Potential Risks to Financial Stability: The Financial Stability Oversight Council’s 2024 Annual Report

12/13/2024|6 minute read

Key Takeaways

• The Financial Stability Oversight Council ("FSOC") issued its 2024 Annual Report on December 6, 2024. The 2024 Annual Report, among other things, highlights areas of current and potential threats to the financial stability of the United States and the areas that FSOC believes should be monitored and addressed by the FSOC's voting members.
• Changes to FSOC's membership and focus are coming with the departure of Treasury Secretary Yellen and many of the FSOC's voting members appointed by President Biden as the Trump Administration is set to take office on January 20, 2025.
• While the Annual Report discusses 14 vulnerabilities, this alert highlights the FSOC's thoughts on commercial real estate, cryptocurrency, cybersecurity and artificial intelligence, and third-party service providers.

The Financial Stability Oversight Council (FSOC or Council) unanimously approved and issued its 2024 Annual Report on December 6, 2024, lauding a strong economy and stable financial system while also outlining numerous risks to U.S. financial stability.[1] Established in 2010 by Title I of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), FSOC has broad authority "to monitor and promote U.S. financial stability," including by monitoring threats to financial stability, facilitating regulatory coordination and information sharing, designating certain nonbank financial companies for Federal Reserve supervision, and recommending heightened prudential standards for banks and nonbank financial companies supervised by the Federal Reserve.[2] FSOC issued its first annual report in 2011.

Under Section 112(a)(2)(N) of the Dodd-Frank Act, FSOC must issue an annual report that discusses its activities, significant financial market and regulatory developments, and potential emerging threats to U.S. financial stability, among other topics. The Council is comprised of 10 voting members and five nonvoting members.[3]

Notably, this is Treasury Secretary Janet Yellen's final FSOC annual report. President-elect Donald Trump has already nominated a new Treasury secretary, Scott Bessent, who will also assume the role of FSOC chairperson following his Senate confirmation. This is the last annual report for several other voting members of FSOC as well due to the upcoming change at 1600 Pennsylvania Avenue next month. In her remarks before the presentation of the Annual Report, Secretary Yellen noted that "the U.S. economy has been marked by a combination of developments that few thought possible." She emphasized a sharp decline in inflation, an unemployment rate "near historic lows," and "robust" economic growth.[4] Nonetheless, she and FSOC cautioned that several threats to the financial system could halt economic progress and must continue to be evaluated by federal and state regulators and the private sector.

The full report, available here, analyzes each risk identified by FSOC. Below, we discuss a few of these risks - namely, those associated with commercial real estate, cryptocurrency, cybersecurity and artificial intelligence (AI), and third-party service providers for banks:

• Commercial Real Estate (CRE): According to the report, CRE credit risks have become "more evident" in 2024 due to a continued rise in vacancies, slower rent growth, and increased borrowing costs.[5] During the second quarter of 2024, outstanding CRE mortgage debt totaled $5.9 trillion and includes owner-occupied and nonowner-occupied real estate, multifamily mortgages, and loans backed by acquisition, development and construction projects.[6] Half of this $5.9 trillion debt is held by banks, and credit stress in CRE loan performance has caused banks to experience a rise in delinquencies, loan losses, and provision expenses.[7] FSOC described the market outlook for CRE as "challenging, with a substantial volume of office loans and multifamily property loans set to reprice or mature over the next three years."[8] Because of lower property values and higher debt costs, CRE borrowers with maturing loans may need to provide more collateral or cash equity injections, or else face "potentially challenging refinance or repayment options and [an] increased risk of becoming nonperforming."[9] FSOC did note, however, that the banking system is "resilient" and that most banks are experiencing limited stress in their CRE loan portfolios.[10] This, of course, could change if the situation does not improve. As a result, FSOC called for continued monitoring of these CRE challenges.[11]
  
• Cryptocurrency: FSOC's discussion of cryptocurrency risks centered on the size and growth of the crypto market. The S&P 500's market cap of $48 trillion still dwarfs the $2 trillion market value of crypto assets, but crypto continues to grow at a strong pace, in part because of the listings of new crypto-asset exchange-traded products.[12] The stablecoin market has given FSOC cause for concern because one firm, Tether, holds roughly 70 percent of the stablecoin sector's global market value.[13] To combat potential stablecoin risks, FSOC recommends that Congress pass legislation that would create a comprehensive federal prudential framework for stablecoin issuers, provide federal financial regulators with explicit rulemaking authority over the spot market for crypto assets that are not securities, and create authority for regulators to have visibility into and supervise activities of crypto-asset entities and their subsidiaries.[14]
  
  While Congress has been working on cryptocurrency and stablecoin legislation throughout the 118th Congress, neither item will become law before Congress completes its work around December 20, 2024. When the 119th Congress convenes on January 3, 2025, there will be new chairs of the House Financial Services Committee, Senate Banking, Housing, and Urban Affairs Committee, and the Senate Agriculture, Nutrition and Forestry Committee, which has jurisdiction over the Commodity Futures Trading Commission, and they will all be working with the incoming Trump administration on crypto policy and legislation beginning January 20, 2025. President-elect Trump has repeatedly expressed his desire to be a crypto-friendly president, and he recently named David Sacks, a businessman and a venture capital investor, to be the administration's AI and crypto czar. He has also announced the nomination of former SEC Commissioner Paul Atkins to be the next SEC chairman.
  
