Nonbank mortgage activity and the use of automated tools in lending decisions are the main focal points in the Financial Stability Oversight Council’s (FSOC) annual report summarizing key vulnerabilities in the financial system and recommendations for mitigating risks, as well as the council’s activities in 2023. Regulators commented on the need for FSOC to have more tools to help stem emerging financial stability risks.

In addition to a lack of liquidity among many nonbank institutions, poor risk management practices and a tendency to rely on uninsured deposits were among the most glaring risks the council identified, noting these were major contributing factors to multiple regional bank failures in spring 2023. FSOC credited swift actions by the Treasury, the Federal Deposit Insurance Corp. and the Federal Reserve with helping to mitigate systemic risks over the past year.

However, the agency’s report also pointed to how rising interest rates have impacted debt servicing costs and lending standards, with potential risks in commercial real estate (CRE) loans. The report also asserted solid economic growth has not been enough to offset the negative effects of inflation and interest rate uncertainty.

“High interest rates are filtering through the financial system and are increasing pressures on banks, both directly, through higher costs of funding, and indirectly, by increasing credit risk,” the report stated. “Banks in advanced economies have significantly tightened lending standards, curtailing the supply of credit for corporations and CRE investors. Surveys suggest that banks in the United States and Europe considerably restricted access to credit in the first three quarters of 2023, and they are expected to continue to do so in coming months.”

The impact of nonbanks on the mortgage market

Evolving nonbank financial institution activities pose risks as well, including challenges in mortgage servicing and private credit. Certain disruption risks were mitigated by the successful transition from London Interbank Offered Rate to alternative reference rates, according to the report.

“The council continues to evaluate the vulnerabilities posed by nonbank financial institutions (NBFIs),” the report stated. “The council’s Hedge Fund Working Group has developed a risk-monitoring system to assess hedge fund–related risks to U.S. financial stability. In addition, the council’s Nonbank Mortgage Servicing Task Force, a working group including staff from member agencies and other government agencies such as the Department of Housing and Urban Development, is facilitating interagency coordination and additional market monitoring of the risks that nonbank mortgage servicers pose to U.S. financial stability.”

Consumer Financial Protection Bureau (CFPB) Director Rohit Chopra, a member of FSOC, weighed in on the impact of risks posed by large nonbank institutions to financial stability, the economy and the mortgage market, as well as the resulting impact on affordable housing availability.

He described the types of disruptions that could result from failures among nonbank firms in the mortgage space, noting their relative fragility compared with federally-insured institutions.

“Regulators are concerned about the fragile nature of these firms,” he said. “They are not subject to the same federal financial requirements as banks, even though they pose similar risks. Mortgage activities are often the sole business line for these firms, which leaves them vulnerable to swings in the market. They also don’t have much cash on hand and borrow heavily from banks that can pull the funding at a moment’s notice.”

Nonbanks originated approximately 65 percent of all mortgages and service more than 50 percent of outstanding mortgage balances, Chopra noted, making their financial stability critical to the health of the mortgage market and the financial system as a whole.

“The CFPB has found that servicing transfers by healthy firms can be difficult and disruptive, even in the best of times,” Chopra said. “If one or several large nonbank mortgage companies failed in a period of stress, their lights might shut off. It could take a while to transfer the servicing activities to a new company, if one was even available. In the meantime, it would be chaotic for consumers. Millions of borrowers may have issues transmitting their payments and may not have anyone in customer service to contact with problems. Distressed borrowers may not be able to access or continue under loss-mitigation plans, which could lead to a wave of avoidable foreclosures. Nonbank failures could also reduce access to credit, especially for low- and moderate-income households that disproportionately rely on nonbank mortgage companies.”

The report suggested granting the Federal Housing Finance Agency (FHFA) additional authority in supervising nonbank entities in the mortgage space, which is supported by the agency’s leadership.

“I am particularly encouraged that the FSOC recommends Congress consider providing FHFA with additional authority to establish appropriate safety and soundness standards for nonbank mortgage servicing and to directly examine for compliance with these standards,” FHFA Director Sandra Thompson said in a statement. “Such authority would give FHFA greater ability to manage the risks identified in the FSOC report and support broader financial stability.”

CFPB recommendations

Chopra outlined the CFPB’s recommendations that Congress focus on promoting firm resilience and homeowner protections. Meanwhile, the CFPB plans to work on strengthening foreclosure protections, he added.

