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2012
A N N U A L
R E P O R T

Financial Stability Oversight Council
The Financial Stability Oversight Council (Council) was established by the DoddFrank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and is
charged with three primary purposes:
1.	 To identify risks to the financial stability of the United States that could
arise from the material financial distress or failure, or ongoing activities,
of large, interconnected bank holding companies or nonbank financial
companies, or that could arise outside the financial services marketplace.
2.	 To promote market discipline, by eliminating expectations on the part of
shareholders, creditors, and counterparties of such companies that the
U.S. government will shield them from losses in the event of failure.
3.	 To respond to emerging threats to the stability of the U.S.
financial system.
Pursuant to the Dodd-Frank Act, the Council consists of 10 voting members
and 5 nonvoting members and brings together the expertise of federal financial
regulators, state regulators, and an insurance expert appointed by the President.
The voting members are:
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the Secretary of the Treasury, who serves as the Chairperson of
the Council;
the Chairman of the Board of Governors of the Federal Reserve System;
the Comptroller of the Currency;
the Director of the Bureau of Consumer Financial Protection;
the Chairman of the Securities and Exchange Commission;
the Chairperson of the Federal Deposit Insurance Corporation;
the Chairperson of the Commodity Futures Trading Commission;
the Director of the Federal Housing Finance Agency;
the Chairman of the National Credit Union Administration; and
an independent member with insurance expertise who is appointed by
the President and confirmed by the Senate for a six-year term.

The nonvoting members, who serve in an advisory capacity, are:
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the Director of the Office of Financial Research;
the Director of the Federal Insurance Office;
a state insurance commissioner designated by the state insurance
commissioners;
•	 a state banking supervisor designated by the state banking supervisors; and
•	 a state securities commissioner (or officer performing like functions)
designated by the state securities commissioners.
The state insurance commissioner, state banking supervisor, and state securities
commissioner serve two-year terms.
F i n a n c i a l S t a b i l i t y O ve r s i g h tiC o u n c i l

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Statutory Requirements for the Annual Report
Section 112(a)(2)(N) of the Dodd-Frank Act requires that the Annual Report
address the following:
i.	 the activities of the Council;
ii.	 significant financial market and regulatory developments, including
insurance and accounting regulations and standards, along with an
assessment of those developments on the stability of the financial system;
iii.	 potential emerging threats to the financial stability of the
United States;
iv.	 all determinations made under Section 113 or Title VIII, and the
basis for such determinations;
v.	 all recommendations made under Section 119 and the result of such
recommendations; and
vi.	 recommendations—
I.	 to enhance the integrity, efficiency, competitiveness, and stability
of United States financial markets;
II.	 to promote market discipline; and
III.	 to maintain investor confidence.

Approval of the Annual Report
This Annual Report was approved unanimously by the voting members of the
Council on July 18, 2012. Except as otherwise indicated, data cited in this report
is as of July 6, 2012.

Abbreviations for Federal Member Agencies of the Council
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Department of the Treasury (Treasury)
–– Office of Financial Research (OFR)
–– Federal Insurance Office (FIO)
Board of Governors of the Federal Reserve System (Federal Reserve)
Comptroller of the Currency (OCC)
Bureau of Consumer Financial Protection (CFPB)
Securities and Exchange Commission (SEC)
Federal Deposit Insurance Corporation (FDIC)
Commodity Futures Trading Commission (CFTC)
Federal Housing Finance Agency (FHFA)
National Credit Union Administration (NCUA)

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Contents
1	 Member Statement....................................................... 1
2	 Executive Summary...................................................... 3
3	 Annual Report Recommendations...............................11
3.1. Reforms to Address Structural Vulnerabilities.........................................11
3.2.Heightened Risk Management and Supervisory Attention ......................13
3.3.Housing Finance Reforms......................................................................16
3.4.Progress on Implementation and Coordination of Financial Reform ........19

4	 Macroeconomic Environment..................................... 23
4.1. U.S. Economic Activity...........................................................................23
4.2. Private Nonfinancial Balance Sheets and Credit Flows .............................27
4.3.Government Sectors .............................................................................33
4.4.External Environment.............................................................................37

5	 Financial Developments.............................................. 45
5.1. Major Financial Markets....................................................................... 45
BOX A:  Impacts of Downgrade of U.S. Treasury Securities ..................................46
BOX B:  Greek Sovereign Debt Restructuring .......................................................48
BOX C:  Recent Fiscal and Banking Developments in Spain ..................................50

5.2.Bank Holding Companies and Depository Institutions............................ 64
5.3.Other Financial Institutions....................................................................73
BOX D:  MF Global Bankruptcy.............................................................................78
BOX E:  Current Status of Remaining Stabilization Facilities Inaugurated
During the Crisis......................................................................................84

5.4.Financial Market Infrastructure............................................................. 86
BOX F:  Algorithmic and High-Frequency Trading..................................................88

C o n te n t s

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6	 Regulatory Developments; Council Activities............ 97
6.1. Safety and Soundness...........................................................................97
6.2.Financial Infrastructure, Markets, and Oversight..................................106
6.3.Consumer and Investor Protection....................................................... 113
6.4.Council Activities................................................................................. 118

7	 Potential Emerging Threats...................................... 123
7.1. Framework: Threats as a Combination of Shocks and Vulnerabilities....123
7.2. Areas of Heightened Uncertainty..........................................................124
7.3. Robustness of Financial Institutions and Markets ................................127
7.4. Continuing Vulnerabilities in the Financial System................................130
BOX G:  Ongoing Vulnerabilities in the Tri-Party Repo Market.............................. 133
BOX H:  Money Market Fund Responses to Euro Area Uncertainty ..................... 134

Appendix A .................................................................... 145
Glossary......................................................................... 189
Abbreviations................................................................. 199
Notes on the Data.......................................................... 207
List of Charts................................................................. 209
Endnotes........................................................................ 215

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Member Statement

The Honorable John A. Boehner
Speaker of the House
United States House of Representatives

The Honorable Joseph R. Biden, Jr.
President of the Senate
United States Senate

The Honorable Nancy Pelosi
Democratic Leader
United States House of Representatives

The Honorable Harry Reid
Majority Leader
United States Senate
The Honorable Mitch McConnell
Republican Leader
United States Senate

In accordance with Section 112(b)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection
Act, for the reasons outlined in the annual report, I believe that additional actions, as described below,
should be taken to ensure that the Council, the Government, and the private sector are taking all
reasonable steps to help ensure financial stability and to mitigate systemic risk that would negatively affect
the economy: the issues and recommendations set forth in the Council’s annual report should be fully
addressed; the Council should continue to build its systems and processes for monitoring and responding
to emerging threats to the stability of the United States financial system, including those described in the
Council’s annual report; the Council and its member agencies should continue to implement the laws they
administer, including those established by, and as amended by, the Dodd-Frank Act through efficient and
effective measures; and the Council and its member agencies should exercise their respective authorities
for oversight of financial firms and markets so that the private sector employs sound financial risk
management practices to mitigate potential risks to the financial stability of the United States.

M e m b e r S t a te m e n t

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Executive Summary
In the nearly five years since the initial strains of the subprime crisis emerged,
the U.S. financial system has traveled from the brink of collapse in late 2008
and early 2009 to a more resilient system with stronger capital, more liquidity,
improved funding, and important progress on reform. Even with that progress,
however, the Financial Stability Oversight Council (Council) believes that the
financial system in the United States and globally still faces significant challenges.
Investor confidence has not been restored to pre-crisis levels. The crisis in the
euro area and general weakness in global economic growth present identifiable
threats to financial stability. There is still work to be done to address structural
vulnerabilities within the financial system itself.
A key feature of the current environment is the stress in the euro area, which has
disrupted sovereign debt markets and put considerable pressure on euro area
banks. European leaders recognize the need to address near-term strains and
are continuing to elaborate a path toward greater fiscal and financial union that
would garner both political and market support. Because the combined economies
of the euro area constitute the second largest economy in the world and are home
to many of the world’s largest and most interconnected financial institutions,
problems in Europe could have very real consequences for financial stability in the
United States.
The potential threats from the crisis in Europe and continued economic weakness
in the United States and globally underscore the need for regulators to continue
strengthening the financial system and addressing structural vulnerabilities. Such
reforms are essential to ensure that financial markets continue to serve the real
economy even during periods of stress. Reducing amplification mechanisms and
strengthening shock-absorbing capacity make the financial system more resilient,
whether shocks originate from inside or outside the system. This increased
resilience in turn can reduce, though not eliminate, the impact these shocks
deliver to economic activity and employment. More broadly, a sound financial
system is a necessary foundation for sustained growth.
Both our financial health and our reform efforts are inextricably linked to
the rest of the world. The very complexity of the global financial system makes
designing and implementing effective reforms an inherently challenging process
that at times moves more slowly than would be the case if we acted alone.
International coordination is necessary, however, as there are key areas where the
effectiveness of the U.S. reforms will depend on a level playing field with strong
and consistent regulatory regimes internationally.

Macroeconomic Environment
Three years after the end of the deepest and longest recession since the Great
Depression, the U.S. economy is expanding at a moderate pace, but growth has
not accelerated to the rate required to make rapid progress replacing lost jobs
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and meeting the employment needs of a growing workforce. Consequently, while
unemployment has trended down, it remains at unacceptably high levels.
Investment spending in the first half of 2012 appears to be growing at a restrained
pace, likely reflecting continued subdued confidence and elevated uncertainty.
Corporate balance sheets are generally strong, and large businesses have access to
ample financing in the capital markets. Smaller businesses, in contrast, continue to
face a more challenging operating environment that has constrained their recovery.
Consumption continues to expand, but U.S. households still see only modest
growth in income. Housing remains a drag on household balance sheets
and weighs on broader economic activity, as housing wealth has declined by
50 percent or $6.8 trillion from its peak in 2006:Q1 to 2012:Q1. Aggregate
household debt is declining gradually, but remains well above historical levels
as a percentage of GDP. Access to mortgage credit is still constrained for many
households, limiting the extent to which they can benefit from low interest
rates. Overall, the mortgage market remains dependent on the Federal Housing
Administration and the government-sponsored enterprises (GSEs). Housing
activity remains weak, but there are some positive signs emerging in recent data.
Fiscal policy is no longer providing support to growth as it did in 2009-2010, and
the federal deficit is declining as a share of GDP. In addition, states and localities
are a drag on demand and employment as they struggle to repair their finances.
However, the U.S. government has benefited from very low interest costs, a factor
that will reverse over time as monetary policy normalizes.
In the long run, U.S. budgetary trends are unsustainable and must be addressed
in a manner that is consistent with supporting the ongoing recovery. The aging of
the population and the rising costs for health care will add to long-term deficits.
States and localities remain challenged by unfunded pension obligations.
Abroad, growth in Europe has slowed sharply as GDP has declined in a
number of nations. Growth in most emerging market economies (EMEs)
remains high relative to the industrialized world, but has been slower of late,
with more variation in performance. EMEs, particularly China, have taken an
increasingly important role in the global economy. However, dependence on
export and investment-led growth leaves many of these economies exposed to
weaker prospects in the developed world. Weak global growth limits the selfhealing capacity of financial institutions and can put stress on parts of the
financial system.

