Introduction to Financial Services: Systemic Risk
Updated January 5, 2023
Introduction to Financial Services: Systemic Risk
Recent Episodes of Financial Instability
3. Contagion effects—for example, a run in which
Systemic risk is financial market risk that poses a threat to
depositors or investors suddenly withdraw their
financial stability. The 2007-2009 financial crisis was
funds from a class of institutions or assets, such
characterized by system-wide financial instability.
as banks or money market funds (MMFs).
Overtaken by panic, market participants became unwilling
4. Disruptions to critical functions—for example,
to engage in even routine transactions at the height of the
when a market can no longer operate because of
crisis. Distress at large financial firms was central to the
a breakdown in market infrastructure.
crisis. Financial stability was not restored until large-scale
financial intervention by the Federal Reserve (Fed) and
Policy Response to the Financial Crisis
Congress helped stabilize markets and provided assistance
In the aftermath of the financial crisis, one priority for
to financial firms. The result was a sharp and long-lasting
policymakers was to contain systemic risk. In other words,
contraction in credit and economic activity.
how might threats to financial stability be identified and
neutralized? Systemic risk (also called macroprudential)
The COVID-19 pandemic also caused significant financial
regulation seeks to prevent both future financial crises and
market turmoil in spring 2020, as investors were faced with
modest breakdowns in the smooth functioning of specific
uncertainty and unprecedented disruptions to economic
financial markets or sectors. It can be contrasted with the
activity. But this time, financial stability was quickly
traditional microprudential regulatory focus on an
restored, albeit again through large-scale financial
individual institution’s solvency.
intervention by the Fed and the CARES Act (P.L. 116-136).
Unlike the previous crisis, distress at large financial firms
Critiques of inadequate systemic risk regulation in the run-
was not central to the instability. Both episodes suggest that
up to the crisis can be placed into two categories: (1)
financial markets remain inherently fragile under periods of
insufficient regulatory authority to identify or mitigate
stress, and federal interventions are likely in future episodes
systemic risk, partly because of financial market opacity;
of instability. This raises questions of whether further
and (2) shortcomings of the regulatory structure that made
reforms are merited to mitigate systemic risk and whether
it unlikely for regulators to successfully identify or respond
federal interventions are acceptable.
to systemic risks. Critics argued that in the fragmented U.S.
regulatory system, no regulator was responsible for
Sources of Systemic Risk
financial stability or focused on the bigger picture, and their
The financial crisis highlighted that systemic risk can
narrow mandates meant there were gaps in oversight.
emanate from financial firms, markets, or products. It can
be caused by the failure of a large firm (hence the moniker
The 2010 Dodd-Frank Wall Street Reform and Consumer
“too big to fail”), or it can be caused by correlated losses
Protection Act (DFA; P.L. 111-203) sought to enhance
among many small market participants. Although historical
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.
financial crisis a notable example. Other events unrelated to
asset values, such as a successful cyberattack on a critical
Financial Stability Oversight Council (FSOC). DFA
market, in theory could also trigger financial instability.
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 a
once (Securities and Exchange Commission MMF reforms,
proposed 157% and 48%, respectively, from 2020 to 2023.
adopted in 2014). FSOC has made informal
recommendations, such as recommendations related to
“Too Big to Fail” (TBTF). DFA sought to end TBTF and
digital assets, government-sponsored enterprise (GSE)
the systemic risk it posed. FSOC’s primary regulatory
capital requirements, and climate risk. In addition, each
authority is the ability to designate nonbank financial firms
annual report contains multiple recommendations to
and payment, clearing, and settlement systems as
member regulators that mostly serve as an update on
systemically important. The former are referred to as
initiatives that they were already undertaking. The report
systemically important financial institutions (SIFIs) and the
has also included some legislative recommendations. The
latter as financial market utilities (FMUs or SIFMUs).
2022 annual report endorsed legislation to regulate
There were previously four SIFIs and are currently zero
cryptocurrencies and fintech third-party service providers.
SIFIs (see Table 1). There are currently eight FMUs.
Arguably, this coordination of the regulatory agenda helps
avoid regulatory gaps or duplication, but it has not led to
Table 1. Former Nonbank SIFIs
significant action on emerging threats. Further, the number
of large firms subject to enhanced regulation was reduced
Designation Date
De-designation Date
by the de-designation of all four nonbank SIFIs and by
AIG
July 9, 2013
Sept. 29, 2017
raising the $50 billion threshold in P.L. 115-174. Since
2020, FSOC appears to have been relegated in favor of a
GE Capital
July 9, 2013
June 29, 2016
subset of members acting outside of FSOC who have
Prudential
Sept. 20, 2013
Oct. 17, 2018
coordinated the response to systemic risk posed by
stablecoins, Treasury markets, and MMFs.
MetLife
Dec. 19, 2014
March 30, 2016 (by
court ruling)
In 2019 guidance, FSOC reoriented its approach away from
Source: CRS, based on FSOC documents.
institution-based regulation (i.e., SIFI designation) and
toward activities-based regulation—regulating particular
Under DFA, designated SIFIs and all bank holding
financial activities or practices to prevent them from
companies with more than $50 billion in assets were subject
causing financial instability—to address systemic risk for
to enhanced prudential regulation by the Fed—special
nonbanks. (These two approaches need not be mutually
safety and soundness requirements (e.g., living wills and
exclusive.) This approach requires FSOC to make policy
Fed-run stress tests) that do not apply to other firms. In
recommendations and regulators or Congress to adopt
2018, P.L. 115-174 replaced that threshold with a graduated
them—although that has happened rarely to date, as noted.
threshold of between $100 billion and $250 billion,
This guidance and MetLife’s successful court challenge to
reducing the number of banks subject to enhanced
its designation arguably make it more difficult for FSOC to
regulation. In addition, under Basel III (an international
designate a SIFI in the future. (No large financial firm has
agreement), the very largest banks are subject to additional
failed since 2010, so OLA has never been tested.)
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 to discourage systemically risky behavior
fail, DFA also attempted to make it less disruptive if they
and may inadvertently increase perceptions that large firms
did fail. As an alternative to bankruptcy, DFA created a
are TBTF and will be bailed out; and (3) regulation imposes
resolution regime for nonbank financial firms if their failure
costs that may unduly increase the price or reduce the
posed a risk to financial stability. Called Orderly
availability of credit. Events in spring 2020 highlighted
Liquidation Authority (OLA), it is modeled on the Federal
these challenges. Foreseeing the severity of the pandemic
Deposit Insurance Corporation’s (FDIC’s) bank resolution
and its effect on financial stability was unlikely, but the
regime, with key differences, and the FDIC administers it.
problems that arose were not new, and federal interventions
Policy Debate
to restore stability may encourage excessive risk-taking by
market participants in the future. For example, MMFs
Through the creation of FSOC and the enhanced regulation
caused instability again in the pandemic despite the 2014
of nonbank SIFIs and large banks, the DFA put an
reforms, and FSOC encouraged further SEC action in 2021.
institutional structure in place to address systemic risk.
Arguably, in practice, this structure has not worked as
CRS Resource
envisioned. The DFA regime envisioned that (1) emerging
CRS Report R47026, Financial Regulation: Systemic Risk
threats to financial stability would be identified by FSOC
and addressed by the regulators or Congress; and (2)
systemic risk posed by large financial firms would be
Marc Labonte, Specialist in Macroeconomic Policy
IF10700
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Introduction to Financial Services: Systemic Risk
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