“The CFPB will do its part to improve the functioning of this market. We will be undertaking a rulemaking to strengthen our foreclosure protections for borrowers,” Chopra said. “The existing rules leave too many borrowers exposed to foreclosure and junk fees while they struggle to meet seemingly endless paperwork requirements. The proposed rule we are considering would shift the focus from a check-the-box compliance exercise to getting distressed homeowners in loss mitigation quickly.

“Under the proposal, foreclosure protections would start from when the borrower first asks for help, even if the servicer doesn’t yet have all the documents. These changes, if ultimately finalized, would permit servicers more flexibility in helping mortgage borrowers struggling to make their payments in a variety of circumstances.”

Risk mitigation tools

While he praised certain aspects of the report, Chopra lamented the lack of details about what tools FSOC should utilize to help mitigate risks posed by nonbanks.  

“The report is silent on what, if any, tools the FSOC itself should use to address these risks,” Chopra said. “That must be the next phase of our work. In line with the 2023 Analytic Framework and Nonbank Designation Guidance, we should carefully consider whether any large nonbank mortgage companies meet the statutory threshold for enhanced supervision and regulation by the Federal Reserve Board.”

Federal Reserve Gov. Michelle Bowman recently spoke of the need for new risk mitigation tools to enhance nonbank liquidity during the Texas Bankers Association’s annual meeting.

“As I think about the tools we use to address financial stability concerns — and the tradeoffs we are often forced to make when exercising these powers — it is helpful to consider the lessons regulators have learned over time,” Bowman said. “While the end goal is the same — ensuring resiliency in the financial system to promote financial stability — there are a number of tools that can be used to address the unique characteristics of vulnerabilities and shocks.”

Bowman presented three principles she believes are important for framing a discussion about the role of banking regulators in promoting financial stability:

• “Bank supervision can be an effective and efficient tool to promote financial stability. It is important that supervisors focus on core banking risks.
• “Where bank regulation may create or exacerbate financial stability risks, we need to take a hard look at whether those risks are justified by the safety-and-soundness benefits of the regulation.
• “As we evaluate the merits of bank regulation and supervision, we must consider how the Federal Reserve’s regulatory proposals affect markets and institutions beyond the bank regulatory perimeter. This will enable us to better understand the potential unintended consequences.”

“There is value in our current approach to addressing financial stability risks,” she said. “We monitor risks and how they build up or manifest as stress in the financial system. And we react in a way that is informed by that monitoring, either to proactively address the buildup of risk, or to address the consequences of events that could threaten financial stability. A review of past events that presented stability concerns can help us evaluate our existing work and inform the direction of future investments.”

Emerging technology risks

Artificial intelligence (AI), cybersecurity and climate-related financial risks also continue to represent an emerging source of vulnerability, requiring careful implementation, ongoing monitoring which the council believes will be crucial for financial system resilience. The council devoted a significant portion of the report to addressing concerns related to AI, noting that while it has many potential benefits, the risks cannot be ignored.

“The use of AI, however, can introduce certain risks, including safety-and-soundness risks like cyber and model risks,” the report stated. “Other potential risks include consumer compliance risks, which can be exacerbated by certain characteristics of many AI approaches, such as difficulty in explaining the model or understanding how it functions. Some AI approaches operate as ‘black boxes,’ which can create challenges in explaining how the technology produces its output. This lack of ‘explainability’ can make it difficult to assess the systems’ conceptual soundness, increasing uncertainty about their suitability and reliability. A particular concern is the possibility that AI systems with explainability challenges could produce and possibly mask biased or inaccurate results.”

Among the main concerns raised by AI has been its possible impact on consumer protection, especially with respect to fair lending issues, the report noted.

“While there are a variety of techniques to address explainability challenges, they have their own strengths and weaknesses,” the report explained. “It is the responsibility of financial institutions using AI to address the challenges related to explainability and monitor the quality and applicability of AI’s output, and regulators can help to ensure that they do so.”

Chopra contended that strong safeguards must be put in place to prevent discrimination or bias that can result when using AI-based tools, models, or processes.

“This is an important consideration because without proper design, testing, and controls, AI can lead to disparate outcomes, which may cause direct consumer harm and/or raise consumer compliance risks,” he explained. “Errors and biases can become even more difficult to identify and correct as AI approaches increase in complexity, underscoring the need for vigilance by developers of the technology, the financial sector firms using it, and the regulators overseeing such firms.”