stated that they are very concerned about rolling out CECL without the completion of an economic impact study. Both stressed upon Brainard the need for Fed Chairman Jerome Powell and the other members of the FSOC to authorize further studies and testing of CECL.

Community Reinvestment Act (CRA)

In response to a question from Rep. Scott Tipton (R-Colo.) as to whether the Fed will modernize the Community Reinvestment Act (CRA) in conjunction with other regulators, Brainard responded that they would like to develop an approach that is responsive to the comments received by the Office of the Comptroller of the Currency (OCC). She stated that the Fed is generally committed to the CRA and would like to see it improved but not disrupted.

Cryptocurrencies

Reps. Nydia Velázquez (D-N.Y.) and Emanuel Cleaver (D-Mo.) asked about Facebook’s proposed blockchain currency, Libra, and what impact it, and blockchain currencies like it, would have on our financial system. Brainard responded that the advent of Libra has sharpened the set of questions that regulators need to think about when examining blockchain currencies, specifically questions such as their potential adoption for payments and whether consumer data will be protected. Brainard cited the potential for these currencies to exist across many jurisdictions and the risk of having incomplete regulatory authorities.

Cybersecurity

Reps. Patrick McHenry (R-N.C.), Bill Foster (D-Ill.) Roger Williams (R-Texas), Velázquez and Loudermilk noted that the threat of data breach and cyber-attack is a serious threat facing the financial system, especially given the industry shift to cloud storage often provided by third-party vendors. Both Brainard and Falaschetti noted that the migration to cloud-based storage will mitigate certain risks while magnifying others. Both agreed that institutions must be held accountable for conducting well-informed and robust risk assessments. Falaschetti noted that his primary concern as it relates to cybersecurity and cloud storage is the interconnected nature of the financial system and the risk of an isolated attack on one entity spreading to others via their channels of transmission. He concluded that OFR is developing a network analysis that would help grant FSOC transparency concerning the nature of this interconnectedness. Foster specifically asked whether major financial firms should be forced to connect to multiple cloud providers. Brainard that the Fed is examining this issue but the concept of resiliency through redundancy is well established and supported.

Loudermilk also expressed his concerns with the Consolidated Audit Trail (CAT) and the collection of Personally Identifiable Information (PII) as well as the patchwork of state breach notification. He stated that these gaps in the system can be exploited and voiced his support for a unified national approach to breach notifications that is flexible enough to adapt to changing conditions.

Leveraged Lending

Rep. Gregory Meeks (D-N.Y.) asked Brainard to elaborate as to why she views leveraged lending as a potential risk to the financial system. She noted that there has been rapid increases in leveraged lending over the past several years but that the most notable issue is the fact that the covenants on these loans have weakened relative to historical measures and that there are features that make them less secure for some investors. Brainard concluded that many of these are now being securitized in collateralized loan obligation (CLO) structures and it will be important to maintain as much transparency as possible into those structures and who is holding these loans in these structures. Brainard stated that she believes risk retention to be an effective risk mitigant. Later, Rep. Andy Barr (R-Ky.) stated that in his view, as well as in the view of Securities and Exchange Commission (SEC) Chairman Jay Clayton, leveraged lending does not represent a systemic risk.

OFR Funding

Reps. Jennifer Wexton (D-Va.) and Meeks asked why OFR staff size was cut from 245 to 100 and whether the OFR has the funding and resources necessary to monitor and map systemic risks to the financial system. Falaschetti stated that the OFR is currently in the process of growing their size to 145 and that he is committed to working with Treasury Secretary Steven Mnuchin to ensure that he receives the necessary funding and resources to fulfill his mandate.

Reference Rates

Reps. David Scott (D-Ga.) and Tipton inquired about the transition away from the London Interbank Offered Rate (LIBOR) and the impact on our financial system. Brainard declared that this transition is needed due to the fragility and ability to manipulate LIBOR. Falaschetti stated that this transaction is a critical contracting and that reconstituting contracts on such a large scale with be very difficult. Additionally, he noted that the OFR is developing fallback language to assist in this process. Brainard stated that she is working to ensure that the relevant banking regulators and agencies provide the necessary resources and education to smaller financial entities who may not be as prepared to make this transition.

Repo Market

Meeks, Scott, McHenry and Williams referenced the Federal Reserve Bank of New York’s recent decision to increase the size of overnight cash loans offered through the repo market and asked why this cash crunch is occurring. Brainard stated that this move was in response to technical issues arising out of the fact that an increase in supply of Treasury securities to be funded coincided with a withdrawal of cash by traditional suppliers to address corporate tax payments. Brainard noted that this imbalance of supply and demand in the repo market possibly indicates that reserves are scarcer than intended given the Fed’s monetary policy framework being one of ample reserves. She added that there are no significant implications currently for average, everyday investors but that this may be an indicator that it is time to allow the balance sheet to grow again to supply the reserves that the short-term money markets are demanding.

Systemic Risks and Oversight

Reps. Bill Posey (R-Fla.) and Jesús García (D-Ill.) referenced the FSOC and their role in designating non-bank financial entities as posing systemic risk. Posey asked how the FSOC would have worked to prevent the bailout of AIG back in 2008. Brainard and Falaschetti stated that this designation authority grants FSOC the ability to view the full scope of financial activity and then work with the relevant supervisors to establish risk mitigating processes. Falaschetti added that the council is pursuing an activities-based approach to designation, thereby enhancing the transparency of the process and allowing FSOC to measure complexity, degree of opaqueness in a market and whether there is effective risk management in place. García criticized the fact that the FSOC has removed the systemic risk-tag from AIG and Prudential and voiced his concern that the lack of designation of large financial non-banks will once again lead to a financial crisis. Brainard stated that she would like to have great ‘lines of sight’ into where these non-bank non-supervised entities are being held.

Trade

Reps. Al Lawson (D-Fla.) and McHenry asked about the global economy and trade. Brainard noted that in terms of monetary policy analysis, she understands that the uncertainty surrounding trade is causing business to ‘sit on the sidelines’ and rethink global supply chains and operations. She stated that due to the nature of the global economy, trade uncertainty and events such as the economic slowdown in China does in fact have a material impact on the health of our financial system.

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