Financial Developments
Market volatility increased sharply in the summer and fall of 2011 around the
U.S. debt ceiling debate, and intensified at the end of 2011 and in the spring
and early summer of 2012 amid concern over Europe. The debt limit debate and
questions about the political will to resolve U.S. fiscal challenges led Standard
and Poor’s to downgrade the long-term sovereign credit rating of the United
States from AAA to AA+ in August 2011. However, demand for U.S. sovereign
debt remains strong. As sovereign bond yields in the euro area periphery
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increased, sovereign yields in the United States, Japan, the United Kingdom
and Germany declined further and are now at historically low levels. These
low yields reflect both safe-haven inflows as well as expectations that global
economic weakness may warrant prolonged monetary policy accommodation.
Extraordinarily low interest rates provide essential support to growth and
jobs, but this low-growth, low-rate environment represents a challenge for life
insurers, pension funds, money market funds (MMFs), and some banks and
credit unions, which invest the savings of many Americans.
Financial stress in Europe and consequent spillovers to the United States has
been mitigated to some degree by the aggressive provision of liquidity within
the euro area. In the initial stages of the crisis, the European Central Bank
(ECB) purchased peripheral sovereign debt directly. U.S. dollar swap lines were
extended and their fees reduced, and the ECB conducted two large longer-term
refinancing operations and authorized further financing under the Emergency
Liquidity Assistance process for banks in the hardest-hit countries.
U.S. financial institutions have strengthened their balance sheets by augmenting
their capital levels and by accumulating more liquid assets. They also have more
stable funding profiles than in recent years, with greater use of deposits and less
reliance on short-term wholesale funding. The number of bank failures has been
decreasing since 2010, and the FDIC’s list of problem banks is shrinking.
Within the euro area, a number of banking systems remain under stress.
Recently, the Spanish government announced plans to strengthen its bank
recapitalization fund with EU support. In late June 2012, euro area heads of
government proposed to allow the European Stability Mechanism (ESM) to
recapitalize banks directly, rather than through national governments, and to
establish a single European banking supervisor. At a subsequent meeting on July
9, euro area finance ministers welcomed the European Commission’s intention
to present proposals in early September for a single supervisory mechanism
involving the ECB, with the European Council expected to consider these
proposals by the end of 2012.
Meanwhile, European financial institutions are reducing their share of lending
activity—including sovereign debt purchases—in other euro area states. Crossborder financing of current account deficits by private sector financial institutions
in core Europe has declined. Official sector funding, notably in the form of ECB
loans to banks in peripheral Europe, is making up for this decline.
Periods of risk aversion in short-term funding markets, particularly in the fall of
2011, have only reinforced the need to promptly address sources of vulnerability
in these markets, such as weaknesses in the tri-party repo infrastructure and
among money market funds. Over the past year, the U.S. tri-party repo market
continued to shift away from non-traditional, riskier collateral towards Treasury
and agency obligations. However, limited progress has been made in substantially
reducing the reliance of this market on intraday credit or improving riskmanagement and collateral practices to avoid fire sales in the event of a large
dealer default. Money market funds continue to maintain short weighted average
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maturities and have shifted their portfolio composition more toward government
debt and repurchase agreements, although they retain some exposure to riskier
assets. As highlighted last year, money market funds remain susceptible to
destabilizing runs because the commitment to a stable net asset value, without
the requisite buffers to absorb losses, gives investors, particularly institutional
investors, an incentive to be the first movers in redeeming shares.
Meanwhile, advances in technology continue to transform the business of
trading, providing financial markets with enhanced speed and efficiency while
potentially enabling increased transparency. The market infrastructure has
generally functioned well over the past year. Still, the trend towards high-speed
algorithmic trading, and the resulting increases in market complexity, may create
vulnerabilities like those witnessed in the “flash crash” of 2010.

Dodd-Frank Implementation and Activities of the Financial Stability Oversight Council
Over the past year, financial regulators have focused on strengthening the
financial system against potential threats and eliminating incentives to take
excessive risk. These efforts are most notable in steps to implement the DoddFrank Act. The financial reforms in the Dodd-Frank Act are designed to create a
more resilient financial system that is better able to absorb a wide range of shocks,
whether they originate within the financial system (as with the subprime crisis of
2007), outside it (for instance in the event of an oil price shock), or a combination
of the two (as is the case with the problems in the euro area). Regulators are
making progress in implementing the Dodd-Frank Act in a consistent and
coordinated manner. The reform effort has proceeded along four broad
dimensions: strengthening the safety and soundness of core financial institutions;
making financial markets more resilient and transparent; implementing new
authorities to resolve large, complex financial institutions; and enhancing investor
and consumer protections.
As a result of this effort, federal banking regulators have imposed tougher
standards on the largest, most complex financial institutions. The Federal
Reserve has proposed enhanced prudential standards for large bank holding
companies—standards that will also apply to nonbank financial companies
designated by the Council for Federal Reserve supervision. Through the
Comprehensive Capital Analysis and Review (CCAR) process, it evaluated bank
holding companies’ capital planning processes to ensure that they would remain
well capitalized in a stressed economic scenario. In addition, the Federal Reserve,
FDIC, OCC, SEC, and CFTC proposed substantively identical proposals to
implement the Volcker Rule, which prohibits banks from engaging in proprietary
trading, and (subject to certain exemptions) from owning, sponsoring, or having
certain relationships with, a hedge fund or private equity fund. In June 2012,
federal banking regulators finalized changes to the market risk capital rule to
better reflect the risks faced by an institution and to help ensure the adequacy
of capital related to an institution’s trading positions. Concurrently, they invited
comment on three joint proposed rules to implement Basel III and the DoddFrank Act that will increase the amount of high-quality capital banks are required
to hold relative to their risk exposures.

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Regulators led by the FDIC have also taken important steps to build a framework
under the “orderly liquidation authority” (OLA) that could be used to resolve a
large failing financial company in cases where normal bankruptcy would have
serious adverse effects on financial stability in the United States. The purpose of
OLA is to ensure that in the event of a big financial company’s failure the cost is
borne by its shareholders and creditors and not the U.S. taxpayer. Establishing
the framework under OLA and progressively working through the many practical
issues required to implement this authority is essential to end the perception
that some financial companies are “too big to fail” and to address other moral
hazard problems. The Dodd-Frank Act also requires the largest bank holding
companies to produce resolution plans or “living wills” to explain how they could
be resolved in an orderly manner if they failed. In July 2012 the first such plans
were submitted to the Federal Reserve and the FDIC.
A stable financial system also requires resilient and transparent markets. To this
end, the CFTC and SEC have proposed and begun to finalize rules that will
provide, for the first time, a comprehensive regulatory framework for the overthe-counter derivatives market. The CFTC and SEC have adopted final rules that
provide precise definitions of the instruments and entities to be covered. The
CFTC has adopted rules that increase market transparency for both the public
and regulators; provide for centralized reporting of trades; require swap dealers
to establish risk-management policies; and require swap dealers to interact fairly
with customers in their sales practices. In addition, the CFTC has completed
rules related to designated contract markets, which will be able to list and trade
swaps, and position reporting rules for physical commodity swaps. Regulators
are also working together to strengthen financial market utilities (FMUs)—the
infrastructures that transfer, clear, and settle financial trades—to enhance their
ability to withstand the failure of participating firms. To this end, the Federal
Reserve and the SEC have proposed, and the CFTC has finalized, rules for FMUs,
including rules establishing risk-management requirements for these entities. In
addition, the Council has made its initial designations of systemically important
FMUs. The Office of Financial Research (OFR) is making substantial progress to
improve the quality and availability of financial market data.
Regulators continue to bring greater transparency to the financial markets. The
SEC has implemented the Dodd-Frank Act’s requirement that advisers to most
hedge funds and certain other private funds register with the SEC. As of March
31, 2012, public reporting of the identities of these advisers is required, as well as
information about the private funds’ size and key service providers. In addition,
in October 2011 the SEC and CFTC adopted a joint rule that requires non-public
reporting by certain advisers to hedge funds and other private funds to facilitate
the assessment of systemic risk. This non-public reporting includes information
about the operations and risk profiles of these private funds, which will enable
regulators to review risk trends over time.
Regulators are working to strengthen protections for consumers and investors.
Notably, the CFPB has adopted and proposed a variety of rules required
under the Dodd-Frank Act, including the adoption of new rules to provide
protections to consumers who make remittance transfers and the proposal of
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rules to consolidate mortgage loan disclosure forms to make loan information
more useful to consumers and to reduce burdens on lenders. In addition, the
CFPB launched its supervision program for very large depository institutions
(in coordination with prudential regulators) and for certain nonbanks. It
has established its consumer response function, and assumed rulemaking
responsibility for federal consumer financial laws.
Because financial markets are global, U.S. authorities are closely engaged
in international regulatory negotiations as they continue to implement the
Dodd-Frank Act. The effectiveness of reform at home could be undermined
if risk is able to migrate to jurisdictions with weaker standards. Therefore, it is
essential to have internationally consistent regulations on capital and liquidity,
resolution regimes, derivatives markets and regulation of large, complex financial
institutions, while acknowledging that individual countries may require different
approaches based on structural differences in their financial systems. The task of
achieving strong and consistent global standards is essential because the ultimate
outcomes of U.S. and international reform efforts are intimately connected.
While much progress has been made, U.S. regulators are operating with
limited resources to implement reforms that apply to very complex markets and
institutions and are essential for the national economic interest. Ultimately, for
these reforms to be successful, regulators must have the necessary resources to
undertake their policymaking, supervisory and enforcement responsibilities.
The Council—which brings together our many different regulatory agencies—
has convened 12 times since last year’s report to share information on key
financial developments, coordinate on regulatory implementation, and monitor
progress on recommendations from the first annual report. The Council finalized
a rule outlining the process it will use for determining which nonbank financial
companies will be supervised by the Federal Reserve and subject to enhanced
prudential standards, including resolution planning requirements. As previously
discussed, the Council has also designated an initial set of systemically important
financial market utilities that will be subject to enhanced risk-management
standards. It remains focused on both identifying near-term threats and
addressing structural vulnerabilities in the financial system.

Potential Emerging Threats to U.S. Financial Stability
Threats to financial stability, like threats to national security, are always present,
even if they are not always easy to discern in advance. The euro area poses an
obvious risk to U.S. financial stability. To date, euro area authorities have been
able to prevent a major dislocation by providing large quantities of liquidity to
their banking systems, and by providing official sector funding on a case-bycase basis, conditional on fiscal and structural reforms, for nations that have
lost market access. The nations under stress have taken painful steps to reduce
structural fiscal deficits, and have undertaken some economic liberalization
in an effort to boost growth and competitiveness. Euro area leaders have also
taken actions towards recapitalizing troubled banks. However, the uncertainty
surrounding euro area developments remains high.

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Many argue that the euro area needs a more system-wide solution that deepens
financial and fiscal integration and completes economic and monetary union.
Such a solution might include a roadmap to strengthen the institutional
foundations of the euro, with appropriate governance and incentives, as well as a
credible crisis-fighting bridge to that future set of arrangements.
Moreover, the challenges surrounding Greece have focused market attention
on the sustainability of countries’ euro membership and the costs of a potential
euro breakup. The establishment of the single currency was a remarkable step
towards greater European unity, and dissolution of the euro would come at
great cost. Specifically, market participants highlight credit risk, legal risk, and
redenomination risk—the risk that obligations due in euros will be repaid in an
alternative, less valuable, currency.
The direct net exposures of large U.S. banks to the most stressed euro area
sovereigns are very small relative to capital. However, a systemic crisis in Europe,
in which contagion and spillover effects spread widely among euro area countries
and markets, represents a significant risk for U.S. institutions. In addition, asset
price declines due to shocks originating in the euro area would likely have an
adverse impact on the balance sheets of U.S. institutions, as would a generalized
deterioration in market sentiment due to increased European volatility.
While Europe is the principal financial stability risk facing the U.S. financial
system today, it is not the only source of potential threat. The U.S. recovery has
not yet transitioned from moderate to self-sustainable growth. The “fiscal cliff”
around year end—including expiration of the tax cuts originally enacted in
2001 and 2003, the expiration of payroll tax cuts and extended unemployment
benefits, and the Budget Control Act-mandated sequester—represents a threat to
the recovery and financial stability if not addressed.
Structural and cyclical weaknesses persist in the housing sector, including the
large number of households with low or negative equity in their homes. As a
result, the housing market could face increased pressures should there be a
slowdown in economic growth. Meanwhile, cybersecurity remains a constant area
of concern and potential vulnerability.
Risks could also arise from uncertainty about the vigor of global growth outside
Europe, including in the emerging markets. Authorities in China and a number
of other EMEs face the challenge of supporting demand and employment at a
time of weakness in the industrialized world while attempting to avoid fuelling
domestic real estate bubbles. China’s substantial contribution to global growth
and its purchases of advanced economy debt mean that a hard landing there
would have important implications for the U.S. economy.
It is essential to enhance the resilience of the financial system against both the
threats that we can identify today and ones we cannot. Vulnerabilities in the
financial system can be grouped into three broad classes or types: inherent
vulnerabilities (features of our financial system that will always make financial
markets and institutions fragile), potential control weaknesses (failures in
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operations, risk management, and governance), and behavioral vulnerabilities
(incentives to take too much risk).
One area that merits ongoing scrutiny is the potential interaction between reliance
on short-term wholesale funding (an inherent vulnerability) and incentives to
“reach for yield” (a behavioral vulnerability) in a low interest rate environment,
for instance, by taking on excessive duration or credit risk or by shortening the
tenor of funding. Some nonbank financial companies already rely heavily on
short-term market financing, which could represent a source of instability if
borrowers were to have difficulty rolling over liabilities in a time of stress. For
example, while short-term funding markets were not disrupted by the recent
downgrades of internationally active financial institutions, these events are causing
market participants to reevaluate both concentration and duration of exposures
in these markets. While the use of short-term liabilities to fund long-term assets
is central to financial intermediation, the risks associated with this practice must
be carefully managed and subjected to appropriate oversight. Events over the
past year have also highlighted the importance of potential control weaknesses
particularly for concentrated exposures or complex trading strategies.
While member agencies of the Council are engaged in implementing the DoddFrank Act, much of the Council’s attention has also been on vulnerabilities
that require additional focus beyond Dodd-Frank rulemaking. As emphasized
in last year’s report, the instability of short-term wholesale funding markets is
exacerbated by ongoing structural vulnerabilities in the tri-party repo market and
in the money market fund industry. These vulnerabilities cannot be adequately
addressed only at the firm level and must be tackled at the system level.
Consistent with the recommendation of the Council last year, the Federal
Reserve has now taken a more direct supervisory approach to pursuing the
necessary changes to the tri-party repo market. Similarly, the SEC continues to
work through policy options for much needed reform of money market funds.
Section 3 of this report sets out the Council’s 2012 recommendations in these and
other areas.
The Council remains vigilant against potential shocks and vulnerabilities in
financial markets. Regulators cannot eliminate risk nor provide guarantees that
in the event of a major disruption in the euro area or elsewhere, there would
be no impact on U.S. financial stability. However, thanks in part to progress on
financial reform, the U.S. financial system is stronger and better able to absorb
shocks than was the case even a year ago. Moreover, the member agencies of the
Council have important tools to combat contagion and mitigate its effects on our
national economy, and will not hesitate to use these tools should the national
interest require them.

