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Updated January 8, 2019
Introduction to Financial Services: Systemic Risk
The 2007-2009 financial crisis was characterized by a
 Contagion effects—for example, a run in which
system-wide breakdown in financial stability. Overtaken by
investors suddenly withdraw their funds from a class of
panic, financial market participants became unwilling to
institutions or assets. Banks and some other financial
engage in even routine transactions at the height of the
firms are vulnerable to runs because their assets (e.g.,
crisis. The result was a sharp and long-lasting contraction in
loans) are less liquid than their liabilities (e.g., deposits).
credit, as shown in Figure 1, and economic activity.
 Disruptions to critical functions—for example, when a
Figure 1. Private-Sector Credit Growth, 2005-2018
market can no longer operate because of a breakdown in
market infrastructure.
Boom and bust cycles in asset values or credit availability
can often be the underlying cause of these four outcomes,
with the bursting of the housing bubble in the recent crisis a
notable example. But one can also imagine other events
unrelated to asset values, such as a successful cyberattack
on a critical market, triggering systemic risk.
Policy Response to the Crisis
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;
Source: Federal Reserve, Z.1 Data Release, Table D. 1.
and (2) shortcomings of the regulatory structure that made
Note: annualized percentage change from previous quarter
it unlikely for regulators to successfully identify or respond
to systemic risks. Critics argued that in the fragmented U.S.
In the aftermath of the crisis, one priority for policymakers
regulatory system, no regulator was responsible for
was to contain systemic risk. In other words, how could
financial stability or focused on the bigger picture, and
threats to financial stability be identified and neutralized?
regulators’ narrow mandates meant that there were gaps in
Systemic risk (also called macroprudential) regulation
regulatory oversight.
seeks to prevent both future financial crises and more
modest breakdowns in the smooth functioning of specific
The 2010 Dodd-Frank Act (DFA; P.L. 111-203) sought to
financial markets or sectors. It can be contrasted with the
enhance regulatory authority to address specific weaknesses
traditional microprudential regulatory focus on risks to an
revealed by the crisis and to modify the regulatory structure
individual institution’s solvency.
to make it forward-looking and nimble enough to respond
to emerging threats. Major changes include the following:
Sources of Systemic Risk
The recent financial crisis highlighted that systemic risk can
FSOC. DFA created the Financial Stability Oversight
emanate from financial firms, markets, or products. It can
Council (FSOC), headed by the Treasury Secretary and
be caused by the failure of a large firm (hence, the moniker
composed of the financial regulators and other financial
“too big to fail”) or it can be caused by correlated losses
officials. FSOC was tasked with identifying risks to
among many small market participants. Although historical
financial stability, promoting market discipline by
financial crises have centered on banks, nonbank financial
eliminating expectations that the government will prevent
firms were also a source of instability in the recent crisis.
firms from failing, and responding to emerging threats to
Daniel Tarullo, a former Federal Reserve governor, placed
financial stability. DFA created the Office of Financial
the sources of systemic risk into four categories:
Research to support FSOC.
 Domino or spillover effects—for example, when one
Generally speaking, FSOC does not have rulemaking
firm’s failure imposes debilitating losses on its
authority to intervene when it identifies emerging threats to
counterparties.
stability. When one of its members has the relevant

authority, FSOC can recommend—but not require—the
Feedback loops—for example, when fire sales of assets
member to intervene. Otherwise, it can recommend a
depress market prices, thereby imposing losses on all
legislative change to Congress. It is required to produce an
investors holding the same asset class. Another example
annual report (on which the Chair testifies) to Congress,
is deleveraging—when credit is cut in response to
where it catalogs emerging threats and recommendations.
financial losses, resulting in further losses.
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Introduction to Financial Services: Systemic Risk
TBTF. DFA sought to end “too big to fail” (TBTF) and the
undertaking. In contrast, this coordination of the regulatory
systemic risk it posed. FSOC’s primary regulatory authority
agenda may help avoid regulatory gaps. The report has also
is the ability to designate nonbank financial firms and
included a smaller number of legislative recommendations
payment, clearing, and settlement systems as systemically
to Congress, notably in the areas of housing finance reform
important. The former are referred to as systemically
and cybersecurity. Generally speaking, recent Congresses
important financial institutions (SIFIs) and the latter as
and the current Administration have favored reducing
financial market utilities (FMUs). From 2013 to 2014, four
existing financial regulatory requirements, not introducing
firms, three of which were insurers, were designated as
new ones. Further, the number of large firms subject to
SIFIs. Between 2016 and 2018, all four were de-designated.
enhanced prudential regulation was reduced by the de-
There are currently eight FMUs.
designation of all four nonbank SIFIs and by raising the $50
billion threshold in P.L. 115-174.
