2017 Reports on Risks to Financial Stability

WASHINGTON – Overall risks to financial stability remain moderate, similar to a year ago, the U.S. Office of Financial Research said in releasing its 2017 Annual Report to Congress and 2017 Financial Stability Report today.

“We assess threats to financial stability by weighing vulnerabilities in the financial system against its resilience,” said OFR Director Richard Berner. “Underneath our moderate assessment are changes in the balance between financial-system vulnerabilities and resilience.”

New vulnerabilities have emerged over the past year, according to the reports. Market risk — the potential for sudden changes in asset prices that could disrupt economic growth — remains elevated, particularly in the stock markets and bond markets. Cybersecurity vulnerabilities are also a concern. Meanwhile, financial-system resilience has improved.

The OFR developed and released two new tools this year to better inform our assessment: the Financial System Vulnerabilities Monitor and the Financial Stress Index.

The vulnerabilities monitor is a heat map that gives early warning signals of potential vulnerabilities that can originate, amplify, or transmit disruptions in the financial system. It depicts risk in six categories: (1) macroeconomic, (2) market, (3) credit, (4) solvency and leverage, (5) funding and liquidity, and (6) contagion.

The stress index is a daily snapshot of stress in global financial markets. Stress can be minor, such as during a brief period of uncertainty and price volatility in the equity market, or major, like the stress driven by runs on Lehman Brothers and other broker dealers during the financial crisis.

These new tools, together with our research, analysis, and surveillance of the financial system, factor into our overall assessment.

The reports also analyze specific threats to financial stability; the 2017 Financial Stability Report analysis is more in depth.

The reports highlight three key threats to financial stability:

1. Vulnerabilities to cybersecurity incidents – A large-scale cyberattack or other cybersecurity incident could disrupt the operations of one or more financial companies and markets and spread through financial networks and operational connections to the entire system, threatening financial stability and the broader economy.
2. Obstacles to resolving failing systemically important financial institutions – There are two paths for the resolution of a failing systemically important financial institution that is not an insured depository institution. Both paths have shortcomings for handling the failure of the largest and most complex bank holding companies, known as global systemically important banks.
3. Structural changes in markets and industry – Three aspects pose threats: (1) lack of substitutability, or the inability to replace essential services if a provider fails or drops that line of business, (2) fragmentation of trading activities through multiple channels and products, and (3) the chance that the transition to a new reference rate to replace the London Interbank Offered Rate, or LIBOR, could be difficult.

As required by the Dodd-Frank Act, the 2017 Annual Report to Congress assesses the state of the United States financial system, including:

• Analysis of threats to the financial stability of the United States
• Key findings from the OFR’s research and analysis of the financial system
• The status of the efforts of the OFR in meeting its mission, including how the OFR supports the Financial Stability Oversight Council, or FSOC, and other key stakeholders

The annual report cites these key findings:

• Network Analysis to Identify Cybersecurity Vulnerabilities and Operational Risk – Network analysis combined with maps of the financial system populated by real-world data may help identify potential systemic vulnerabilities to cybersecurity and operational threats.
• Reducing Regulatory Reporting Burdens – Preliminary OFR analysis indicates that examples cited by industry about duplicative, conflicting, and inconsistent regulatory reporting requirements merit further exploration.
• LIBOR Alternative – Alternatives to LIBOR are needed. LIBOR is an interest rate benchmark, formerly the London Interbank Offered Rate and now ICE LIBOR (Intercontinental Exchange LIBOR). Among the many steps needed to achieve a smooth transition to these alternatives, officials and market participants must help develop active derivatives markets that use the new rate.
• Legal Entity Identifier – To realize the full potential of the Legal Entity Identifier (LEI), a financial data standard, strategic regulatory mandating of the LEI is required, according to industry advocates. The LEI is like a bar code for precisely identifying parties to financial transactions.
• Assessing the Systemic Importance of Banks – A multifactor approach that captures several dimensions of risk is superior to using asset size alone in determining the systemic footprint of U.S. banks. The asset-size threshold could subject some large U.S. banks with traditional business models to costs for complying with regulations that are unaligned to their risks.
• Financial Data Services Initiatives – The FSOC and its member agencies could increase efficiency by adopting initiatives to facilitate appropriate data sharing and reduce the costs of financial data acquisition.

The 2017 Annual Report to Congress is available here and the 2017 Financial Stability Report is available here.