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Annual Report Recommendations
The Dodd-Frank Act requires the Council to make annual recommendations
to: (1) enhance the integrity, efficiency, competitiveness, and stability of U.S.
financial markets; (2) promote market discipline; and (3) maintain investor
confidence. In this section, we discuss the ongoing work of the Council, its
members, and the private sector to address these important mandates and lay out
concrete recommendations.

3.1	

Reforms to Address Structural Vulnerabilities

Reforming Structural Vulnerabilities in Wholesale Short-Term Funding Markets
Stable wholesale short-term funding markets are a critical component of a wellfunctioning financial system, but if they suffer disruptions, these markets can
rapidly spread shocks across financial institutions. The Council continues to be
particularly focused on structural vulnerabilities in money market funds (MMFs)
and the tri-party repo market, as follows.

Money Market Funds
The Council continues to support the implementation of structural reforms
to mitigate the run risk in MMFs. Specifically, these reforms are intended to
address the structural features of MMFs that caused a run on prime MMFs and
the freezing of the short-term credit markets after the Reserve Primary Fund was
unable to maintain a stable net asset value (NAV) in September 2008. In 2010,
the SEC adopted MMF reforms designed to make MMF portfolios more resilient
by improving credit quality standards, reducing maturities, and—for the first
time—instituting liquidity requirements. The 2010 reforms appear to be working
as designed and meeting the intended goals. However, the SEC’s 2010 reforms
did not address—and were not intended to address—two core characteristics of
MMFs that continue to contribute to their susceptibility to destabilizing runs.
First, MMFs have no mechanism to absorb a sudden loss in the value of a portfolio
security, without threatening the stable $1.00 NAV. Second, there continues to be
a “first mover advantage” in MMFs, which can lead investors to redeem at the first
indication of any perceived threat to the value or liquidity of the MMF.
SEC Chairman Schapiro recommended two alternative reforms to address these
remaining structural fragilities. They are (1) a mandatory floating NAV; and/
or (2) a capital buffer to absorb losses, possibly combined with a redemption
restriction to reduce the incentive to exit the fund. The Council supports this
effort and recommends that the SEC publish structural reform options for public
comment and ultimately adopt reforms that address MMFs’ susceptibility to runs.
In addition, the OCC issued a proposed rulemaking in April 2012 that would
partially align the requirements for short-term bank common and collective
investment funds (STIFs) with the SEC’s revisions to Rule 2a-7 under the
Investment Company Act. In an effort to impose comparable standards on
Annual Repor t Recommendations

11

comparable financial activities, the Council further recommends that, where
applicable, its members align regulation of cash management vehicles similar
to MMFs within their regulatory jurisdiction to limit the susceptibility of these
vehicles to run risk.

Tri-Party Repo Market
The elimination of most intraday credit exposure and the reform of collateral
practices in the tri-party repo market continues to be an area of intense focus for
the Council. The Tri‐Party Repo Infrastructure Reform Task Force was formed
in September 2009 in response to the financial crisis. Before being disbanded in
February 2012, the Task Force accomplished a number of changes in process and
practice that laid a foundation for future risk reduction, including: (1) moving
the daily unwind of some repos from 8:30 a.m. to 3:30 p.m., which shortens the
period of credit exposure; (2) introducing automated collateral substitution; and
(3) introducing three-way trade confirmation functionality. While important,
these changes do not meaningfully reduce reliance on intraday credit from the
clearing banks.
The industry has indicated that elimination of intraday credit associated with
tri-party settlement will be a multi-year effort. The Council views this proposed
timeline as unacceptable to achieve timely substantive reductions in risk. The
Council recommends that the industry implement near-term steps to reduce
intraday credit usage within the next 6 to 12 months and an iterative strategy over
six-month increments to continue both to reduce intraday credit substantially
and to implement improvements in risk-management practices across all market
participants. In addition, the Council recommends that regulators and industry
participants work together to define standards for collateral management in
tri-party repo markets, particularly for lenders, such as MMFs, that have legal or
operational restrictions on the instruments that they can hold.

Customer Protection Standards and Segregation of Customer Assets
Financial intermediaries hold customer assets for a variety of purposes, such as
maintaining cash balances prior to investment and as margin. Intermediaries
are able to increase efficiencies and lower costs for their customers by investing,
and earning a return on, these customer assets. However, appropriate limits
on the ways in which intermediaries can use these assets, including customer
segregation rules, are a necessary part of strong customer protection standards
that contribute to market integrity and confidence. Customer protection
standards also help ensure the prompt return of assets to customers in the event
of a financial intermediary’s insolvency. Recent developments highlight the
importance of such standards, including protection standards for trading in
foreign markets, that are well-understood by market participants and enforced
by regulators.
The CFTC and SEC recently took a number of actions to maintain strong
standards for customer protection. Specifically, in December 2011, the CFTC
amended its rules to add additional safeguards to the processes whereby
customer funds may be invested by derivatives clearing organizations and futures
commission merchants. In addition, in February 2012, the CFTC adopted new
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standards to protect the collateral posted by customers clearing swaps through
futures commission merchants on derivatives clearing organizations. Further, the
SEC recently reopened the comment period on a 2007 proposal to amend certain
customer protection rules.
The Council recommends that regulators continue to take steps to enforce
existing customer protection standards and to enhance such standards going
forward, particularly in light of the reforms to the swaps market introduced by
the Dodd-Frank Act. The Council further recommends that regulators consider
strengthening regulations governing the holding and protection of customer
funds deposited for trading on foreign futures markets.

Clearinghouse Risk Management
The Dodd-Frank Act mandates central clearing of standardized swaps to mitigate
the counterparty risk inherent in bilateral, over-the-counter (OTC) transactions.
Although central clearing decreases counterparty risk, it also increases the
concentration and operational risks presented by a clearinghouse standing
between the two sides of numerous transactions.
The Dodd-Frank Act provides various tools that can be used to address this
increased concentration risk. For example, the Council is authorized to designate
financial market utilities as systemically important, which subjects such utilities
to heightened risk-management standards. As discussed in more detail in Section
6, the Council recently designated a number of financial market utilities. The
CFTC and SEC also took actions to further strengthen clearinghouse riskmanagement standards. For example, in November 2011, the CFTC adopted
new risk-management standards for derivatives clearing organizations and
the SEC continues to work to finalize rules on risk-management standards for
clearing agencies.
The Council recommends that regulators continue to seek ways to strengthen the
risk-management standards for clearinghouses and to work together to monitor
clearinghouse practices across their respective jurisdictions to determine industry
best practices that could be followed more broadly.

3.2	

Heightened Risk Management and Supervisory Attention

Robust Capital and Liquidity Planning
Capital and liquidity buffers form the most fundamental protection for the
broader financial system and the economy against unexpected risks or failures
of risk management at financial institutions. Consistent with the Council’s
2011 report, considerable progress has been made over the past 12 months on
robust capital and liquidity planning at U.S. financial institutions. In addition
to carrying out the 2012 Comprehensive Capital Analysis and Review (CCAR)
exercise, the Federal Reserve proposed enhanced prudential standards, including
capital and liquidity planning requirements, for the largest bank holding
companies and for nonbank financial companies designated by the Council.
Jointly with the FDIC and OCC, the Federal Reserve released supervisory
guidance on stress testing for all banking organizations with total consolidated
Annual Repor t Recommendations

13

assets over $10 billion in May 2012. In June 2012, the Federal Reserve, FDIC, and
OCC invited public comment on three proposed rules that would implement
in the United States the Basel III and other regulatory capital reforms and
the changes required by the Dodd-Frank Act. Concurrently, the agencies also
approved a final rule to implement changes to the market risk capital rule.
The Council recommends continued interagency coordination on regulation to
help ensure enhanced capital planning and robust capital buffers for financial
institutions. The Council also recommends continued research and development
of stress-test methodologies to reflect evolution of the financial markets.
On liquidity planning, supervisors and private sector risk managers should
closely monitor the risks inherent in short-term funding of longer-term assets.
Although this practice is an essential function of the financial system, institutions
should refrain from over-reliance on wholesale short-term funding where it could
create additional vulnerabilities in extreme but plausible stress scenarios. In
2010, the federal banking agencies, state bank regulators, and the NCUA issued
a policy statement on funding and liquidity risk management that addressed the
importance of cash flow projections, diversified funding sources, stress testing,
a cushion of liquid assets, and a formal, well-developed contingency funding
plan as primary tools for measuring and managing liquidity risk. In late 2011,
the Federal Reserve proposed a rule to require enhanced risk management of
funding and liquidity risk by U.S. bank holding companies with total consolidated
assets of $50 billion or more. In addition, the Basel III liquidity framework
augments these expectations and proposes thresholds for short-term and longerterm funding resilience. The Council recommends that financial institutions take
particular care to construct their funding models to be resilient to disruptions in
wholesale short-term funding markets.

Effective Resolution Plans
Effective resolution plans for the largest financial institutions are important
supervisory tools to address the operational and legal complexity of these
firms on an ongoing basis, as well as to implement the new orderly liquidation
authority. Last fall, the Federal Reserve Board and the FDIC approved a final rule
that requires bank holding companies with total consolidated assets of $50 billion
or more and nonbank financial companies designated by the Council to develop,
maintain, and periodically submit resolution plans, also known as “living wills.”
The FDIC also issued another rule requiring FDIC-insured depository institutions
with assets of $50 billion or more to file resolution plans. Taken together, these
resolution plan requirements will improve efficiencies, risk management, and
contingency planning. The Council recommends that firms use these plans
to reduce organizational complexity to facilitate orderly resolution under the
bankruptcy code.

Bolster Resilience to Interest Rate Shifts
While the ongoing environment of low interest rates supports the economic
recovery, it can also pose particular challenges for financial institutions
by compressing net interest margins and inducing losses on products with
guaranteed returns, leading such institutions to pursue riskier investment
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strategies in an effort to “reach for yield.” Often, such strategies only show their
negative consequences when a shift occurs in interest rates or credit conditions.
Banking regulators and the NCUA, working with the Federal Financial
Institutions Examination Council (FFIEC), released an advisory on Interest
Rate Risk Management in January 2010 and provided additional clarification
on this advisory through the issuance of an FAQ in January 2012. This guidance
recommends stress testing for: (1) instantaneous and significant changes in the
level of interest rates; (2) substantial changes in rates over time; (3) changes in
the relationships among key market rates; and (4) changes in the slope and the
shape of the yield curve. The NCUA also issued a final rule in January 2012 aimed
at mitigating interest rate risk in credit unions.
The Council recommends that regulatory agencies and private sector risk
managers continue their scrutiny of how potential changes in interest rates could
adversely affect the risk profiles of financial firms and recommends using extreme
but plausible interest rate scenarios in stress testing.