Under the DFA, designated SIFIs and all bank holding
companies with more than $50 billion in assets were subject
Going forward, the current Administration has suggested
to enhanced prudential regulation by the Federal Reserve—
that activities-based regulation—regulating particular
special safety and soundness requirements (e.g., living wills
financial activities or practices to prevent them from
and Fed-run stress tests) that do not apply to other firms.
causing financial instability—is a more appropriate way to
P.L. 115-174 created a graduated threshold of $100 billion
address systemic risk for nonbanks than institution-based
and $250 billion, thus reducing the number of banks subject
regulation (i.e., SIFI designation). (These two approaches
to enhanced regulation. In addition, under Basel III (an
need not be mutually exclusive.) This approach would
international agreement implemented domestically through
require FSOC to make policy recommendations and
rulemaking), the very largest banks are subject to additional
regulators or Congress to adopt them, although as noted that
capital and liquidity requirements that do not apply to other
has happened rarely to date.
firms. Collectively, these DFA and Basel III requirements
aim to make it less likely that large financial firms will fail,
Criticisms of the current regime include (1) its success
given the systemic risk that their failure could pose.
depends on policymakers accurately identifying and
responding to emerging threats, although they failed to do
In addition to reducing the likelihood that large firms would
so before the financial crisis; (2) it reduces the role for
fail, DFA also attempted to make it less disruptive if they
market discipline in discouraging systemically risky
did fail. As an alternative to bankruptcy, DFA created a
behavior and may inadvertently increase perceptions that
resolution regime for nonbank financial firms if their failure
large firms are too big to fail (i.e., the government will bail
posed a risk to financial stability. The new resolution
them out); and (3) it imposes costs that may unduly increase
regime, called Orderly Liquidation Authority (OLA), is
the price or reduce the availability of credit. According to
modeled on the FDIC’s bank resolution regime, with key
the 2017 FSOC Annual Report, “The U.S. financial
differences, and is administered by the FDIC.
regulatory system should promote economic growth not just
by preventing financial crises that reduce growth, but also
Opacity. DFA enhanced the transparency of certain
by minimizing those regulations that increase costs without
markets to regulators and the public (e.g., new reporting
commensurate benefits.”
requirements for hedge funds and derivatives).
One challenge to assessing the effectiveness of systemic
Derivatives. By subjecting derivatives markets to reporting,
risk regulation is that periods of financial instability or
capital, clearing, and exchange requirements, DFA
breakdown are rare. Financial markets have generally been
attempted to preclude another buildup of large, sudden
stable since post-crisis reforms were implemented, which
losses by derivatives participants, such as AIG experienced.
could be a sign of success. But, as a cautionary tale, the
period of stability before the financial crisis masked
Current Policy Debate
systemic risk that only became evident when it was too late.
Through the creation of FSOC and the enhanced regulation
of SIFIs and banks with more than $50 billion in assets, the
CRS Resources
DFA put an institutional structure in place to address
CRS Report R45052, Financial Stability Oversight Council
systemic risk. Arguably, in practice, this structure has not
(FSOC): Structure and Activities, by Jeffrey M. Stupak.
worked as envisioned, however. The DFA regime
envisioned that (1) emerging threats to financial stability
CRS Report R42150, Systemically Important or “Too Big
would be identified by FSOC and addressed by the
to Fail” Financial Institutions, by Marc Labonte.
regulators or Congress and (2) systemic risk posed by large
financial firms would be mitigated through the Fed’s
CRS Insight IN10997, Activities-Based Regulation and
enhanced regulation and their failure would be managed
Systemic Risk, by Marc Labonte and Baird Webel.
through OLA.
CRS Insight IN10982, After Prudential, Are There Any
In practice, from 2010 to 2018, FSOC has issued only one
Systemically Important Nonbanks?, by Marc Labonte and
formal recommendation to a member agency to address
Baird Webel.
systemic risk (SEC money market reforms, adopted in
2014). Each annual report contained multiple
Marc Labonte, Specialist in Macroeconomic Policy
recommendations to member regulators that mostly serve as
an update on initiatives that regulators were already
IF10700
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Introduction to Financial Services: Systemic Risk

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