FSOC Annual Review Identifies Primary Risks to US Financial System | Practical Law

FSOC Annual Review Identifies Primary Risks to US Financial System | Practical Law

The Financial Stability Oversight Council (FSOC) published its annual review, which identifies primary risks to the US financial system, including climate change, digital assets, LIBOR transition, and other vulnerabilities.

FSOC Annual Review Identifies Primary Risks to US Financial System

Practical Law Legal Update w-034-2107 (Approx. 5 pages)

FSOC Annual Review Identifies Primary Risks to US Financial System

by Practical Law Finance
Published on 01 Feb 2022USA (National/Federal)
The Financial Stability Oversight Council (FSOC) published its annual review, which identifies primary risks to the US financial system, including climate change, digital assets, LIBOR transition, and other vulnerabilities.
On December 17, 2021, the Financial Stability Oversight Council (FSOC) published its annual report, which identifies the following primary risks to the US financial system, and in certain cases provides recommendations for addressing those vulnerabilities:

Climate Change

This segment is split into two categories: physical risk and transition risks.
  • Physical risks. Refers to harm to people and property from acute or longer term chronic phenomena. There are direct and indirect effects on financial institutions and investors connected to those people and properties. Increased legal and operational risks may occur, leading creditors to pull back from impacted areas.
  • Transition risks. Refers to stresses to certain institutions or sectors arising from the shifts in policy, consumer and business sentiment, or technologies associated with the changes necessary to limit climate change. The costs associated with fulfilling commitments to transition to a low-greenhouse gas economy, changes in public policy, the adoption of new technologies and shifting consumer and investor preferences may decrease the ability of impacted organizations to meet their financial obligations.

Rapid Growth of Digital Assets

  • Risks. This rapidly growing market requires regulatory attention and coordination. Digital assets seem to be driven by speculation, making them highly volatile. As a result, there is a risk of operational failures, fraud, and market manipulation. These assets pose risks through direct or indirect connections with banking services. Digital assets also pose risks related to illicit financing, national security, cybersecurity, privacy, and international monetary and payment system integrity.
  • Recommendations. The FSOC recommends that federal and state regulators continue to examine risks to the financial system posed by new and emerging uses of digital assets and coordinate to address potential issues that arise from digital assets. The FSOC suggests member agencies review and adopt the recommendations of the President's Working Group (PWG) report on stablecoins (see Legal Update, President's Working Group on Financial Markets Issues Report Supporting Federal Regulation of Stablecoins and Urging Congressional Action).
    The FSOC also encourages coordination among US financial regulators to address risks arising from digital assets. The FSOC will further assess and monitor the potential risks of stablecoins and recommends that its members consider appropriate actions within each member’s jurisdiction to address those risks while continuing to coordinate and collaborate on issues of common interest. The FSOC will be prepared to consider steps available to it to address risks outlined in the PWG report in the event comprehensive legislation is not enacted.

LIBOR Transition

The FSOC has identified three risks for the transition away from the London Interbank Offered Rate (LIBOR).
  • Risk: Selection of reference rate. The FSOC advises market participants to conduct a comprehensive evaluation of the market depth and design of any alternative reference rate, but highlights the recommendation of the Secured Overnight Financing Rate (SOFR) by the Alternative Reference Rates Committee (ARRC). The FSOC notes that SOFR is based on a deep market and that other rates based on smaller markets could introduce volatility and disruption during times of market stress if the rate is based on a volume of transactions that is lower than the volume of instruments actually produced at that rate.
  • Risk: Possibility of continued issuance of instruments that create or extend LIBOR exposure.
  • Risk: Legacy contracts without robust fallback provisions in the event of LIBOR's cessation, which will create risks if parties do not take action to transition these contracts.
  • Recommendation. Market participants should execute a plan to transition from LIBOR to an alternative reference rate. It is also important that parties consider potential LIBOR exposure in services provided by third parties. Market participants should evaluate whether their fallback provisions are sufficiently strong to mitigate risk that the contract's interest rate benchmark becomes unavailable. December 31, 2021 was the date that the FSOC and other agencies and related committees such as ARRC recommended for parties to cease issuance of instruments linked to LIBOR. FSOC notes that the ARRC has recommended SOFR because it provides a robust rate, suitable for use in most products and with underlying transaction volumes that are unmatched by other LIBOR alternatives. The Federal Reserve, Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) previously communicated that a supervised institution may use any reference rate for its loans that the institution's management determines is appropriate based on its funding model and customer needs, while several FSOC members have emphasized that derivatives and capital markets should move to SOFR given its robustness.


  • Risk. A cybersecurity incident could potentially threaten the stability of the US financial system by disrupting a key financial service or utility, causing a loss of confidence among a broad set of customers or market participants or compromising the integrity of critical data. The increased reliance on third-party providers for teleworking strategies and other technologies leaves the financial sector vulnerable.
  • Recommendation. The FSOC recommends that federal and state agencies continue to monitor cybersecurity risks and conduct cybersecurity examinations of financial institutions and financial infrastructures. The FSOC supports the partnerships between government agencies and private firms including the Financial and Banking Information Infrastructure Committee (FBIIC), the Financial Services Sector Coordinating Council, and the Financial Services Information Sharing and Analysis Center (FS-ISAC). These partnerships focus on improving the financial sector's ability to rapidly respond to and recover from significant cybersecurity incidents, thereby reducing the potential for such incidents to threaten the stability of the financial system and the broader economy.

Nonbank Financial Intermediation

According to FSOC, the potential risks to financial stability from nonfinancial business borrowing depend in part on the ability of businesses to service their obligations, the ability of the financial sector to absorb losses from defaults and downgrades, and the continued willingness of market participants to provide intermediation during times of stress. Under this umbrella falls the subsectors of corporate credit, short term wholesale funding markets, residential real estate markets, and commercial real estate markets.

Resilience of US Treasury

  • Risk. According to the report, after 2008, large and complex US financial institutions built up stronger capital and liquidity positions and have become more resilient. However, today there is some uncertainty regarding the outlook of credit quality at banks, given the unknown path that the pandemic will take, and the ongoing economic recovery.
  • Recommendations. The FSOC recommends that:
    • financial regulators continue to require that the largest financial institutions maintain sufficient capital and liquidity to enhance their resilience against economic and financial shocks;
    • regulators continue to monitor and assess the impact of regulations and rules on financial institutions and financial markets and ensure that bank holding companies are appropriately monitored based on their size, risk, concentration of activities, and offerings of new products and services; and
    • regulators continue to review counterparty credit risk management and capital practices at financial institutions.