Maintain Discipline in Complex Trading Strategies, Underwriting, and New
Financial Products
Events in the past year, including the publicly announced trading loss at
JPMorgan Chase, demonstrate the importance of robust risk management
when addressing complex trading strategies, illiquid positions, or concentrated
exposures to areas of heightened risk. Such risk-management practices include:
strong and clear lines of authority, reporting, and oversight; rigorous and
ongoing validation of models used to design, execute, and control trading
strategies; a formal process for changes to approved models; appropriate risk
limits and metrics; and strong capital buffers. The Council recommends that
financial institutions’ senior management establish, and directors approve,
strong risk-management and reporting structures to help ensure that risks are
assessed independently and at appropriately senior levels. The Council further
recommends that institutions establish clear accountability for failures of
risk management.
While these examples highlight the importance of risk management in
trading strategies, similar dynamics operate in maintaining disciplined credit
underwriting standards and in vetting emerging financial products. In its 2011
Report, the Council noted the importance of maintaining discipline in credit
underwriting standards and responding appropriately when there are signs
that loan terms may allow borrowers to take on excessive risk. The 2011 Report
also highlighted leveraged lending as an area for continued monitoring. While
there was a pull-back in leveraged lending during the crisis, volumes have since
increased while underwriting practices have deteriorated. In response to these
trends, the federal banking agencies in March 2012 issued for comment revised
and strengthened supervisory guidance to govern leveraged transactions financed
by banks. The Council recommends that oversight of all of these activities
continue to form an ongoing focus of supervisors’ efforts and the Council’s
monitoring of the financial system.

Annual Repor t Recommendations

15

High-Speed Trading
High-speed trading activities, combined with automated mechanisms for the
generation, transmission, and matching of orders, represent technological
developments that require particular attention. Speed and automation confer
important advantages to financial markets. However, potential operational, credit,
transmission, and other risks require careful monitoring. This is particularly
true for markets that have limited experience with high-speed and algorithmic
trading or where regulatory circuit breakers are not in place. In its 2011 Annual
Report, the Council stressed the importance of keeping pace with competitive
and technological developments in financial markets. The SEC and CFTC have
taken a number of steps to address potential risks, such as facilitating improved
audit trails for surveillance use by regulatory authorities, and requiring risk
controls that pause or halt trading in securities and futures markets, including a
new “limit up-limit down” for equity securities (described further in Section 6).
For example, in July 2012, the SEC adopted a rule requiring the self-regulatory
organizations (SROs) to develop a plan to create a consolidated audit trail that
would provide for a centralized order tracking system—capturing customer
and order event information for orders in exchange-listed equities and equity
options, across all markets, from the time of order inception, through routing,
cancellation, modification, or execution. This single tracking system would
enable regulators to monitor trading that is widely dispersed across a variety of
market centers. The Council supports these efforts by the two Commissions. More
generally, the Council recognizes that acceleration in the speed and automation
of trade execution requires a parallel acceleration in trading risk management
and controls. The Council recommends that the CFTC and SEC consider error
control and risk-management standards for exchanges, clearing firms, and other
market participants that are relevant for a high-speed trading environment.
The Council also recommends that the CFTC and SEC continue to track
developments in current and evolving market structure and analyze the need for
policy responses when appropriate.

Issues Related to Cybersecurity
The quickly evolving cyber threat environment requires strengthening the
ongoing collaboration and coordination among financial regulators and private
entities in the financial sector. The Council recommends continued engagement
by financial regulators with both public and private sector organizations to
identify and respond to emerging cyber threats against the financial system.
The development of mechanisms for sharing information related to cyber
threats and vulnerabilities should continue to be explored. Regulators should
continue to take steps to help ensure that information security standards for
financial institutions are appropriate to the current threat environment, and that
examinations assess institutions’ performance against those standards.

3.3	

Housing Finance Reforms

Reforms to the Housing Finance System
The U.S. housing finance system has required extraordinary federal government
support over the past several years. Since September 2008, Freddie Mac and
Fannie Mae (the government-sponsored enterprises, or GSEs) have been in
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conservatorship under FHFA. Even today, nearly four years later, approximately
90 percent of newly issued mortgages carry some form of government support,
and the market continues to lack sufficient private capital to back residential
mortgage credit risk.
During the past year, certain member agencies of the Council worked on
a framework for housing reform that facilitates increased private sector
involvement, while protecting consumers from abuses and reducing taxpayer
exposures. In early 2012, FHFA released a Strategic Plan for the GSEs to develop
approaches to mortgage finance infrastructure that could support any potential
path towards broader housing reform going forward. The Strategic Plan is
designed to reduce the GSEs’ risk profile and to increase incentives for the private
sector to absorb mortgage credit risk through improved pricing and enhanced
risk sharing. At the same time, it preserves a role for the GSEs in mitigating credit
losses from the legacy book and providing foreclosure alternatives to borrowers.
In addition, the CFPB is working toward implementing important Dodd-Frank
Act rules to help ensure that lenders make a reasonable determination, based
on verified information, that a consumer has the ability to repay a loan. Such
provisions can help protect consumers from many of the abuses that led up to the
crisis and can improve transparency and confidence in the mortgage markets.
Member agencies of the Council are also working to promote more efficient
markets for residential mortgage-backed securities (RMBS). In particular, the
SEC continues to consider appropriate disclosure rules for RMBS, forming part
of its Regulation AB, which will provide private market participants with more
transparent information about the assets underlying RMBS. Enhanced clarity
and guidelines for asset-backed securities, including securitization of residential
mortgages, is also the goal of work by five Council member agencies, along with
the U.S. Department of Housing and Urban Development (HUD), on the DoddFrank Act’s risk retention rule.
All of these efforts are important near-term steps to encourage private capital
to take on additional mortgage credit risk. Nonetheless, additional certainty is
necessary about the future of housing finance infrastructure and related policy
issues to further promote the return of private capital. In particular, there do
not yet exist broadly agreed-upon standards to characterize the quality and
consistency of mortgage underwriting. Such standards are necessary to support
the valuation and liquidity of mortgage-backed instruments. There continue to
be non-uniform foreclosure practices across different states. And there remains
uncertainty about the legal liability of a mortgage securitizer should a loan fail
to conform to representations and warranties that were made about specific
loan characteristics.
Treasury and HUD, in their joint white paper on longer-term housing
finance reform released in February 2011, put forth a range of options for the
government’s role in a privatized system of housing finance. Treasury continues to
evaluate these options and continues to pursue working with Congress on these
issues to support a safer and more robust long-term housing finance system.
Annual Repor t Recommendations

17

The Council recommends continued work to develop a long-term housing
finance reform framework that supports the central role of private capital and
the emphasis on consumer and investor protections in any future housing finance
system. It is critical for the Council members, HUD, and Congress to continue
their work to develop standards and best practices. In addressing these issues,
Council members should be mindful of the important role of housing in the
economy, the nascent recovery, and household finances and act to balance these
concerns. As the Council members, HUD, and Congress continue their work to
establish a new and lasting system for housing finance, it is critical to address the
weaknesses that became evident in the recent housing crisis.

Mortgage Servicing Standards and Servicer Compensation Reform
The Council continues to focus on the need for national mortgage servicing
standards and servicer compensation reform to strengthen confidence in the
mortgage market. The lack of clear servicing standards in the period leading up
to the housing crisis led to problems in assisting borrowers to avoid foreclosure,
inappropriate servicing practices, and additional losses for investors.
In early 2011, the federal prudential banking regulators, along with HUD, FHFA,
and Treasury, formed an interagency working group to address the need for
fair, clear, and uniform national servicing standards. This followed an earlier
review by the Federal Reserve, OCC, and FDIC of major servicers that resulted
in supervisory consent orders that are now being implemented by the largest
mortgage servicers. Also in April 2011, FHFA announced the Servicing Alignment
Initiative for Fannie Mae and Freddie Mac, which produced a consistent set of
protocols for servicing mortgages from the onset of delinquency. In February
2012, the federal government (led by the Department of Justice, together with
Treasury and HUD) and 49 states reached a $25 billion settlement with the
nation’s five largest mortgage servicers to address mortgage loan servicing and
foreclosure abuses. The CFPB joined the interagency working group in July 2011,
and in April 2012 provided a public outline of its plans for mortgage servicing
regulations, with formal rules expected to be proposed for comment this summer.
In addition, in September 2011, the Joint Mortgage Servicing Compensation
Initiative, launched by FHFA, released a discussion document seeking comments
on two alternative servicing compensation structures for servicing single-family
mortgages. The current structure of mortgage servicing compensation could
have contributed to an underinvestment in servicing capacity and greater
concentration in the mortgage servicing industry. One proposal would establish a
reserve account within the current compensation structure that could be used to
increase servicing capacity in times of stress. The other proposal would create a
new fee-for-service compensation structure to better align incentives and reduce
the capital intensity of mortgage servicing assets.
Mortgage servicing standards can contribute to long-term servicing improvements
for all borrowers and other participants in the mortgage market. The Council
recommends that the FHFA, HUD, CFPB, and the other agencies, as necessary,
develop comprehensive mortgage servicing standards that require consistent
and transparent processes for consumers and promote efficient alternatives to
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foreclosure where appropriate. In addition, the Council recommends continued
efforts to implement compensation structures that align the incentives of
mortgage servicing with those of borrowers and other participants in the
mortgage market.

3.4	

Progress on Implementation and Coordination of Financial Reform

The Dodd-Frank Act
In the two years since the Dodd-Frank Act became law, members of the Council
and their agencies have proposed and finalized a substantial number of rules
implementing provisions of the Act, and they continue to work on additional rules
in a coordinated manner. The reforms in the Dodd-Frank Act strengthen the
resilience of the financial system and provide a clear agenda for the regulatory
community to address vulnerabilities exposed in the recent crisis. As described
in Section 6, the Dodd-Frank Act establishes new protections for financial
consumers and investors. It improves financial markets through designation of
and enhanced risk-management standards for systemically important financial
market utilities. It provides for private fund adviser registration and reporting
and imposes constraints on risk as well as transparency requirements for
derivatives markets. In conjunction with international agreements on consistent
global prudential standards, the Dodd-Frank Act will require financial firms to
operate with larger capital and liquidity buffers and better risk controls, and it
requires firms to submit resolution plans to the FDIC, Federal Reserve, and the
Council. Finally, the Dodd-Frank Act provides important new authority to resolve
a large, complex financial institution in an orderly manner.
Finalizing the rulemakings under the Dodd-Frank Act and implementing the
required changes effectively will require close coordination among the regulatory
community and open dialogue with the public and industry. To meet the
challenges of designing and enforcing these new rules, the resources dedicated
to financial oversight must increase. Regulatory agencies must have sufficient
resources to attract and retain talented individuals, acquire needed data, develop
the requisite analytic capabilities, and invest in systems to monitor market activity
and enforce the new rules. The Council recommends complete and expeditious
implementation of the Dodd-Frank Act, along with the provision of the resources
needed to accomplish this essential task.

International Coordination
In its 2011 Annual Report, the Council stressed the importance of international
financial regulatory coordination. Financial markets are global in scope, while
regulation proceeds at the national level. To promote a level global playing field
and to diminish the risk of having capital flow to the jurisdiction with the least
restrictive regulatory regime, it is essential to have internationally strong and
consistent regulations that form a coherent and effective whole, while allowing an
appropriate degree of autonomy for individual countries to accommodate their
own particular needs. It is particularly important for international regulators to
consistently apply strong, well-calibrated standards for the critical areas of capital,
liquidity, derivatives, central clearing, and failure resolution.

Annual Repor t Recommendations

19

Considerable progress has been made over the past year on coordinating
regulatory principles internationally. National regulators continue to implement
the Basel III standards; and in June 2012, the Federal Reserve, OCC, and FDIC
jointly issued the finalized market risk capital rules, as well as three notices of
proposed rulemaking (NPR), that would replace the agencies’ current capital
requirements with requirements consistent with aspects of Basel II, Basel 2.5
and Basel III. The translation of these international agreements to domestic
regulation is a key step in the regulatory reform efforts and is critical for
enhancing the resiliency of regulated financial institutions and the financial
system more generally.
Furthermore, the Basel Committee established the assessment methodology and
a capital surcharge framework for globally systemically important banks (G-SIBs)
in November 2011 to enhance their loss absorbency capacity and reduce the
probability of their failure. This methodology comprises five broad categories
of size, interconnectedness, lack of readily available substitutes for the services
provided, global (cross-jurisdictional) activity, and complexity. In the same
month, the Financial Stability Board (FSB) issued the Key Attributes of Effective
Resolution Regimes for Financial Institutions, which was endorsed by the G-20
leaders and is intended to provide international standards for national recovery
and resolution planning regimes. Specifically, it addresses the “too-big-to-fail”
problem by making it possible to resolve any financial institution in an orderly
manner without exposing the taxpayer to the risk of loss.
In addition, the final version of the Principles for Financial Market
Infrastructures (PFMI), issued by the Committee on Payment and Settlement
Systems (CPSS) and the International Organization of Securities Commissions
(IOSCO), was published in April 2012. The PFMI covers payments systems,
central counterparties, securities settlement systems, and other financial
utilities, and provides an updated set of international standards on issues such
as governance, risk management, financial resources, liquidity, and operational
robustness. These principles are especially important as the international
community moves to implement the G-20 commitment to central clearing and
reporting of OTC derivatives. In insurance, the International Association of
Insurance Supervisors updated the Insurance Core Principles in October of
last year. These principles provide a global framework for the supervision and
regulation of the insurance sector.
The Council recommends continued international coordination of Basel III
implementation, with an aim towards consistent and rigorous definitions of
capital and risk weights across countries. The Council also recommends the
continued development of international standards and national implementation
for margin, central clearing, and reporting of OTC derivatives; and that
supervision and regulation of financial market utilities (FMUs) embody the
principles articulated in the PFMI. In addition, the Council recommends
continued efforts to develop strong and internationally consistent procedures
for the supervision and regulation of global systemically important financial
institutions, including appropriate capital and liquidity requirements and
internationally accepted resolution regimes for such institutions. The Council
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strongly encourages international implementation and enhanced international
coordination among home and host jurisdictions regarding recovery and
resolution planning.

