Updated January 4, 2021
Introduction to Financial Services: Systemic Risk
Recent Episodes of Financial Instability
Boom and bust cycles in asset values or credit availability
The 2007-2009 financial crisis was characterized by
often can be the underlying cause of these four outcomes,
system-wide financial instability. Overtaken by panic,
with the bursting of the housing bubble in the financial
market participants became unwilling to engage in even
crisis a notable example. Other events unrelated to asset
routine transactions at the height of the crisis. Distress at
values, such as a successful cyberattack on a critical
large financial firms was central to the crisis. Financial
market, also could trigger financial instability.
stability was not restored until large-scale financial
intervention by the Federal Reserve (Fed) and Congress
Policy Response to the Financial Crisis
helped stabilize markets and provided assistance to
In the aftermath of the financial crisis, one priority for
financial firms. The result was a sharp and long-lasting
policymakers was to contain systemic risk. In other
contraction in credit and economic activity.
words—how might threats to financial stability be
identified and neutralized? Systemic risk (also called
The Coronavirus Disease 2019 (COVID-19) pandemic also
macroprudential) regulation seeks to prevent both future
caused significant financial market turmoil in spring 2020,
financial crises and modest breakdowns in the smooth
as investors were faced with uncertainty and unprecedented
functioning of specific financial markets or sectors. It can
disruptions to economic activity. But this time, financial
be contrasted with the traditional microprudential
stability was quickly restored, albeit again through large-
regulatory focus on risks to an individual institution’s
scale financial intervention by the Fed and the CARES Act
solvency.
(P.L. 116-136). Unlike the previous crisis, distress at large
financial firms was not central to the instability. Both
Critiques of inadequate systemic risk regulation in the run
episodes suggest that financial markets remain inherently
up to the crisis can be placed into two categories: (1)
fragile under periods of stress, and federal interventions are
insufficient regulatory authority to identify or mitigate
likely in future episodes of instability. This raises questions
systemic risk, partly because of financial market opacity;
of whether further reforms are merited to mitigate systemic
and (2) shortcomings of the regulatory structure that made
risk and whether federal interventions are acceptable.
it unlikely for regulators to successfully identify or respond
to systemic risks. Critics argued that in the fragmented U.S.
Sources of Systemic Risk
regulatory system, no regulator was responsible for
The financial crisis highlighted that systemic risk can
financial stability or focused on the bigger picture, and
emanate from financial firms, markets, or products. It can
regulators’ narrow mandates meant there were gaps in
be caused by the failure of a large firm (hence, the moniker
regulatory oversight.
“too big to fail”), or it can be caused by correlated losses
among many small market participants. Although historical
The 2010 Dodd-Frank Act (DFA; P.L. 111-203) sought to
financial crises have centered on banks, nonbank financial
enhance regulatory authority to address specific weaknesses
firms also were a source of instability in the financial crisis.
revealed by the crisis and to modify the regulatory structure
Daniel Tarullo, a former Fed governor, placed the sources
to make it forward-looking and nimble enough to respond
of systemic risk into four categories:
to emerging threats. Major changes included the following:
Domino or spillover effects—for example, when one
Financial Stability Oversight Council (FSOC). DFA
firm’s failure imposes debilitating losses on its
created FSOC, headed by the Treasury Secretary and
counterparties.
composed of the financial regulators and other financial
officials. FSOC was tasked with identifying risks to
Feedback loops—for example, when fire sales of assets
financial stability, promoting market discipline by
depress market prices, thereby imposing losses on all
eliminating expectations that the government will prevent
investors holding the same asset class. Another example
firms from failing, and responding to emerging threats to
is deleveraging—when credit is cut in response to
financial stability. DFA created the Office of Financial
financial losses, resulting in further losses.
Research to support FSOC.
Contagion effects—for example, a run in which
Generally speaking, FSOC does not have rulemaking
investors suddenly withdraw their funds from a class of
authority to intervene when it identifies emerging threats to
institutions or assets. Banks and some other financial
stability. When one of its members has the relevant
firms are vulnerable to runs because their assets (e.g.,
authority, FSOC can recommend—but not require—the
loans) are less liquid than their liabilities (e.g., deposits).
member to intervene. Otherwise, it can recommend a
Disruptions to critical functions—for example, when a legislative change to Congress. It is required to produce an
market can no longer operate because of a breakdown in
annual report (on which the Chair testifies) to Congress,
market infrastructure.
where it catalogs emerging threats and recommendations.
https://crsreports.congress.gov
link to page 2 Introduction to Financial Services: Systemic Risk
“Too big to fail” (TBTF). DFA sought to end TBTF and
threats to financial stability would be identified by FSOC
the systemic risk it posed. FSOC’s primary regulatory
and addressed by the regulators or Congress, and (2)
authority is the ability to designate nonbank financial firms
systemic risk posed by large financial firms would be
and payment, clearing, and settlement systems as
mitigated through the Fed’s enhanced regulation, and their
systemically important. The former are referred to as
failure would be managed through OLA.
