House Committee on Financial Services: The Annual Report of the Financial Stability Oversight Council (FSOC)

House Committee on Financial Services

The Annual Report of the Financial Stability Oversight Council (FSOC)

Tuesday, February 6, 2024

Topline

• Republicans expressed their disappointment that FSOC, under Yellen’s leadership, is ineffective and places the US capital markets and overall economy at risk. They also reiterated their disapproval of the Basel III endgame proposal.
• Democrats remained divided on Basel III and asked about FSOC’s Annual Report and designation authority.

Witnesses

• The Honorable Janet L. Yellen, Chair, Financial Stability Oversight Council (FSOC)

Opening Statements

Committee Chairman Patrick McHenry (R-N.C.)

In his opening statement, McHenry discussed the role of the Financial Stability Oversight Council (FSOC) and criticized the Council for expanding its regulatory reach to fit the Biden Administration’s political priorities. He noted that FSOC did nothing to identify the emerging instability that set off the March 2023 banking sector turbulence and said there is a lack of transparency from the Council. McHenry acknowledged that while Republicans have worked to get the answers the American people deserve, FSOC has been busy making changes to enable it to serve as a roving regulator, which he regards as something architects of the Dodd-Frank Act vigorously promised FSOC would not be.

McHenry expressed concerns about FSOC relaxing the criteria used to designate non-bank financial companies as systematically important and putting them under Federal Reserve regulation. He explained that the proposal is based on the premise that the US financial system would be best served with more oversight and control by the Federal Reserve, even beyond banks. He closed by questioning the effectiveness of FSOC, referencing previous failures in identifying and responding to emerging risks.

Committee Ranking Member Maxine Waters (D-Calif.)

In her opening statement, Waters applauded Secretary Yellen and President Biden’s economic team, stating that they have been hard at work to turn the tide on the disastrous economy that Trump left the US with. She referenced that in 2023, the unemployment rate remained under 4%, the economy created a whooping 2.7 million jobs, and mentioned that the inflation rate has fallen to the pre-pandemic level of 2%. Waters accredited the successes to Secretary Yellen’s hard work and leadership. She accused Republicans of having teamed up with Wall Street to spread misinformation and try to block efforts to strengthen capital at the nation’s biggest banks.

She explained that less capital means consumers are left more vulnerable, especially in a downturn, while bank executives take home bigger bonuses each year. Waters assured Committee members that Yellen would set the record straight about how capital reforms would ensure first-time homebuyers, business owners, and communities of color looking to build wealth can better access credit and prevent future bank crises. She closed by applauding the Council for continuing the work that Committee Democrats started by guarding Americans against risk from artificial intelligence (AI), cryptocurrencies, and climate change.

Subcommittee Chair Andy Barr (R-Ky.)

In his opening statement, Barr accused FSOC of failing to identify systemic risks as they emerge, not promoting any market discipline, and not responding to the emerging stability threat in March 2023. Barr said that FSOC has not fulfilled its statutory purposes and instead has become an unaccountable roving regulator. He continued by saying we are left with an FSOC that is used to pressure nominally independent financial regulators into whatever policy objectives the Biden Administration wants to push. Barr closed by criticizing FSOC for operating as a partisan body and a rogue regulator, which he noted is not what was intended in Dodd-Frank.

Subcommittee Ranking Member Bill Foster (D-Ill.)

In his opening statement, Foster said FSOC has been a vital forum for US financial regulators to share information regarding systemic risk to the US economy. He recognized that FSOC’s comprehensive view of the financial system is critical because systemic risks rarely develop in ways that fall entirely within the jurisdiction of a single agency. Foster applauded FSOC for acknowledging AI as a risk factor, saying he was happy to have seen the steps that financial regulators have started to take to address AI.

Testimony

Janet Yellen, Secretary, Department of the Treasury

In her testimony, Yellen discussed the economic recovery that the Biden Administration has driven over the past years. She recognized GDP growth, a decline in inflation, and a healthy labor market as part of the reason that families are now able to put additional income back into the economy. She claimed that without a continuously solid and resilient US financial system, there would not have been growth.

Yellen recognized the work FSOC completed in 2023, noting the monitoring of a wide range of risks including risks stemming from commercial and residential real estate sectors and from global geopolitical conflicts as well as technological developments. She also said in March 2023, when two regional banks failed, FSOC reacted quickly to prevent contagion to banks with similar vulnerabilities and to maintain confidence in the banking system. Yellen noted that the Council increased transparency this year with the issuing of an analytic framework that for the first time provides the public with in-depth information on how FSOC monitors, assesses, and responds to potential financial risks.

