DTCC White Paper: Financial Services Industry Faces New Systemic Risks

The global financial services industry faces increasingly complex systemic risk that is becoming harder to foresee, according to a new white paper by The Depository Trust & Clearing Corporation (DTCC). While steps to mitigate risk have been made since the financial crisis, some of these regulations have actually spawned new risks, and new threats such as cyber attacks have emerged, which could adversely affect the entire industry.

In mid-2012, DTCC created an internal Systemic Risk Council with the purpose of identifying and advising on risks. This year’s white paper comes as a result of these initiatives.

Specifically, DTCC identified cybersecurity as the most pressing areas of concern. Risks to the financial industry include the threat of distributed denial of service attacks, attacks against systems containing transaction records, andthe disclosure of private information via compromise of internal systems.

In order to manage systemic risk, major industry participants created the Financial Services Information Sharing and Analysis Center (FS-ISAC) in 1999, which holds an important role today because it enables banks to share information about threats. If one bank is compromised by cyber attacks, alerting other banks can prevent system-wide collapse.

“DTCC is very, very active [in cybersecurity], but we can’t do it alone,” said Mike Leibrock, DTCC vice president, systemic risk. “It’s a combination effort between industry and regulation.”

In terms of new regulations, the paper found that even though these rules have mitigated some risk, they have also created new challenges. For example, regulations on clearing OTC derivatives could cause systemic issues by creating collateral shortages.

“The risks we see from regulations are twofold,” said Leibrock. “One aspect is the sheer volume and complexity of these regulations is causing a huge resource strain for the industry…The other aspect is that certain of these regulations have the potential to cause increased risk due to unintended consequences.”

The paper also identified concerns with counterparty risk, as the “too-big-to-fail” issue is still present. Power continues to be consolidated at the top with only a few U.S. banks offering critical services and holding the majority of assets.

Additionally, DTTC found that the interconnectedness of the financial services industry creates systemic risk, because even though this practice increases efficiency, there is a greater chance that a problem in one area would spread throughout the system.

Leibrock also noted that market quality is one of the top risks facing the industry. After the financial crisis, significant legal charges have been brought against the industry in cases such as the LIBOR scandal. These cases have the potential to bring down firms if fines are too substantial, or more importantly, erode faith in the industry and cause a pullback in investment. The paper identifies that part of the problem in managing this risk is that depends on human behavior, but with increased scrutiny, there’s reason to believe market quality will improve going forward.

“History has shown time and time again that financial crises and other major risk events can occur with little notice and have a significant impact on the securities industry and real economy,” said Noel Donohoe, DTCC’s group chief risk officer. “Despite the positive results of risk mitigation efforts by the financial industry since the 2008 crisis, we urge continued vigilance and focus on systemic risks, especially given the growing interconnections and interdependencies in global markets.”