systemically important financial institutions (SIFIs) and the
latter as financial market utilities (FMUs). There are
In practice, since 2010, FSOC has issued only two
currently zero SIFIs, but there were previously four (see
recommendations to member agencies to address systemic
Table 1). There are currently eight FMUs.
risk (SEC money market reforms, adopted in 2014, and
GSE capital requirements, proposed in 2020). Each annual
Table 1. Former Nonbank SIFIs
report contains multiple recommendations to member
regulators that mostly serve as an update on initiatives that
Designation
De-designation
they were already undertaking. The report has also included
SIFI
Date
Date
a smaller number of legislative recommendations to
AIG
July 9, 2013
Sept. 29, 2017
Congress in some years, notably in the areas of housing
finance reform and cybersecurity. Arguably, this
GE Capital
July 9, 2013
June 29, 2016
coordination of the regulatory agenda helps avoid
Prudential
Sept. 20, 2013
Oct. 17, 2018
regulatory gaps but has not led to action on emerging
threats. Generally speaking, recent statutory and regulatory
MetLife
Dec. 19, 2014
March 30, 2016
changes reduced existing financial regulatory requirements
(by court ruling)
and did not introduce new ones. Further, the number of
Source: CRS based on FSOC documents.
large firms subject to enhanced prudential regulation was
reduced by the de-designation of all four nonbank SIFIs and
Under DFA, designated SIFIs and all bank holding
by raising the $50 billion threshold in P.L. 115-174.
companies with more than $50 billion in assets were subject
to enhanced prudential regulation by the Fed—special
In 2019, FSOC reoriented its approach away from
safety and soundness requirements (e.g., living wills and
institution-based regulation (i.e., SIFI designation) and
Fed-run stress tests) that do not apply to other firms. The
toward activities-based regulation—regulating particular
Economic Growth, Regulatory Relief, and Consumer
financial activities or practices to prevent them from
Protection Act (P.L. 115-174) replaced that threshold with a
causing financial instability—to address systemic risk for
graduated threshold of between $100 billion and $250
nonbanks. (These two approaches need not be mutually
billion, reducing the number of banks subject to enhanced
exclusive.) This approach requires FSOC to make policy
regulation. In addition, under Basel III (an international
recommendations and regulators or Congress to adopt
agreement), the very largest banks are subject to additional
them—although that has happened rarely to date, as noted.
capital and liquidity requirements that do not apply to other
firms. Collectively, these DFA and Basel III requirements
Criticisms of the current regime include the following: (1)
aim to make it less likely that large financial firms will fail,
its success depends on policymakers accurately identifying
given the systemic risk that their failures could pose.
and responding to emerging threats, although they failed to
do so before the financial crisis ; (2) it reduces the role for
In addition to reducing the likelihood that large firms would
market discipline in discouraging systemically risky
fail, DFA also attempted to make it less disruptive if they
behavior and may inadvertently increase perceptions that
did fail. As an alternative to bankruptcy, DFA created a
large firms are too big to fail (i.e., the government will bail
resolution regime for nonbank financial firms if their failure
them out); and (3) regulation imposes costs that may unduly
posed a risk to financial stability. Called Orderly
increase the price or reduce the availability of credit. Events
Liquidation Authority (OLA), it is modeled on the Federal
in spring 2020 highlight these challenges. Foreseeing the
Deposit Insurance Corporation’s (FDIC’s) bank resolution
severity of the COVID-19 pandemic and its effect on
regime, with key differences, and the FDIC administers it.
financial stability was unlikely, and federal interventions to
restore stability may encourage excessive risk-taking by
Opacity. DFA enhanced the transparency of certain
market participants in the future.
markets to regulators and the public (e.g., new reporting
requirements for hedge funds and derivatives).
CRS Resources
CRS Report R45052, Financial Stability Oversight Council
Derivatives. By subjecting derivatives markets to reporting,
(FSOC): Structure and Activities, by Marc Labonte
capital, clearing, and exchange requirements, DFA
attempted to preclude another buildup of large, sudden
CRS Report R42150, Systemically Important or “Too Big
losses by derivatives participants, such as AIG experienced.
to Fail” Financial Institutions, by Marc Labonte
Policy Debate
CRS Insight IN10997, Activities-Based Regulation and
Through the creation of FSOC and the enhanced regulation
Systemic Risk, by Marc Labonte and Baird Webel
of nonbank SIFIs and large banks, the DFA put an
institutional structure in place to address systemic risk.
Arguably, in practice, this structure has not worked as
Marc Labonte, Specialist in Macroeconomic Policy
envisioned. The DFA regime envisioned that (1) emerging
IF10700
https://crsreports.congress.gov
Introduction to Financial Services: Systemic Risk
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