Data Resources and Analytics
The Council recommends that improvement in data standards should be a
high priority for financial firms as part of their risk-management process and
for the regulatory community—not just in the United States but globally. The
development of the Legal Entity Identifier is a valuable first step, one that will
help to identify precisely the parties to particular financial transactions. It
will also enable a more accurate and consistent understanding of legal entity
hierarchies, which is essential for effective counterparty risk management. The
Council recommends that the Office of Financial Research (OFR) continue to
work with the member agencies to promote and establish, where necessary, data
standards for identification of legal entities, financial products, and transactions,
and to improve the access to and aggregation of data by the regulators. Finally,
the Council recommends that cross-border exchange of supervisory data among
supervisors and regulators continue to be facilitated in a manner that safeguards
the confidentiality and privilege of such information, in order to help provide
comprehensive oversight of financial institutions with a global reach and improve
coordination on financial stability.

Annual Repor t Recommendations

21

4
	
4.1	

Macroeconomic Environment

U.S. Economic Activity

The economic recovery that began in the second
half of 2009 continued in 2011 and early 2012.
Nonetheless, the pace of activity and employment
growth remained quite modest compared with previous
economic expansions, as a number of factors have
continued to weigh on growth in spending and
production. These factors include a depressed housing
market, the spillover effects of the fiscal and financial
difficulties in Europe, continued fiscal retrenchment
of state and local governments within the United
States, uncertainty about the federal budget and
related policies, and less credit availability for many
households and small businesses compared to precrisis norms.

4.1.1	

Real Gross Domestic Product

Economic growth continued at a modest to
moderate pace in 2011 and early 2012. Real
GDP increased less than 1 percent at an annual
rate in the first half of 2011, as economic
activity was held down by temporary factors,
particularly supply chain disruptions stemming
from a major earthquake and tsunami in Japan
and the damping effect of a sharp run-up in
energy and commodity prices on consumer
spending (Chart 4.1.1). Growth picked up in
the second half of the year to an annual rate
of nearly 2.5 percent, as the effects of these
temporary factors waned. Real GDP expanded
at an annual rate of 1.9 percent in the first
quarter of 2012, and available indicators suggest
a continued moderate pace of growth in the
second quarter. Among the factors that are
hampering growth are a depressed housing
market, the spillover effects of the fiscal and
financial difficulties in Europe, continued fiscal
retrenchment of state and local governments
within the United States, uncertainty about
U.S. federal budget and policy, and credit
availability that is significantly tighter relative
to pre-crisis norms for many households and
small businesses.

Chart 4.1.1	 Change in Real Gross Domestic Product

Macroeconomic Environment

23

Chart 4.1.2	 Change in Real Personal Consumption Expenditures

Chart 4.1.3	 Personal Saving Rate

Chart 4.1.4	 Private Housing Starts

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Consumption and Residential Investment
Real personal consumption expenditures (PCE)
increased 1.6 percent in 2011 (Q4/Q4) and 2.5
percent (annualized rate) in the first quarter
of this year (Chart 4.1.2). Real disposable
income rose more modestly, held down by the
weak labor market. The weak pace of income
growth over 2011 and early 2012, combined
with increases in consumer outlays, brought the
personal saving rate down from 5.2 percent in
late 2010 to 3.7 percent in the first quarter of
2012 (Chart 4.1.3).
In addition to the weak gains in income, a
number of other factors also restrained the pace
of improvement in consumer expenditures.
Household wealth (relative to income) remains
well below the elevated levels that prevailed
in the mid-2000s, when it was supported by
house prices and household equity holdings.
Similarly, underwriting standards remain tight
for many potential borrowers—particularly
for mortgage credit, which continues to weigh
down housing demand and refinancing activity
despite historically low interest rates. In part,
these factors have been reflected in readings on
consumer sentiment, which remain low relative
to levels before the financial crisis, despite
having retraced much of the decline that
occurred in the summer of 2011 as difficulties
in Europe flared and the debate over the U.S.
debt ceiling became heated.
The housing market remains strained. In 2011,
both new and existing home sales remained
near the low levels that have prevailed, on
average, since 2008. Residential construction
activity and housing starts remained tepid,
especially for single-family homes, given weak
demand, the abundant stock of vacant homes,
and low housing prices (Chart 4.1.4). However,
recent indicators have been somewhat more
encouraging. Home prices have begun to
stabilize, with some measures showing an uptick
in early 2012. In addition, multifamily housing
starts have been trending upward since early
2010, albeit from low levels.

Business Fixed Investment
Real business fixed investment (BFI) posted
a solid increase in 2011, rising 8.1 percent on
a Q4/Q4 basis. However, growth has been
slower so far in 2012, and BFI as a share of GDP
remains considerably below its pre-recession
level. Much of the deceleration in BFI this year
has been in expenditures on equipment and
software (E&S), which rose at an annual rate of
just 3.5 percent in the first quarter after rising
9.6 percent (Q4/Q4) in 2011; this step-down
in E&S investment may be related in part to
renewed concerns among businesses about
the global economic and financial situation.
Meanwhile, investment in nonresidential
structures has increased somewhat, on net,
in recent quarters after a period of very steep
declines, but conditions in the sector remain
difficult: vacancy rates for commercial space are
still high, prices of existing structures are low,
and financing conditions for builders are still
tight despite some signs of recent easing.

Government Purchases
Real government expenditures at the federal,
state, and local level continue to contract. Real
state and local government purchases fell by
2.5 percent on a Q4/Q4 basis in 2011 due to
ongoing budgetary pressures, continuing the
pattern seen since the onset of the recession
and financial crisis. Real federal government
purchases fell throughout 2011 and early 2012
following the withdrawal of the fiscal stimulus
provided during the crisis and large declines
in federal defense spending in 2011:Q4 and
2012:Q1.

Imports and Exports
Real exports of goods and services rose 4.7
percent over 2011, boosted by continued growth
in overall foreign economic activity. The
increase in export demand was concentrated
in the emerging market economies (EMEs),
while exports to the euro area declined toward
the end of the year. As U.S. economic activity
grew modestly in 2011, real imports of goods
and services rose by 3.6 percent. Altogether, the
contribution of net exports to growth in real

Macroeconomic Environment

25

Chart 4.1.5	 Net Change in Payroll Employment

GDP was essentially zero last year and in the
first quarter of this year.

4.1.2	

The Labor Market

The labor market strengthened over the course
of 2011 and the first several months of 2012.
Nonetheless, the improvement in employment
and other labor market indicators since the end
of the recession has been modest, and the labor
market has a considerable distance to go before
returning to the conditions that prevailed prior
to the recession and financial crisis.

Chart 4.1.6	 Civilian Unemployment Rate

Chart 4.1.7	

26

Labor Force Participation Rate

2 0 1 2 F S O C / / Annual Report

Nonfarm payroll employment increased at an
average monthly rate of 153,000 jobs in 2011
(Chart 4.1.5). The private sector added an
average of 175,000 jobs monthly last year, while
government payrolls dropped at an average
rate of 22,000 per month (mostly at state and
local governments). During the first half of
2012, private payrolls advanced about 159,000
per month, just below the average pace in 2011,
and the pace of job loss at governments has
moderated somewhat. Overall through June
2012, the level of payroll employment remains
about five million below its peak in January 2008.
The unemployment rate has declined
significantly, from its peak of 10 percent in
October 2009 to 8.2 percent in June 2012,
although it remains far above levels that
prevailed prior to the recession (Chart 4.1.6).
Some of this decline in the unemployment
rate is attributable to reduced labor force
participation (Chart 4.1.7). While part of the
reduction in participation reflects demographic
shifts associated with an aging baby boomer
population, the weak economy has played an
important role by discouraging many workers
from continuing to search for positions. In
addition, long-duration joblessness continues to
account for an especially large share of the total.
In June 2012, 5.2 million persons among those
counted as unemployed—about 42 percent of
the total—had been out of work for more than
six months (Chart 4.1.8). The number of workers
employed part-time for economic reasons has
fallen somewhat over the past year, though it
remains high by historical norms.

4.2	 Private Nonfinancial Balance Sheets
and Credit Flows
4.2.1	

Chart 4.1.8	 Long-Term Unemployment*

Nonfinancial Corporate Sector

The ratio of debt to net worth in the nonfinancial
corporate sector, which had spiked during the
downturn, continued to decline in 2011. Credit
flows to this sector have remained relatively strong,
with robust bond issuance and an increased pace of
lending from bank and nonbank companies. Credit
quality indicators remain solid, with low delinquency
and default rates.
Nonfinancial corporate balance sheets
deteriorated significantly during the recession,
with measures of balance sheet leverage reaching
historical highs. Corporate balance sheets
improved markedly in 2010 and a bit more in
2011. The ratio of debt to net worth in this sector
is now in line with its average level over the past
20 years (Chart 4.2.1). Profits at nonfinancial
corporations increased sharply in 2010 and
remained high in 2011, driving equity market
values for nonfinancial corporations back to
near pre-crisis levels and allowing nonfinancial
corporations to boost capital through
retained earnings. In particular, nonfinancial
corporations have accumulated a substantial
buffer stock of liquid assets (Chart 4.2.2).
This improvement in corporate profits
and credit quality supported high levels of
borrowing by nonfinancial corporate firms.
In bond markets, which comprise the largest
source of credit to the corporate sector, gross
issuance by investment grade nonfinancial firms
has been very strong (Chart 4.2.3), although
issuing firms appear to have mainly used these
bonds to refinance existing debt. Issuance of
high-yield bonds dropped in the second half
of 2011, but the pace of issuance through May
2012 remained above the 2001-2012 average
annual pace. Corporate bond spreads widened
during fall of 2011 as investors became more
cautious in the wake of the U.S. debt ceiling
talks in August 2011 and developments
in European markets (Chart 4.2.4). As of
July 6, 2012 corporate spreads still remained
elevated relative to early 2011. The amount of

Chart 4.2.1	 Nonfinancial Corporate Credit Market Debt to
Net Worth

Chart 4.2.2	 Financial Ratios for Nonfinancial Corporations

Macroeconomic Environment

27

Chart 4.2.3	 Bond Issuance by Nonfinancial Firms

Chart 4.2.4	 Corporate Bond Spreads

commercial paper issued by businesses edged
up only slightly over the past year despite
relatively stable cost of issuance.
The net amount of loans to the nonfinancial
corporate sector, which includes loans from
bank and nonbank sources, rose at an annual
rate of $132 billion in 2011, with the same
pace of growth continuing in the first quarter
of 2012. Bank lending to commercial and
industrial (C&I) borrowers continued to rise
between June 2011 and April 2012, reaching
$1.4 trillion. While the bulk of this increase has
been organic, charter conversions by thrifts
boosted C&I loans in the banking sector by
about $16 billion over this period. Over the
same period, respondents to the Senior Loan
Officer Opinion Survey (SLOOS) generally
continued to report less stringent underwriting
standards and lower spreads on C&I loans to
large and medium-sized firms (Chart 4.2.5).
Available indicators of credit quality remain
solid: the default rate on nonfinancial
corporate bonds is at a low level by historical
standards (Chart 4.2.6); C&I loan delinquency
rates continued to decline through the first
quarter of 2012 (Chart 4.2.7); and expected
year-ahead default rates for nonfinancial
firms as measured by Moody’s KMV model
remain steady.

