The global economic crisis has powerfully re-taught a lesson that we have understood for some time — the whole world is economically connected. In response, the Dodd-Frank Act (DFA) has created new regulatory structures such as the Financial Stability Oversight Council (FSOC), and put more regulations in place to improve market transparency and to consolidate reporting in the hope that more information and more monitoring and more diligence will prevent the next economic crisis, or at least provide a longer lead time to try to avoid a crash or perhaps achieve a softer landing. The legislation was drafted in an intensely emotional climate and, as a result the DFA is imperfect. In some places, it is too complicated. However, in other places, for instance in its focus on transparency, financial stabilityand mitigation of systemic risk, it is praiseworthy.

Per Ben Bernanke, “Systemic risk can be broadly defined as the risk of the possibility that the failure ofa large inter-connected firm could lead to a breakdown in the wider financial system.” The DFA uses theword “inter connectedness” many times in the statute when addressing financial stability. The DFA creates an analytical regulatory environment with a very strong focus on risk. In this context, risk means the possibility of an unexpectedly bad outcome from an event or events, which may or may not have been foreseen. “Inter connectedness” throughout the financial system means that risk cannot simply be evaluated as to the impact on a single company. Because all risk evaluation is contextual, financial services companies will need to create a number of methodologies for risk assessment.

So, how does outsourcing in financial services companies play a role in financial stability? A typical outsourcing transaction takes a function or operation that a company would have controlled and operated for itself, and puts that function or operation in the care and control of a third party. Risks arise because an outsourcing transaction connects a third party to the financial system through thecontracting company. Under the Bank Service Corporation Act, third parties providing outsourcedservices to FDIC-insured banks are subject to examination and oversight by the Federal bank regulators. Third-party servicers also may be deemed to be “institution-affiliated parties” under the Federal Deposit Insurance Act, making them subject to the enforcement jurisdiction of the federal bank regulators. In other settings, the third party may not be regulated at all. In all cases, the third party has the potential to introduce risk to a financial institution and also to the financial system as a whole.

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