Yellen noted that there are five areas of ongoing work that are further detailed in the Council’s 2023 annual report and said the first area of focus are risks to the banking sector and from non-bank financial institutions. She explained that FSOC supports member agencies’ plans to review whether capital measures appropriately reflect a banking institution’s ability to absorb losses, improve resolvability at large, complex, or interconnected banks, and address vulnerabilities from uninsured deposit levels and depositor composition. She said the second area the Council is focused on is member agencies enhancing assessment efforts and increasing coordination around climate-related financial stability risks from increasingly severe and frequent climate-related events. She then noted the third area of focus is bolstering efforts to protect against cyber security risks. Yellen said fourth area the Council is closely monitoring is the increasing use of artificial intelligence in financial services which brings potential benefits, such as reducing costs and improving efficiencies, and potential risks, like cyber and model risk. Yellen said the fifth and final area of focus is the digital assets and cryptocurrency space, including runs on cryptocurrency platforms and the risks associated with stablecoins. She closed by asking Congress to pass legislation to provide for the regulation of stablecoins and of the spot market for crypto assets that are not securities.

Question & Answer

Basel III Endgame Proposal

Waters applauded the Basel III endgame proposal and asked Yellen why the new bank capital proposal is so important for financial stability. Yellen said it’s critical for the stability of the entire financial system for there to be strong standards of capital liquidity and risk management for banks, especially in large banks. She added that the proposals are out for comments, and it’s up to the banking regulators to decide on the appropriate specifics.

Rep. Frank Lucas (R-Okla.) expressed concerns that the Basel III endgame proposal would undermine many of the steps taken by Congress to strengthen the financial system and support the economy. He asked Yellen if Treasury has provided feedback to the Fed, and if she is confident that the proposal will not undermine the resilience of the US capital markets that are so critical to the economy. Yellen noted that she is not aware that the Treasury has provided any formal feedback to the Fed on the Basel regulations and that the banking regulators are currently considering how to respond to comments they received on the proposal.

Lucas then asked if Yellen is concerned that the proposal will undermine the resilience of the US capital markets. Yellen clarified that she is not taking a position on the proposal and the details of the rule. She added that she believes that there should be strong capital and liquidity standards to ensure that these institutions operate in a safe and sound manner, but that the banking agencies must evaluate the specifics.

Lucas noted that the Fed’s proposal would raise costs associated with market making in the Treasury futures markets and that at the same time, the SEC finalized a rule that would increase central clearing for Treasury markets along with other reforms. He then asked Yellen how she has engaged with the SEC and Fed to evaluate the cumulative impact of the proposals and how we can be sure there will be no serious negative impacts. Yellen said that they have formed an interagency working group to focus on the resilience and operation of the Treasury market. She said the group has looked at improved disclosure and has taken the view that increased central clearing can make the Treasury market more resilient.

Rep. David Scott (D-Ga.) vocalized his concerns with Basel III endgame proposal, saying that it would require the largest banks to hold more capital than their actual risk taking and that it will further diminish the credit capacities and weaken the economic conditions for Americans and then asked for Yellen’s thoughts. Yellen said that she knows the banking agencies have received many comments that expressed this concern and noted that it’s important to ensure that credit availability is not significantly diminished.

Rep. Nydia Velazquez (D-N.Y.) disagreed with Scott’s statements and voiced her support for the Basel III proposal because it would strengthen capital requirements at the US’s largest institutions.

Rep. Bill Huizenga (R-Mich.) expressed his frustrations with Yellen for not declaring her stance on Basel III endgame and asked her who she is telling her thoughts to if not Congress. Yellen noted that she meets on a regular basis with all the heads of supervisory agencies including the Office of the Comptroller of Currency (OCC)and FDIC.

Rep. Ann Wagner (R-Mo.) asked Yellen if she believes that US banks continue to have sound levels of regulatory capital. Yellen agreed. Wagner then asked why the Basel III endgame proposal, which would require massive increases in regulatory capital, is being considered. Yellen said the regulators proposed regulations to enhance the safety and soundness of the banking sector. Wagner followed up saying that as Yellen just stated and as is stated in FSOC’s annual report, the banking sector is already well capitalized. Yellen said there are risks that the regulators’ guidance suggests could be handled better than they are currently.

Barr explained that the Basel III endgame proposal would de facto repeal regulatory tailoring, eliminate the use of internal risk models, transition the industry and regulators toward a standardized framework, and push financial activity outside of the banking regulatory perimeter. He added that the banking industry will get small and more concentrated as a result. He then asked Yellen how the proposal would reduce systemic risk. Yellen clarified that having strong capital, liquidity, and resolution standards diminishes systemic risk and that we have seen an example of this in the ability of the banking sector to weather the pandemic.

Barr then asked Yellen if a less diverse banking system, with no regional banks due to the forced consolidation this proposal would provide, coupled with less diverse business models would strengthen financial stability or undermine financial stability. Yellen said she believes we benefit from having a diverse banking system with institutions that meet different needs of different firms and noted that the banking agencies have received extensive comment on all these issues.