4.2.2	

Chart 4.2.5	 Bank Business Lending Standards and Demand

Commercial Real Estate Sector

Financing conditions in the commercial real estate
sector remain strained following a long period of
banks reporting tighter underwriting standards
and subdued commercial mortgage-backed security
(CMBS) issuance.
In contrast to the relatively sanguine credit
conditions for corporate borrowers, financial
conditions in the commercial real estate
(CRE) sector remain strained amid weak
underlying economic fundamentals and tight
underwriting standards by banks. Prices for
some segments of commercial properties
have remained at low levels, and vacancy and
delinquency rates continue to be elevated.
After a sustained period of tightening, recent

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2 0 1 2 F S O C / / Annual Report

SLOOS data show that lenders have generally
refrained from further tightening standards
on CRE loans. At the same time, moderate
fractions of respondents indicated stronger
demand for CRE loans in recent quarters.
Consistent with these results, the decline
in CRE loans on banks’ balance sheets has
slowed over the past year. Nonetheless, credit
conditions for CRE remain tight by historical
standards. In particular, respondents to a
special question in the July 2011 SLOOS
reported that CRE standards were at or near
their strictest levels since 2005, and the survey
results have shown little change in standards,
on net, since July 2011.
After relatively strong post-crisis issuance of
CMBS in the first half of 2011, the amount of
new CMBS issuance has been more subdued
recently, and issuance in early 2012 was slightly
below the pace set in the first half of 2011
(Chart 4.2.8). CMBS delinquency rates and
spreads remained high as borrowers struggled
to refinance much of the approximately $33
billion in maturing five-year loans that were
originated at the peak of CRE prices in 2007.

4.2.3	

Chart 4.2.6	 Nonfinancial Corporate Bond Default Rate

Chart 4.2.7	 Noncurrent Commercial & Industrial (C&I) Loans

Noncorporate Business Sector

Small business lending remains subdued, in part
because of the ongoing low real estate prices that
have reduced the value of potential collateral for
small business loans. There are some signs, however,
that credit conditions for small business are
gradually improving.
Net worth in the noncorporate sector, which
is composed primarily of small businesses, fell
sharply during the downturn but turned up in
2010 and grew a bit more in 2011. Real estate
comprises a large share of the assets held by the
noncorporate sector (Chart 4.2.9), so changes
in real estate values tend to have a very large
impact on small business balance sheets. The
value of real estate assets fell 12 percent in the
noncorporate sector from 2007 to 2009, leading
to a significant increase in the ratio of debt to
net worth (Chart 4.2.10). This ratio recovered
some in 2010 and 2011, as net worth improved

Chart 4.2.8	 CMBS New Issuance

Macroeconomic Environment

29

Chart 4.2.9	 Noncorporate Assets

Chart 4.2.10	 Noncorporate Credit Market Debt to Net Worth

Chart 4.2.11	 Net Borrowing by Nonfinancial Noncorporate
Businesses

and debt contracted slightly, but it remains well
above pre-recession levels.
Small businesses generally have access to a
narrower range of financing options than
corporations and thus depend more on bank
loans, frequently secured by real estate. Since
the beginning of the financial crisis, lower
real estate collateral values and strains in
the banking sector have constrained credit
availability for many small businesses. However,
there are signs that credit conditions for
small businesses are gradually improving.
Net borrowing by nonfinancial noncorporate
businesses turned positive in the second half
of 2011, after declining substantially during
the crisis (Chart 4.2.11). Furthermore, after a
sustained period of tightening of standards and
terms on loans to small businesses, respondents
to the SLOOS noted some easing on loan
standards and spreads in recent quarters (Chart
4.2.12). In addition, since the beginning of
2012, the fraction of banks reporting stronger
demand for C&I loans from small businesses
has edged up. While the stock of small loans to
businesses on bank balance sheets at the end
of last year was more than 15 percent below its
peak before the crisis, these loans ticked up in
the fourth quarter of 2011, registering their first
increase since 2008, and continued to increase
in the first quarter of 2012.
Business lending by credit unions, which
predominantly lend to small businesses,
increased by 6 percent in 2011 to reach nearly
$16.5 billion. Similar improvements in credit
conditions are evident in the small business
surveys conducted by the National Federation
of Independent Business. The fraction of firms
reporting that credit had become more difficult
to obtain declined through the first quarter of
2012 (Chart 4.2.13).
Notwithstanding these improvements, the
fraction of firms reporting difficulty obtaining
credit remains elevated relative to the pre-crisis
period. Owners of new businesses, who might
have tapped into the equity in their homes
or used their homes as collateral for small

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2 0 1 2 F S O C / / Annual Report

business loans, have found conditions especially
challenging in recent years. In addition,
business receivables at finance companies, an
important source of small business financing,
continued to decline through February 2012
and were down nearly 30 percent from their
peak in July 2008.

4.2.4	

Chart 4.2.12	 Bank Business Lending Standards and Demand

Household Sector

Household net worth improved slightly, on net, from
the end of 2010 to the first quarter of 2012. The
fraction of household income needed to cover debt
service payments decreased further, though mortgagerelated debt remains high relative to home values.
Consumer credit has grown steadily, mostly owing to
an expansion in non-revolving credit, including a
significant increase in the amount of student loans to
finance higher education.
Aggregate household net worth rose almost
$1 trillion in 2011 to $60.0 trillion (nominal)
in 2011:Q4, then jumped an additional $2.8
trillion in 2012:Q1. This large increase in
household net worth in the first quarter
primarily reflected gains on corporate equity
(directly and indirectly held), although gains on
real estate assets and net saving also contributed
to this increase in net worth (Chart 4.2.14).
As discussed earlier, home prices continued to
decline in 2011 but appear to have stabilized,
and some measures of home prices have shown
upticks recently. Owners’ equity in housing has
remained near a record low of approximately
40 percent since mid-2008 through March
2012, roughly 20 percentage points lower than
its average over 1990 to 2005 (Chart 4.2.15).
All told, the ratio of household net worth to
disposable personal income is now around
its post-WWII average level, although it is far
below the level reached in 2007. However, not
all households have experienced a significant
improvement in their balance sheet positions.
For example, lower-income households with
smaller exposures to the stock market have not
benefitted much from the recovery in equity
prices over the past several years.

Chart 4.2.13	  mall Businesses’ Difficulty Obtaining Credit
S

Chart 4.2.14	 Household and Nonprofit Balance Sheets

Household debt outstanding, about threequarters of which is accounted for by home
Macroeconomic Environment

31

Chart 4.2.15	 Share of Owners’ Equity in Household Real Estate

Chart 4.2.16	 Household Debt Service Ratio

Chart 4.2.17	 Household Financial Obligations Ratio

mortgages, declined further in 2011. This
decline represented, to some degree, efforts
by households to pay down their existing
debt, as well as a low volume of new mortgage
originations. It also reflects the effects of
foreclosures and “short sales,” which have,
in the aggregate, reduced mortgage debt on
household balance sheets. Moreover, access
to residential mortgages remains constrained
by tight underwriting standards, discussed
further in Section 5.1.4. Deleveraging by
households, along with low interest rates,
various government tax and transfer programs,
and rising employment and income, have
helped households manage their monthly
debt burdens. The household debt service
ratio—the fraction of disposable income
needed to cover household debt payments—
continued to fall last year (Chart 4.2.16). The
financial obligations ratio, which measures a
household’s burden from a broader measure
of commitments, including rent payments and
homeowners’ insurance, also moved down last
year for homeowners (Chart 4.2.17).
As of the first quarter of 2012, non-mortgage
consumer credit outstanding increased nearly
5 percent from a year earlier to $2.5 trillion.
Most of this increase in consumer borrowing
is in non-revolving credit (Chart 4.2.18), which
accounts for nearly two-thirds of total consumer
credit as of the first quarter in 2012. Among
non-revolving credit, student and auto loans
have been the fastest-growing categories, with
new student loans primarily originated by the
federal government.
Growth in revolving credit, on the other hand,
has continued to be weak, even contracting
recently after posting gains in the fourth
quarter of 2011. The reduction in revolving
credit is in part driven by the fact that all but
“super prime” borrowers continue to face
tight underwriting standards for credit cards
as lenders pursue higher-quality borrowers.
While the credit card limits for super prime
borrowers with credit scores greater than 750
have been increasing since 2011, limits for
“prime” borrowers with credit scores between

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2 0 1 2 F S O C / / Annual Report

650 and 749 picked up only slightly. In contrast,
credit card limits for “subprime” borrowers
with credit scores less than 650 continued
to edge down until the end of 2011 (Chart
4.2.19). Data on credit card solicitations show
a similar preference by banks toward higher
quality borrowers.
Delinquency rates for consumer credit remain
low. Student loan delinquencies and defaults
are above pre-crisis level, but are below the
peaks seen during the recession. Relatively low
delinquency rates for revolving credit and auto
loans likely reflect, in part, the composition
shift toward higher-quality borrowers. In
particular, the increases in delinquency rates
on credit card and auto loans during the
crisis were largely driven by a sharp rise in the
delinquency rate of subprime borrowers, which
remains significantly above historical levels
(Chart 4.2.20). In contrast, the delinquency
rates on credit card and auto loans to super
prime and prime consumers were more stable
through the crisis and are currently at their
historical averages.
At the same time, demand for credit by most
consumers continues to be modest relative to
the pre-crisis period as households continue
to recalibrate their balance sheets in the wake
of large wealth losses during the crisis, tepid
gains in labor markets, moderate economic
growth, and economic uncertainties. Only a
small fraction of respondents to the SLOOS,
on net, report stronger demand for credit
by consumers. Looking across the credit
spectrum, credit applications increased
slightly over the past year but, through the first
quarter of 2012, remained largely subdued
relative to the pre-crisis period (Chart 4.2.21).

4.3	

Chart 4.2.18	 Nonmortgage Consumer Credit Flows

Chart 4.2.19	 Average Amount of Revolving Credit Available

Chart 4.2.20	 Credit Card Delinquency Rates by Credit Score

Government Sectors

Government finances in the United States
deteriorated sharply during the recession, as
public sector borrowing largely replaced private
borrowing in credit markets (Chart 4.3.1). So far,
global financial markets have been able to absorb
the substantial increase in U.S. federal debt, but
Macroeconomic Environment

33

Chart 4.2.21	 Applications for Credit

concerns about the prospects for meaningful deficit
reduction in coming years persist.

4.3.1	

Chart 4.3.1	 Net Debt Outstanding as a Percent of GDP

Chart 4.3.2	 Federal Unified Budget Surplus

Federal Government

The deficit in the federal unified budget
widened significantly during the recession
and gradually narrowed thereafter. The
Congressional Budget Office (CBO) projects
the deficit in the current fiscal year to be 7.6
percent of nominal GDP—1.1 percentage points
lower than in 2011 but substantially above the
average value of 1.3 percent of GDP for precrisis fiscal years 2000 to 2007 (Chart 4.3.2).
This appreciable increase in the deficit mostly
reflects the usual cyclical response of revenues
and spending to a weak economy, as well as the
fiscal actions taken to ease the effects of the
recession and aid the recovery.
The outlook for the budget over the medium
term is subject to considerable uncertainty
with respect to both the performance of the
economy and the policy path that will be
followed. The CBO presents two scenarios
based on different assumptions about
expenditure and tax configurations. In the
CBO baseline projection for the period
through 2022, which assumes that current laws
generally remain unchanged, the deficit shrinks
appreciably over the next couple of years and
remains small thereafter. However, in the CBO
“Alternative Fiscal Scenario,” which is arguably
more plausible because it generally maintains
the tax and spending policies that have recently
been in effect, the deficit narrows much less
in the near term and turns back up after 2018,
mainly because of the budgetary pressures
stemming from the aging of the population and
rapidly rising costs for health care. Consistent
with this projection for the deficit, federal debt
held by the public is expected to rise from 68
percent of GDP at the end of fiscal year 2011 to
93 percent of GDP in 2022 (Chart 4.3.3).
Concerns about the budget outlook weighed
on the rating agencies’ assessments of U.S.
sovereign debt. In August 2011, Standard and
Poor’s downgraded the long-term sovereign
credit rating of the United States, citing that

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2 0 1 2 F S O C / / Annual Report

the effectiveness, stability, and predictability
of American policymaking and political
institutions had weakened at a time of fiscal
and economic challenges. (See Box A: Impacts
of Downgrade of U.S. Treasury Securities.)
Moody’s and Fitch have U.S. sovereign debt
on negative outlook. These rating actions do
not appear to have affected the demand for
Treasury securities, as market participants
continue to purchase U.S. debt for its relative
safety and liquidity. Bid-to-cover ratios at
Treasury security auctions remain at the top
end of historical ranges, and indicators of
foreign participation have remained on trend
with recent years.
Despite the sizable increase in public debt
outstanding, net interest costs amounted to
only about 1.5 percent of GDP in recent years,
consistent with trends of the past decade but
lower than average values during the 1990s
of about 3 percent of GDP (Chart 4.3.4). This
decline reflects the fact the interest rates
have fallen to historically low levels even as
debt outstanding has increased. The average
maturity of public debt outstanding has
risen sharply since late 2008 and is above its
30-year average.

