Summary:
The U.S. financial system has experienced two major episodes of financial instability in the 21st century (as well as a few minor incidents)—the 2007-2009 financial crisis and instability surrounding the onset of the COVID-19 pandemic in the spring of 2020. In both cases, the federal government and the Federal Reserve responded by extending, on an overwhelming scale, financial assistance to financial markets and institutions to restore stability. Although the government generally recouped principal and interest on this assistance after markets stabilized, trillions of taxpayer dollars were pledged.
Systemic risk is financial market risk that poses a threat to financial stability. After the financial crisis, systemic risk regulation was a major focus of regulatory reform, notably in the 2010 Dodd-Frank Act (P.L. 111-203). These reforms can be categorized as attempting to improve the monitoring of systemic risk, contain systemic risk (with a focus on issues that had caused systemic risk during the crisis), and alter the standing authority under which agencies could provide assistance during a crisis. To better monitor emerging threats to financial stability, the Dodd-Frank Act created the Financial Stability Oversight Council (FSOC), headed by the Treasury Secretary and composed of all the federal financial regulators and a few other financial officials. FSOC can make nonbinding recommendations to its member agencies and Congress on how to address emerging threats. It can also designate nonbank financial firms as systemically important financial institutions (SIFIs). To address the “too big to fail” issue, large banks and SIFIs are subject to enhanced prudential regulation (heightened safety and soundness standards) by the Federal Reserve.
Arguably, not all of these reforms have worked as intended. Over its lifespan, FSOC has designated three insurance firms and one nonbank lender as SIFIs. All four were later de-designated, one in a court case that the Trump Administration declined to appeal. In 2019, FSOC issued guidance that shifted its focus from SIFI designation and other entity-based regulation to activity-based regulation. Yet FSOC has made few recommendations for activity-based regulation since 2010 and has moved slowly to make and implement recommendations. By contrast, systemic risk can emerge and grow quickly. Recommendations cannot be implemented unless Congress or the relevant agency acts, assuming any agency has the existing authority to address that threat.
The pandemic experience suggests that financial-crisis-related reforms proved successful in preventing the failure of large financial firms that would result in “bailouts” (pandemic “bailouts” were limited to nonfinancial firms) but unsuccessful in creating a more resilient financial system that could withstand sudden shocks without resorting to large-scale government intervention to maintain stability at the first signs of panic. While sectors that saw substantive reforms, such as banks and derivatives, proved to be resilient during the pandemic, areas of nonbank financial markets (such as money market funds, repo markets, and other short-term borrowing markets) that were not fundamentally reformed after the financial crisis broke down and relied on the same Federal Reserve emergency programs that were created during the financial crisis, as well as new emergency programs that were not required in the financial crisis. These programs restored financial stability and set off a large increase in asset values after the spring of 2020. This experience raises issues of fairness and moral hazard stemming from whether risk-taking financial market participants should be protected from bad outcomes. Government intervention to prevent financial instability is intended to prevent large losses in income and employment, as was the case in the financial crisis. Yet the speed at which financial instability turned to boom raises questions of whether government intervention was an overwhelming success or unnecessary, because in hindsight markets might have stabilized without assistance.
Historically, long financial booms have been punctuated by shorter but sudden downturns. Many systemic risks never ultimately result in financial instability. Over time, financial markets have been characterized by ongoing innovation that has created new opportunities and new risks. Innovation can be driven by new technology or ideas, or efforts to exploit gaps or inconsistency in a fragmented U.S. regulatory system, or both. Recently, the market share of fintech firms and value of cryptocurrencies has risen rapidly, yet there have been no fundamental regulatory changes to acknowledge this reality.
R47026 Financial Regulation: Systemic Risk (31 pages):
https://crsreports.congress.gov/product/pdf/R/R47026