The recently released 2016 Annual Report from the Financial Stability Oversight Council (FSOC), which was established under the Dodd-Frank Wall Street Reform and Consumer Protection Act and operates within the US Department of the Treasury, focused on risks presented by the blooming fintech industry and the continuing concern over cyber threats and vulnerabilities.
The report found the financial system to be in good shape overall, with members in agreement that regulatory reforms and a strengthening of market discipline despite the global financial crisis has brought about resiliency in the U.S. financial system, while vulnerabilities have remained moderate.
With that said, the Council did note that technological developments may pose threats to current stability, especially since many new products and services aren’t covered by regulation.
The report stated that delivery mechanisms, new products, and business practices, including marketplace lending and distributed ledger systems, present opportunities to minimize transaction costs and improve efficiency. However, some innovations also come with risks, such as credit risk intrinsic to the use of new and untested underwriting models. Vigilance in monitoring rapidly growing financial products and business practices is essential, even if they are relatively new.
Marketplace lending, for example, is an emerging option to extend credit by using algorithmic underwriting yet to be tested during a business cycle, potentially leading to marketplace loan investors to a comparative aversion to fund new lending during times of stress.
The FSOC also cautions financial regulators to be aware of signs of erosion in lending standards as the industry grows. When intermediaries receive fees for arranging new loans, they are incentivized to evaluate and monitor loans less rigorously as they do not retain an interest in the loans they originate. There is also a risk of deterioration of underwriting standards by traditional lenders who are competing against marketplace lenders, potentially spilling over into other market segments.
Distributed ledger systems, the report notes, also present risks for participants and financial regulators to monitor. The limited experience market participants have in working with distributed ledger systems could cause operational vulnerabilities that don’t become apparent until the systems are deployed at scale.
The changing market structure necessitates adaptation by financial regulators to reduce the importance of centralized intermediaries, according to the Council, and coordination of regulation is vital considering users span national boundaries and regulatory jurisdictions.
Cybersecurity-related dangers also create serious operational risks, according to regulators. Investments in cybersecurity by the financial services sector have been essential to reducing vulnerabilities, and continuing such efforts should remain a priority.
Other recommendations included information sharing, incorporation of baseline protections, and preparation for response to and recovery from cyber incidents.
Why it matters
Government regulators have prioritized a balance between facilitating innovation and incorporating effective regulation. While innovation allows participants to adapt to changing marketplace demands, reap the benefits of new technology, and find creative responses to regulatory constraints, special attention must be paid to ensure new products and practices do not blunt the effectiveness of existing regulations or pose new risks to markets or institutions.
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