4.3.2	

Chart 4.3.3	 Federal Debt Held by the Public

Chart 4.3.4	 Interest Outlays and Average Maturity of U.S.
Public Debt

State and Local Governments

State and local budgets were strained during
the recession, and municipalities continue
to struggle to repair their fiscal positions.
From the middle of 2008 to April 2012, these
governments cut roughly 650,000 jobs (more
than 3 percent of their workforces) and
trimmed other operating expenditures to satisfy
balanced budget requirements. They have also
reduced capital expenditures, which, in real
terms, have fallen to their lowest levels since the
late 1990s. In part because of the weakness in
capital spending, state and local borrowing has
decelerated noticeably since the onset of the
recession, and posted a small decline in 2011
and in the first quarter of 2012 (Chart 4.3.5).

Chart 4.3.5	 Change in State and Local Government Debt

State and local government tax revenues, in
aggregate, began to register mild growth in
2010 after declining in the aftermath of the
Macroeconomic Environment

35

Chart 4.3.6	 Change in State Tax Revenue

Chart 4.3.7	 Change in Local Tax Revenue

Chart 4.3.8	 Municipal Bond Issuance by Type

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2 0 1 2 F S O C / / Annual Report

financial crisis (Chart 4.3.6). Much of the
improvement has been at the state level, where
personal income tax receipts in particular
have picked up as the economic recovery has
proceeded. In contrast, tax collections at
the local level have exhibited essentially no
growth over the past two years, mainly because
property tax collections, which account for
roughly three-fourths of local tax revenues,
have been depressed by the downturn in home
prices and a reluctance to raise tax rates at a
time when real incomes of constituents are
under pressure (Chart 4.3.7).
Overall, the resources available to state and
local governments to finance their spending
remain tight. The sector’s tax revenues are
only slightly higher than they were in 2008.
The federal stimulus grants provided under
the American Recovery and Reinvestment Act
of 2009 have largely wound down, and other
initiatives (e.g., the Build America Bonds
program) have expired. Many states have cut
back on assistance to their localities in order to
shore up their own budgets. Finally, balances
in reserve funds, which provide an important
safety valve in times of budgetary stress, have
been depleted in many cases.
As a result of these budgetary issues, net credit
flows to state and local governments have been
mixed over the past year. While the amount
of revenue bonds issued continues to exceed
the amount of general obligation bonds, the
share of general obligation bonds among the
total issuance increased substantially in 2012
(Chart 4.3.8). Net issuance of municipal bonds
has been slow as of late, in part reflecting the
weakness in infrastructure investment and
ratings downgrades by Moody’s over the past
12 months, which have substantially outpaced
upgrades. At the same time, the cost of
municipal bonds—as measured by the yield
ratio to similar maturity Treasury securities—
has risen, with investors demanding higher
returns from issuers facing fiscal challenges
(Chart 4.3.9). The issuance of Variable Rate
Demand Obligations (VRDOs), an important
source of funding for municipalities, has

also been declining since the financial crisis
(Chart 4.3.10). A primary reason is the gradual
retraction of European banks from providing
liquidity to this market.
Budget trajectories will remain challenged
in coming years, as many state and local
governments will need to increase their
contributions to their employee pension funds,
both to rebuild assets after experiencing
significant financial losses and to address
chronic underfunding during the past
decade. In addition, many governments are
not setting aside money to fund their ongoing
obligations to provide health care to their
retired employees. Unfunded liabilities remain
substantial. Estimates of aggregate unfunded
pension liabilities span a wide range, in part
because of differences in how liabilities are
valued, but may be in the range of $2 trillion
to $3 trillion. (For an additional discussion
of accounting issues related to state and local
pension funds, see Section 5.3.5.) Estimates
for the cost of providing retiree health benefits
are subject to even greater uncertainty, in part
because of the difficulty of projecting health
care costs decades into the future, but one
estimate put the states’ collective unfunded
liability as of 2010 at over $625 billion.

4.4	

Chart 4.3.9	 Municipal Tax-Exempt Bond Yield Ratios

Chart 4.3.10	 ARS and VRDO Funding of Long-Term Muni Bonds

External Environment

Outside of the United States, both realized and
prospective growth rates have been mixed over the past
year. The primary financial stability focus has been on
the developments in Europe. Despite ongoing efforts
by European authorities to contain the crisis, debt
sustainability concerns, fiscal consolidation efforts,
bank deleveraging, and funding market stresses on
banks and sovereigns continue to weigh on European
growth prospects. Outside of the euro area, foreign
growth picked up in 2012:Q1, with lower growth
in the euro area and China partly offset by more
positive developments in other regions. The tone of the
incoming data in 2012:Q2 is decidedly weaker.

4.4.1	

Advanced Foreign Economies

In the aggregate, the advanced economies
maintained positive growth through 2011 and
Macroeconomic Environment

37

Chart 4.4.1	 Real GDP Growth

early 2012 (Chart 4.4.1). The growth rates
across advanced economies reflect a mix of
more positive outcomes in the United States
and Japan, among others, and the challenges
within European countries in managing fiscal
problems, bank funding stress and deleveraging,
and structural change (Chart 4.4.2).

Euro Area Economic Conditions and
Policy Initiatives

Chart 4.4.2	 Developed Market Economies GDP Growth

Chart 4.4.3	 Euro Area GDP Growth

Over the last 12 months, the euro area
sovereign debt crisis intensified as concerns
about the sustainability of public finances and
the robustness of banks in some countries
soared. Some European financial institutions
faced reduced access to funds, reflecting in
part their large exposures to stressed sovereigns
as well as their reliance on wholesale funding
markets, including short-term dollar funding
provided by money market funds. European
leaders recognize the need to deepen their
economic and monetary union, as exemplified
by the new fiscal compact treaty signed by most
European Union (EU) members in March
2012 and by the proposal to establish a single
European banking supervisor put forth in June
2012. Work continues on elaborating a systemwide solution capable of commanding both
political and market support.
The euro area economies experienced a
widespread slowing of economic activity due
to the intensification of the crisis, the effects
of banking problems and the related bank
deleveraging on lending to the real economy,
and the impact of fiscal consolidation efforts.
Despite various measures implemented by the
European authorities to combat the crisis,
discussed below, the euro area GDP contracted
by 1.2 percent (annual rate) in the fourth
quarter of 2011, and the GDP growth rate
for the first quarter of 2012 was near zero.
Similarly, labor market conditions deteriorated
further, as the unemployment rate reached
11.1 percent in May 2012, the highest level
since 1995.
Growth prospects in the euro area differ across
countries (Chart 4.4.3). Germany, France, and

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2 0 1 2 F S O C / / Annual Report

Ireland continue to grow, although at a more
subdued pace, while Italy, Spain, Portugal,
and Greece are projected to contract, with
unemployment rates rising substantially.
Vulnerable European countries continue to
face important challenges as they strive to
improve fiscal positions, strengthen vulnerable
banks, and carry out structural reforms to
improve their long-term growth outlook, even
as short-term growth is weak or negative. The
stresses in the sovereign debt markets of euro
area countries are discussed in greater detail
in Section 5.1.
European authorities responded to these
developments with a number of policy
measures. In response to Greece’s plunging
output and challenges meeting fiscal targets,
EU and IMF officials, the Greek government,
and private creditors finalized an enhanced
rescue package in February 2012. This package
included a more ambitious private-sector debt
exchange involving a significant principal
write-down, together with additional official
financing through early 2016. (See Box B:
Greek Sovereign Debt Restructuring.)
Additionally, European authorities took actions
to improve the fiscal governance in the region
and to enhance their ability to provide financial
support to euro area countries under stress.
EU members, excluding the United Kingdom
and the Czech Republic, signed a new fiscal
compact treaty designed to strengthen fiscal
rules, enhance surveillance, and improve
enforcement. This treaty, if ratified, would
require countries to legislate national fiscal
rules and should generally limit structural
fiscal deficits to 0.5 percent of GDP. Authorities
moved up the introduction of the European
Stability Mechanism (ESM), a permanent €500
billion lending facility, to July 2012—about
a year earlier than originally planned. In
addition, they agreed to increase the combined
lending capacity of their rescue facilities from
€500 billion to €700 billion, of which €500
billion remains uncommitted. Moreover,
European authorities augmented the scope and
flexibility of the existing facilities, empowering
Macroeconomic Environment

39

Chart 4.4.4	 ECB Liquidity Providing Operations

them to purchase sovereign debt in primary and
secondary markets and offer debt guarantees.
European policymakers also took steps to
strengthen the capital positions of euro area
financial institutions. In October of 2011, the
European Banking Authority (EBA) announced
that large banks would be required to build
up “exceptional and temporary” capital
buffers to meet a core tier one capital ratio
of 9 percent and cover the cost of marking to
market their sovereign debt exposures by the
end of June 2012. According to a December
2011 EBA report, 62 banks intended to create
capital buffers equivalent to €98 billion,
about 25 percent larger than required. (This
does not include the Greek banks and three
other institutions that would be recapitalized
separately by national authorities.) More
recently, in June 2012, Spain requested EU
assistance to recapitalize its banking sector.
(See Box C: Recent Fiscal and Banking
Developments in Spain.) Finally, in an effort to
address the link between banks and sovereigns,
euro area leaders agreed in late June 2012 to
establish a single supervisory mechanism for
banks in the euro area and to grant the ESM
the possibility of recapitalizing banks directly.
Meanwhile, the European Central Bank (ECB)
adopted various policy measures to support
liquidity conditions in financial markets. First,
in August 2011, the ECB resumed purchases
of euro area marketable debt, including the
debt of Italy and Spain, in order to improve
the functioning of sovereign debt markets
and facilitate the transmission of monetary
policy in the region. Then, in December 2011,
the ECB eased rules on collateral for ECB
refinancing operations and scheduled two
longer-term refinancing operations (LTROs)
to improve banks’ funding conditions. With
the LTROs, the value of outstanding ECB
liquidity providing operations has increased to
over €1.25 trillion (Chart 4.4.4). Moreover, in
November 2011, the Bank of Canada, the Bank
of England, the Bank of Japan, the ECB, the
Federal Reserve, and the Swiss National Bank
engaged in coordinated actions to enhance

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2 0 1 2 F S O C / / Annual Report

their capacity to provide liquidity support
to the global financial system. In particular,
the reduced fees applied to draws on dollar
liquidity swap lines provided by the Federal
Reserve, as well as the extended expiration of
these facilities, were intended to ease strains
in financial markets and thereby mitigate the
effects of such strains on the supply of credit to
households and businesses.
These measures contributed to improvements
in euro area financial conditions during
the first few months of this year, with dollar
funding pressures substantially diminished.
The net result was a considerable narrowing of
euro-dollar foreign exchange (FX) swap basis
spreads, reflecting reduced short-term dollar
funding pressure for euro area institutions
(Chart 4.4.5). Recent utilization of the dollar
liquidity swap lines peaked at over $100 billion
in February 2012, with the outstanding amount
for the Federal Reserve’s dollar liquidity swap
lines at $28 billion as of July 4 (Chart 4.4.6).

Chart 4.4.5	 Euro-Dollar Implied FX Swap Basis

Chart 4.4.6	 Total Swap Line Amount Outstanding

Growth and financial stability conditions in
the euro area remain under pressure. Market
participants are attentive to the limited capacity
of the euro area financial backstop in the
context of its multiple possible uses. Although
the Greek debt restructuring and subsequent
triggering of credit default swap (CDS)
contracts, discussed further in Box B: Greek
Sovereign Debt Restructuring, passed without
broad market disruption, much uncertainty
remains in the region. Uncertainty about fiscal
consolidation and structural reform highlight
the challenges of adjustment within a monetary
union. Meanwhile, concerns about other
European peripherals (including Portugal,
Ireland, Italy, and Spain), especially around
fiscal sustainability, health of their banking
sectors, and general competitiveness of their
economies, continue to weigh on real growth
and financial activity in these countries.

