Group Lacks Authority to Deal With Loan Risks: GAO

FSOC monitors potential threats to the financial system and coordinates the country’s response to potential threats — should be bringing regulators and people from the private sector in for emergency scenario simulations, to see how players in the CLO market might act in  crisis, Clements writes.

The Conference of Federal Reserve Bank Presidents, for example, has already participated in two leveraged loan market crisis simulations, according to Clements.

CLO market crisis simulations could give FSOC a better understanding of its limitations, and what it could do in a real crisis in spite of those limitations, Clements says.

That kind of knowledge could be especially important for FSOC, “given that the mission to respond to risks was given to FSOC but the authorities to act are fragmented among multiple financial regulators,” Clements says.

Clements says one important gap in FSOC’s toolbox is a lack of the ability to make binding recommendations to other state or federal agencies about how to monitor and control what looks like a risky activity.

FSOC can designate  a specific company as one that is important to the financial system and in need of extra regulatory attention, but it can’t designate a potentially risky activity as being in need of extra attention, Clements says.

“For example, if the actions of a large group of different types of investors in nonbank leveraged loans or CLO securities were found to be a significant threat to financial stability, FSOC could try to designate each of the nonbanks in the group individually,” Clements says.

“Assuming each met the statutory standards for designation (and any additional conditions imposed by FSOC), the Federal Reserve would impose enhanced prudential standards on the entities. However, this would be a difficult and time-consuming process that likely would require FSOC to consider each nonbank individually,” he explains.

If FSOC could designate activities as systemically important and risky, it might have an easier time justifying the need for extra oversight, and it might have an easier time getting regulatory agencies other than the Federal Reserve to help provide the extra oversight, Clements says.

— Read A New Way to Hedge CLO Risk Is Here. It’s More CLOs., on ThinkAdvisor.

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