Rep. Roger Williams (R-Texas) stated that the nation’s federal banking agencies have been bombarding the US financial system with excessive regulations and dangerous proposals, like the Basel III endgame proposal and said that increasing costs will make it harder for Americans to obtain a loan where they want to start their own business, expand current business operations, or buy their own home or small business.

Williams asked Yellen that if FSOC and federal regulators have repeatedly identified the US banking system as capitalized and resilient, then what is the need for massive increases in regulatory capital called for in Basel III endgame, and how Congress can ensure proposals are good public policy when they lack a rigorous cost-and-benefit analysis. Yellen said banking agencies have clearly articulated what their concerns are with the way in which operations risks and market risk are handled and some of the ways in which internal models are used to evaluate credit risk.

Rep. Ritchie Torres (D-N.Y.) noted that in some cases, more regulation has led to financial activity leaving the banking sector and asked to what extent banking regulation in America has led to the emergence of a largely deregulated shadow banking system. Yellen said that naturally happens and that there are attempts to exit the regulatory system noting private credit as an example of this. Torres followed up, asking to what extent Basel III would accelerate this market trend toward shadow banking. Yellen said it’s conceivable that it could, but that it’s also important that FSOC in part exists to make sure the trend is monitored. Torres asked if we are managing risk in this case, or simply transferring it. Yellen said we are making sure there is adequate regulation to address risks that could have negative spillover effects.

Rep. William Timmons (R-S.C.) asked Yellen if FSOC has reviewed proposals put forward by the banking regulators for their risks to financial stability. Yellen said FSOC does not generally engage in regular reviews of banking regulations that are within the authority of the banking regulators.

Rep. Dan Meuser (R-Pa.) asked if Yellen is concerned with the overwhelming feedback on Basel III endgame proposal about the potential harm the proposal would cause. Yellen said that her understanding is that regulators believe that changes in some of the proposals are going to be appropriate and necessary to address commenters.

Digital Assets and Stablecoins

McHenry asked Yellen why she believes there should be federal legislation on the spot market. Yellen said there are many areas with respect to digital assets where FSOC does have clear regulatory authority, but that FSOC has identified some gaps around consumer investor protection and addressing financial stability risk. She added it would be very useful for Congress to take action to fill those gaps. Yellen finished by saying stablecoins pose a potential risk to the financial system and that a regulatory framework that is appropriate for handling those risks would be welcome.

McHenry followed up referencing New York State’s digital assets regulatory framework and asked Yellen if she thought an approach like New York’s regime would be applicable to solving this problem. Yellen said that FSOC believes that it is important for there to be a federal regulatory floor that would apply to all states and that a federal regulator should have the right to decide if a potential issuer is barred from issuing a stablecoin. McHenry then asked for clarity if Yellen believes that federal law needs to be changed to have proper regulation of the digital asset spot market. Yellen agreed.

Rep. French Hill (R-Ark.) asked how Yellen has encouraged the SEC and CFTC to work together on digital assets and asked if Yellen has met with Securities and Exchange Commission (SEC) Chair Gary Gensler to discuss stablecoins and the digital assets regulatory framework. Yellen said she speaks to the SEC and the Commodity Futures Trading Commission (CFTC) Chairs regularly about stablecoins.

Rep. Warren Davidson (R-Ohio) asked if it’s appropriate for FSOC to list digital assets among its top priorities given the relative size of the market. Yellen said the market is relatively small, but that there is potential for stablecoins to be a big problem, so FSOC has made recommendations to Congress to create legislation.

Torres asked Yellen if a stablecoin issuer operates differently from a bank, why FSOC is not regulating it differently from a bank. Yellen said perhaps it should be regulated differently from a bank, but nevertheless, it’s necessary to regulate the risks to make sure that the deposits are channeled into safe assets.

Timmons asked if the current lack of regulatory structure makes it harder for consumers to tell the difference between quality products and crypto scams, and how Yellen believes regulatory clarity will help mitigate risk to the consumer. Yellen said she believes there are some risks to the consumer and that Treasury hasn’t made recommendations to Congress yet, but that the CFPB and SEC have some regulatory authorities in this space that they can use.

Foreign Adversaries

Rep. Brad Sherman (D-Calif.) asked Yellen why the US provides a capital gains allowance for investing in Chinese stock. Yellen said that capital gains should be treated similarly and only taxed when they’re realized. Sherman then asked if there a national purpose to encourage Americans to invest in Chinese equities that Yellen is aware of. Yellen clarified that her view is that both inward and outward investment are economically beneficial.

Rep. Blaine Luetkemeyer (R-Mo.) asked Yellen if she would commit to making a capital increase for the World Bank conditional on graduating China from its developing nation status for World Bank assistance and not allowing Beijing’s voting power to increase at the World Bank. Yellen said FSOC is not looking for a capital increase for the World Bank currently, and that they are strongly opposed to the World Bank lending to China.

