Updated January 13, 2022
Introduction to Financial Services: Systemic Risk
Recent Episodes of Financial Instability
3. Contagion effects—for example, a run in which
The 2007-2009 financial crisis was characterized by
depositors or investors suddenly withdraw their
system-wide financial instability. Overtaken by panic,
funds from a class of institutions or assets, such
market participants became unwilling to engage in even
as banks or money market funds (MMFs).
routine transactions at the height of the crisis. Distress at
4. Disruptions to critical functions—for example,
large financial firms was central to the crisis. Financial
when a market can no longer operate because of
stability was not restored until large-scale financial
a breakdown in market infrastructure.
intervention by the Federal Reserve (Fed) and Congress
helped stabilize markets and provided assistance to
Policy Response to the Financial Crisis
financial firms. The result was a sharp and long-lasting
In the aftermath of the financial crisis, one priority for
contraction in credit and economic activity.
policymakers was to contain systemic risk. In other words,
how might threats to financial stability be identified and
The COVID-19 pandemic also caused significant financial
neutralized? Systemic risk (also called macroprudential)
market turmoil in spring 2020, as investors were faced with
regulation seeks to prevent both future financial crises and
uncertainty and unprecedented disruptions to economic
modest breakdowns in the smooth functioning of specific
activity. But this time, financial stability was quickly
financial markets or sectors. It can be contrasted with the
restored, albeit again through large-scale financial
traditional microprudential regulatory focus on an
intervention by the Fed and the CARES Act (P.L. 116-136).
individual institution’s solvency.
Unlike the previous crisis, distress at large financial firms
was not central to the instability. Both episodes suggest that
Critiques of inadequate systemic risk regulation in the run-
financial markets remain inherently fragile under periods of
up to the crisis can be placed into two categories: (1)
stress, and federal interventions are likely in future episodes
insufficient regulatory authority to identify or mitigate
of instability. This raises questions of whether further
systemic risk, partly because of financial market opacity;
reforms are merited to mitigate systemic risk and whether
and (2) shortcomings of the regulatory structure that made
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 their
emanate from financial firms, markets, or products. It can
narrow mandates meant there were gaps in oversight.
be caused by the failure of a large firm (hence the moniker
“too big to fail”), or it can be caused by correlated losses
The 2010 Dodd-Frank Act (DFA; P.L. 111-203) sought to
among many small market participants. Although historical
enhance regulatory authority to address specific weaknesses
financial crises have centered on banks, nonbank financial
revealed by the crisis (e.g., derivatives markets); reduce
firms were also a source of instability in the financial crisis
opacity in certain markets (e.g., new reporting requirements
and the pandemic. Boom and bust cycles in asset values or
for hedge funds and derivatives); and modify the regulatory
credit availability can often be the underlying cause of
structure to make it forward-looking and nimble enough to
crises, with the bursting of the housing bubble in the
respond to emerging threats. Major changes included the
financial crisis a notable example. Other events unrelated to
following:
asset values, such as a successful cyberattack on a critical
market, could also trigger financial instability in theory.
Financial Stability Oversight Council (FSOC). DFA
created FSOC, headed by the Treasury Secretary and
Daniel Tarullo, a former Fed governor, identified four
composed of the financial regulators and other financial
categories of systemic risk:
officials. FSOC was tasked with identifying risks to
financial stability, promoting market discipline by
1. Domino or spillover effects—for example,
eliminating expectations that the government will prevent
when one firm’s failure imposes debilitating
firms from failing, and responding to emerging threats to
losses on its counterparties.
financial stability. DFA also created the Office of Financial
2.
Research (OFR) in Treasury to support FSOC.
Feedback loops—for example, when fire sales
of assets depress market prices, thereby
Generally speaking, FSOC does not have rulemaking
imposing losses on all investors holding the
authority to intervene when it identifies emerging threats to
same asset class. Another example is
stability. When one of its members has the requisite
deleveraging—when credit is cut in response to
authority, FSOC can recommend—but not require—the
financial losses, resulting in further losses.
member to intervene. Otherwise, it can recommend a
legislative change to Congress. It is required to produce an
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link to page 2 Introduction to Financial Services: Systemic Risk
annual report (on which the chair testifies) to Congress,
mitigated through the Fed’s enhanced regulation, and their
where it catalogs emerging threats and recommendations.
failure would be managed through OLA.
FSOC’s and OFR’s budgets, which are proposed by the
Treasury Secretary and not subject to congressional
To date, FSOC has used the statutory process to
appropriations, decreased in nominal terms by 27% and
recommend that member agencies address systemic risk
38%, respectively, from 2016 to 2019 and increased by
once (Securities and Exchange Commission MMF reforms,
0.4% and 21%, respectively, in 2021.
adopted in 2014). FSOC has made informal
recommendations, such as recommendations related to
“Too Big to Fail” (TBTF). DFA sought to end TBTF and
government-sponsored enterprise (GSE) capital
the systemic risk it posed. FSOC’s primary regulatory
requirements and climate risk. In addition, each annual
authority is the ability to designate nonbank financial firms
report contains multiple recommendations to member
and payment, clearing, and settlement systems as
regulators that mostly serve as an update on initiatives that
systemically important. The former are referred to as
they were already undertaking. The report has also included
systemically important financial institutions (SIFIs) and the
some legislative recommendations to Congress. The 2021
latter as financial market utilities (FMUs or SIFMUs).
annual report endorsed legislation to regulate
There were previously four and are currently zero SIFIs
cryptocurrencies and fintech third-party service providers
(see Table 1). There are currently eight FMUs.
but did not recommend that Congress enact legislation that
passed the House (H.R. 4616) to address the LIBOR
Table 1. Former Nonbank SIFIs
transition. Arguably, this coordination of the regulatory
agenda helps avoid regulatory gaps or duplication, but it has