• Cybersecurity and AI: Cybersecurity and AI risks also remain at the forefront of FSOC's concerns. Global cyberattacks have almost doubled since before COVID-19 and are unlikely to diminish anytime soon, due to the ongoing conflicts in Ukraine and the Middle East.[15] Cyberattacks can cripple the integrity and security of financial institutions and undermine public confidence in the financial system as a whole.[16] On top of this, developments in digital assets, AI and quantum computing "can provide new vectors for cyber incidents," according to FSOC.[17] FSOC warned that although cyberattacks have not yet made a systemic impact on financial systems, such impacts are possible and could severely hamper the financial industry through corrupted and unreliable data, identity theft and fraud, and a cessation of trading activities if market participants and customers question the security of data stored by financial institutions.[18] Accordingly, it is "critical" for every financial sector participant to remain up to date on the latest cybersecurity developments in the financial sector, and both financial institutions and federal and state regulators should continue to maintain awareness and promote efforts to defend against cyberattacks.[19] Relatedly, FSOC cautioned against the developments in AI in financial services. It acknowledged the many potential benefits AI presents, but also noted several concerns, including the use of AI in cyberattacks and generative AI, which may produce incorrect, biased or misleading information.[20] More specifically, cyberthreat actors may "use AI tools, such as generative AI, to aid their attacks on the financial services sector, particularly through the use of social engineering, malware generation, vulnerability discovery, and disinformation."[21] And AI used in financial services that provides inaccurate, biased or misleading information could likewise "contribute to risks to safety-and-soundness, investor protection, and market integrity, which could lead to potential financial stability risks."[22] To combat these and other risks associated with AI, FSOC called for continued monitoring of the development of AI technologies in the financial services sector and for interagency development of expertise to analyze and monitor AI-related risks.[23]
  
• Third-Party Service Providers: More and more, financial institutions are turning to third-party service providers, such as financial technology companies, to assist with their provision of products and services to consumers. These third-party service providers can provide benefits, such as reduced costs and increased revenues, but their use likewise presents new risks and amplifies some current risks.[24] For example, FSOC cited a Treasury Department report on cloud services provided by third parties for financial institutions that found several challenges in the use of these cloud services, including insufficient transparency to support due diligence, exposure to potential operational incidents, and gaps in human capital and tools to securely deploy cloud services.[25] To address concerns with third-party service providers, FSOC recommended continued collaboration between federal banking regulators and states, and recommended that Congress pass legislation that would ensure adequate examination and enforcement powers by federal financial regulators to oversee third-party service providers that interact with their regulated entities.[26]

Conclusion

Next year's FSOC annual report will continue to recommend actions to ensure financial stability, mitigate risk and promote economic growth. The report is also likely to recommend that the Council and its members monitor and address those risks using their respective authorities. However, FSOC's scrutiny of nonbanks, including asset managers, private credit, private equity, and hedge funds as potentially systemically important financial institutions is likely to change under the Trump administration.

[1] Press Release, United States Department of the Treasury, Financial Stability Oversight Council Releases 2024 Annual Report (Dec. 6, 2024), https://home.treasury.gov/news/press-releases/jy2738.

[2] Council Work, United States Department of Treasury, https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/financial-stability-oversight-council/council-work.

[3] Council Members, United States Department of Treasury, https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/financial-stability-oversight-council/about-fsoc/council-members.

[4] Remarks by Secretary of the Treasury Janet L. Yellen at the Open Session of the Meeting of the Financial Stability Oversight Council (Dec. 6, 2024), https://home.treasury.gov/news/press-releases/jy2737.

[5] 2024 FSOC Annual Report at 7, 17.

[6] Id. at 17.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

[11] Id. at 20.

[12] Id. at 8.

[13] Id. at 8-9, 45.

[14] Id. at 48-49.

[15] Id. at 12.

[16] Id.

[17] Id. at 12-13.

[18] Id. at 80.

[19] Id. at 83.

[20] Id. at 83-85.

[21] Id. at 85.

[22] Id. at 84.

[23] Id. at 86.

[24] Id. at 13, 86.

[25] Id. at 86.

[26] Id. at 88.

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