Rep. Josh Gottheimer (D-N.J.) asked Yellen if she believes that the US should impose sanctions on China because of its ties to Iran. Yellen told Gottheimer to redirect the question to the State Department and that she is not aware of that kind of action being considered.

Rep. Bryan Steil (R-Wis.) asked if Treasury has sanctioned any of the Chinese entities purchasing Iranian oil products. Yellen said she is not aware if Treasury has, but that Treasury is trying to stop these oil shipments by sanctioning shippers and others involved. Steil then asked Yellen how she responds to concerns that China should not receive high-level engagement if it’s purchasing oil from Iran. Yellen said that President Biden and President Xi agreed that their countries should talk to one another and create channels for exchanging information and sharing concerns and discussing them. She added that it’s a way to stabilize the US-China relationship, and that her dialogues with her Chinese counterparts are intended to do that.

Designation Authority

McHenry asked Yellen if FSOC has identified any firms that are being analyzed for designation. Yellen said she cannot speak about individual firms and that FSOC has not reached a stage where they have taken action or received recommendations with respect to designation. She then noted FSOC put out revised guidance pertaining to non-bank designations and clarified that designation is only one of FSOC’s tools and is not in any sense FSOC’s “preferred” tool.

Sherman asked Yellen why FSOC is focused on designating entities that don’t have substantial liabilities such as mutual funds and money managers. Yellen said FSOC only designates an entity if they determine that its material distress would pose a severe threat to the financial stability of the US.

Rep. Joyce Beatty (D-Ohio) asked what due process protections exist for firms that FSOC is looking at designating as systemically important. Yellen said the company would be provided with a great deal of information if it completed stage 1 and entered stage 2 and that the firm could provide any information it thought was eligible, has the right to a hearing, and that any designation requires a 2/3 vote including the vote of the Chairperson.

Meuser asked Yellen if she believes that any business subject to non-bank designation should receive a cost-benefit analysis to determine the effects of the business. Yellen said that FSOC was given the ability to designate a non-bank whose materials would pose a risk to the financial system and clarified that FSOC did not require a cost-benefit analysis in association with something that a business could have done and chose not to. She defended that point saying there are good reasons not to do a cost-benefit analysis as the benefit is a reduced chance of a financial crisis and that it is not a useful exercise to attempt to quantify the costs associated with a financial crisis.

Rep. Rashida Tlaib (D-Mich.) asked Yellen if she believes that no non-bank financial institution is systemically important. Yellen said that very often the financial stability risks are not created by an institution, but rather by market-based practices within a market and added that it’s not appropriate to choose one or two large money market funds to designate. She concluded that she doesn’t think designation is the right tool and that an approach that regulates practices in the industry would be better.

Economic Stability and Other Regulators’ Proposals

McHenry asked Yellen what she says to Americans struggling with high inflation and economic hardship. Yellen responded by acknowledging the hardship Americans are facing and stating that it is the Administration’s priority to bring inflation down and alleviate some of the burdens on hardworking households.

Hill asked Yellen if she supports the SEC’s custody proposal as written. Yellen said that she had some concerns with how the proposal would impact banks and that that is something that she has discussed with Chair Gensler.

Hill asked Yellen what FSOC thinks about CFPB’s proposal under Director Chopra that considers designating non-bank payment platforms as systemically important. Yellen said that FSOC has not taken a position on the proposal and that it is important that Congress addresses this issue.

Luetkemeyer asked what FSOC has done to make banks that are overly exposed to interest rate risk change their risky business models. Yellen said the supervision of these banks rests with the banking agencies.

Huizenga referenced the SEC’s climate proposal and asked Yellen if the SEC consulted on the proposal or if they jammed FSOC as they did Congress. Yellen said she is supportive of the SEC’s rule of requiring additional disclosure.

Williams asked Yellen if FSOC is exploring nature related financial risk and if FSOC will urge federal banking regulators to issue guidance to financial institutions on how to manage nature related risks. Yellen said the banking agencies are evaluating the risks posed by climate related risks and working with financial institutions to ensure they’re accurately evaluating the risks climate change poses.

Torres mentioned concerns he had about volatility at New York Community Bank and asked Yellen if she was monitoring that situation for a potential crisis and whether she shared his concerns. Yellen said she was in touch with supervisors and that FSOC was monitoring banking stresses carefully.

Rep. Scott Fitzgerald (R-Wis.) asked what actions Congress can take to maintain the dominance of the dollar. Yellen said that the US dollar is valued as an asset because of the deep and liquid Treasury market that the US has, the strength of the US economy, and the strength of the US currency. She added that she has not seen anything that she believes poses a deep threat to the dollar.

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