Designation Date
De-designation Date
not led to significant action on emerging threats. Generally
AIG
July 9, 2013
Sept. 29, 2017
speaking, statutory and regulatory changes during the
previous Administration reduced existing financial
GE Capital
July 9, 2013
June 29, 2016
regulatory requirements and did not introduce new ones.
Prudential
Sept. 20, 2013
Oct. 17, 2018
Further, the number of large firms subject to enhanced
regulation was reduced by the de-designation of all four
MetLife
Dec. 19, 2014
March 30, 2016 (by
nonbank SIFIs and by raising the $50 billion threshold in
court ruling)
P.L. 115-174. Since 2020, FSOC appears to have been
Source: CRS based on FSOC documents.
relegated in favor of a subset of members acting outside of
FSOC who have coordinated the response to systemic risk
Under DFA, designated SIFIs and all bank holding
posed by stablecoins, Treasury markets, and MMFs.
companies with more than $50 billion in assets were subject
to enhanced prudential regulation by the Fed—special
In 2019 guidance, 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. In
toward activities-based regulation—regulating particular
2018, P.L. 115-174 replaced that threshold with a graduated
financial activities or practices to prevent them from
threshold of between $100 billion and $250 billion,
causing financial instability—to address systemic risk for
reducing the number of banks subject to enhanced
nonbanks. (These two approaches need not be mutually
regulation. In addition, under Basel III (an international
exclusive.) This approach requires FSOC to make policy
agreement), the very largest banks are subject to additional
recommendations and regulators or Congress to adopt
capital and liquidity requirements that do not apply to other
them—although that has happened rarely to date, as noted.
firms. Collectively, these DFA and Basel III requirements
This guidance and MetLife’s successful court challenge to
aim to make it less likely that large financial firms will fail,
its designation arguably make it more difficult for FSOC to
given the systemic risk that their failures could pose.
designate a SIFI in the future. (No large financial firm has
failed since 2010, so OLA has not yet been tested.)
In addition to reducing the likelihood that large firms would
fail, DFA also attempted to make it less disruptive if they
Criticisms of the current regime include the following: (1)
did fail. As an alternative to bankruptcy, DFA created a
its success depends on policymakers accurately identifying
resolution regime for nonbank financial firms if their failure
and responding to emerging threats, although they failed to
posed a risk to financial stability. Called Orderly
do so before the financial crisis; (2) it reduces the role for
Liquidation Authority (OLA), it is modeled on the Federal
market discipline to discourage systemically risky behavior
Deposit Insurance Corporation’s (FDIC’s) bank resolution
and may inadvertently increase perceptions that large firms
regime, with key differences, and the FDIC administers it.
are TBTF and will be bailed out; and (3) regulation imposes
Policy Debate
costs that may unduly increase the price or reduce the
availability of credit. Events in spring 2020 highlighted
Through the creation of FSOC and the enhanced regulation
these challenges. Foreseeing the severity of the pandemic
of nonbank SIFIs and large banks, the DFA put an
and its effect on financial stability was unlikely, but the
institutional structure in place to address systemic risk.
problems that arose were not new, and federal interventions
Arguably, in practice, this structure has not worked as
to restore stability may encourage excessive risk-taking by
envisioned. The DFA regime envisioned that (1) emerging
market participants in the future. For example, MMFs
threats to financial stability would be identified by FSOC
caused instability again in the pandemic despite the 2014
and addressed by the regulators or Congress; and (2)
reforms, and FSOC encouraged further SEC action in 2021.
systemic risk posed by large financial firms would be
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Introduction to Financial Services: Systemic Risk

IF10700
Marc Labonte, Specialist in Macroeconomic Policy


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https://crsreports.congress.gov | IF10700 · VERSION 5 · UPDATED

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