4.4.2	

Emerging Market Economies

In the second half of last year, economic growth
in many EMEs slowed slightly, as earlier policy
tightening, a weakening of external demand
Macroeconomic Environment

41

Chart 4.4.7	 Emerging Market Economies GDP Growth

Chart 4.4.8	 Net International Financial Flows to EMEs

owing to the fiscal crisis in Europe, and supply
chain disruptions stemming from floods in
Thailand weighed on growth (Chart 4.4.7).
At the beginning of this year, growth in EMEs
rebounded, reflecting a restoration of the
normal supply chain and some improvement in
demand from advanced economies. However,
the indicators for the second quarter of 2012
suggest significantly weaker activity in EMEs.
On balance, EMEs have received substantial
volumes of net inflows of capital since late 2009,
which also contributed to currency appreciation
pressures. These inflows decelerated in the
second half of last year, reflecting both a
general flight to safety and concerns about
growth spillovers from the deteriorating
situation in Europe (Chart 4.4.8). Declining
commodity prices are also a concern for
some emerging economies, particularly in
Latin America. Overall, while growth across
major EMEs, including Brazil, Mexico, India,
Russia, and China, stayed firmly in positive
territory, these global headwinds weighed on
local prospects.
Chinese growth prospects remain relatively
solid by international standards. Year-overyear growth slowed in 2012:Q1 to just above 8
percent, reflecting weaker investment spending,
with macro-prudential restrictions weighing
on the property sector, and slower export
growth, especially to Europe. A possible hard
landing of the Chinese economy is a risk that
could spill over to other EMEs and the global
economy, which has created some anxiety in
financial markets. There are growing concerns
that weaker external demand in the advanced
economies, combined with a deceleration in
domestic investment, could lead to a more
prolonged economic slowdown in China than
was previously expected. Another source of
concern is the movement of savings into lesswell-regulated nonbank financing channels
in an effort to obtain higher yields. Finally,
additional risks could emerge from stresses in
the banking sector, stemming from the massive
increase in credit to the domestic economy
(“social financing” in the official Chinese

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2 0 1 2 F S O C / / Annual Report

terminology), deployed as part of China’s policy
response to the global financial crisis in 20082009 (Chart 4.4.9). To contain a potential
run-up in inflation, property prices, and debt
levels resulting from this credit expansion,
Chinese authorities began taking a tighter
monetary stance in late 2010, with some success.
But with the latest data pointing to weakerthan-expected economic activity in China in
the first five months of 2012, authorities began
implementing a number of fiscal and monetary
measures to support growth.

Chart 4.4.9	 Change in Total Chinese Social Financing

Macroeconomic Environment

43

5
	

Financial Developments

5.1	

Major Financial Markets

5.1.1	

Sovereign Debt Markets

Chart 5.1.1	 Federal Debt Outstanding Held by Public

Developments in sovereign debt markets during the
last year were heavily influenced by the escalation
of uncertainty in euro area sovereign and banking
sectors and by continued concerns about the domestic
and global growth outlook. While sovereign debt
from the euro area periphery remains stressed, yields
for sovereign debt from the United States, the United
Kingdom, Germany, Switzerland, and Japan are
at record or near-record lows, reflecting flight to
quality and continued expectations of accommodative
monetary policy.

U.S. Sovereign Debt

Chart 5.1.2	 Yield Curve

The total amount of outstanding U.S. sovereign
debt has risen to $11.0 trillion as of May 31,
2012 (Chart 5.1.1). Despite this increase in
supply, the U.S. sovereign yield curve flattened
considerably since mid-2011, with a decline
in longer-term yields driving this change
(Chart 5.1.2). The historically low levels of
longer-term yields are a reflection of both
flight to quality and continued monetary policy
accommodation associated with the weak
pace of economic growth and the elevated
unemployment rate.
Foreign holdings of U.S. debt remain
substantial, with over $2.2 trillion of U.S.
Treasury securities held by China and Japan
and almost $3 trillion across other foreign
holders in April 2012 compared to about $2
trillion and $2.4 trillion, respectively, in April
2011 (Chart 5.1.3). Nearly three-quarters of
these holdings are by foreign official entities.

Chart 5.1.3	 Foreign Holders of U.S. Federal Debt

Financial Developments

45

BOX A:  IMPACTS OF DOWNGRADE OF U.S. TREASURY SECURITIES
On August 5, 2011, Standard & Poor’s (S&P) lowered their
long-term sovereign credit rating on the United States of
America to AA+ from AAA and reaffirmed their short-term
rating of A-1+. S&P stated that the downgrade reflected
their opinion that the Budget Control Act, which was
signed into law on August 2, fell short of what would be
“necessary to stabilize the government’s medium-term
debt dynamics.” They further stated that, “More broadly,
the downgrade reflects our view that the effectiveness,
stability and predictability of American policymaking and
political institutions had weakened at a time of ongoing
fiscal and economic challenges.”
Before the downgrade, there was significant market
focus on the debt ceiling debate in Congress. As the
deadline approached, there were dislocations in the front
end of the Treasury yield curve, and some T-Bill yields
rose dramatically then normalized after the debt limit
was raised.

Chart A.1	

S&P Downgrade of U.S. Debt: Flight to Quality

Chart A.2	

S&P Downgrade of U.S. Debt: Effect on Equities

Because of widespread speculation in the market that
S&P would take action, and the relatively minor scale
of the downgrade, Treasury market participants were
prepared, and there were no reports of forced selling.
Also, many institutions’ portfolio restrictions specifically
carved out “obligations of the U.S. government” rather
than specifying a level or degree of credit rating.
Treasury yields fell immediately following the downgrade,
while major stock indices declined, indicating that
investors were less concerned with the inherent
riskiness of Treasury securities than with the potential
consequences of fiscal retrenchment for the near-term
macroeconomic recovery. Specifically, on Monday August
8 (the business day immediately following the downgrade),
the 10-year Treasury yield closed down 24 basis points.
The cumulative yield changes through August 11 for the
two-year, five-year, and ten-year yields were -10 basis
points, -23 basis points, and -22 basis points, respectively
(Chart A.1). Risky securities lost value following news of
the downgrade, with the S&P 500 index registering a 6.8
percent decline and the Nikkei index falling by 2.2 percent
by close of trading August 8 (Chart A.2).

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2 0 1 2 F S O C / / Annual Report

In addition to the U.S. sovereign rating, several other
entities were downgraded shortly after August 5. These
included clearinghouses, highly rated insurers, and various
government related entities and their debt.
There was little market reaction to a move by the Chicago
Mercantile Exchange (CME) to increase haircuts on U.S.
Treasury securities just before the downgrade, and most
clearinghouses did not adjust their haircuts on Treasury
securities even after the downgrade.

European Sovereign Debt
Over the last 12 months, the European
fiscal crisis intensified as concerns about the
sustainability of public finances in peripheral
European countries escalated and banks
struggled to obtain financing. (See Section 4.4.)
In July 2011, euro area authorities proposed a
voluntary debt exchange on Greek sovereign
bonds. This, along with weakening growth
prospects and fiscal slippage, led to a surge in
Greek government bond yields (Chart 5.1.4).

Chart 5.1.4	 Euro Area 10-Year Yield Spreads to German Debt

As discussed in Section 4.4, European
authorities responded to these developments
with a number of policy measures. The private
sector exchange of Greek sovereign debt, which
was largely concluded in March of this year,
involved a significant principal write-down
and additional official disbursements of aid
financing through early 2016. The insertion
and triggering of collective action clauses for
the purpose of the debt exchange caused credit
default swaps (CDS) contracts written on Greek
sovereign debt to be triggered, which occurred
without any significant market disruptions.
The participation rate in this exchange was
over 95 percent. (See Box B: Greek Sovereign
Debt Restructuring.)
More recently, market pressure on Spain
intensified. On May 11, the Spanish government
announced a series of measures to address
vulnerabilities in the Spanish banking sector,
including enhanced provisioning requirements
on real estate related loans, clear separation of
problem real estate assets into independently
managed asset management vehicles, and plans
to have independent external auditors evaluate
the quality of bank assets. This was followed
two weeks later by an unexpectedly large
capital support request from Bankia, Spain’s
fourth largest bank, and on June 9 by Spain’s
announcement of its intent to request European
support for bank recapitalization (for which
European authorities agreed to provide up to
€100 billion). (See Box C: Recent Fiscal and
Banking Developments in Spain.)

Financial Developments

47

BOX B:  GREEK SOVEREIGN DEBT RESTRUCTURING
In March and April 2012, Greece restructured
approximately €199 billion in government and governmentguaranteed debt through a discounted exchange of
instruments. Due to the use of collective action procedures,
the restructuring was subsequently deemed a credit event
by the International Swaps and Derivatives Association
(ISDA), triggering payouts on Greek credit default swaps
(CDS). In the aftermath of the Greek restructuring event, the
CDS market largely functioned as intended. Despite early
attempts to achieve a purely voluntary restructuring that
would have circumvented a CDS trigger, low preliminary
participation rates indicated a need to trigger collective
action clauses to force higher participation, which in turn
triggered CDS payouts (Chart B.1).
Chart B.1	

Chart B.2	

Greece: Debt Exchange

Greece: Average Bond Price and CDS

The exchange reduced Greece’s debt held by the private
sector by €106 billion, equivalent to 53.5 percent of the
tendered debt. Creditors participating in the exchange
received a combination of new Greek government bonds
(31.5 percent for a total of €63 billion) and short-term
European Financial Stability Facility (EFSF) notes (15
percent for a total of €30 billion) (Chart B.2). Participating
creditors also received detachable GDP warrants, which
pay up to 1 percent of the outstanding bonds’ face
amount in years when real GDP growth and nominal
GDP exceed specified targets. Taking into consideration
the lower coupons and extended maturities of the new
bonds, the exchange entailed net present value losses for
participating creditors estimated at 75-80 percent. CDS
48

protection sellers subsequently paid out only an estimated
$2.5 billion to protection buyers, reflecting the relatively
small net exposure to outstanding CDS contracts.

2 0 1 2 F S O C / / Annual Report

As with all International Monetary Fund (IMF) programs,
sustainable debt dynamics were a pre-condition for
European Union (EU) and IMF lenders to disburse funds
under a second official sector aid program. Greece’s debt
restructuring helped to achieve this, putting Greece’s
high public debt burden (165 percent of GDP in 2011) on
a path toward 120 percent by 2020. Although the debt
exchange substantially reduced Greece’s outstanding
debt to private sector creditors, Greece’s overall debt
burden is expected to remain quite heavy, reflecting
continued borrowing from official sector creditors to
finance the debt exchange, bank recapitalization costs
related to losses resulting from the debt exchange and
deteriorating asset quality, and continued deficit financing.
As a result, public sector creditors are projected to
hold nearly three-quarters of Greek sovereign debt by
end of 2012. The new Greek bonds trade at distressed
levels; yields hovering near 20 percent reflect Greece’s
heavy indebtedness and the high degree of uncertainty
about the outlook for implementation of Greece’s reform
program. On June 17, parties supporting the EU/IMF aid
program won enough seats in the Greek Parliament to
form a governing majority, easing fears about a near-term
exit from the euro and confirming Greece’s commitment
to reform.

The strains in the peripheral euro area
sovereign debt and bank funding markets
also caused additional pressure in some core
countries, such as France. In August 2011, the
central banks of the euro system recommenced
purchasing euro area sovereign bonds,
including Spanish and Italian bonds, in the
context of the Securities Markets Programme
(SMP), to address the severe tensions in some
market segments that had been hampering
monetary policy transmission. This activity
occurred in the context of intensified
strains in peripheral sovereign debt markets,
widening credit spreads and bid-ask spreads,
particularly for Spanish and Italian sovereign
debt, and sharply higher liquidity risk premia.
As funding markets tightened further, euro
area governments announced plans for
enhanced fiscal and structural reforms, while
central banks announced the extension and
repricing of U.S. dollar swap lines, and the
European Central Bank (ECB) implemented
two unprecedented three-year longer-term
refinancing operations (LTROs), as discussed
in Section 4.4.
These various measures helped stabilize
markets in late 2011 and early 2012, as new
governments were elected in Spain and Italy.
However, general uncertainty over conditions
in the euro area has increased once again over
the past few months, as the sustainability of the
strategies currently being undertaken in the
hardest hit countries is called into question.
Sovereign debt and bank credit spreads
increased for Spain and Italy, after having
narrowed over the first quarter of 2012. Credit
spreads remain elevated in many sovereign
debt and bank funding markets—notably
for bank maturities beyond the ECB LTRO
period of three years—and market functioning
remains irregular with marked recent pressure
on spreads in Italy and Spain. The primary
buyers of Italian and Spanish sovereign debt in
recent months have been their own domestic
banks, which in turn rely on ECB financing and
support. Private foreign investors, such as prime
money market funds (see Section 5.3), have
continued to reduce participation in euro area
Financial Developments

49

BOX C:  RECENT FISCAL AND BANKING DEVELOPMENTS IN SPAIN
Spain announced on June 9 that it intends to request
European Union (EU) assistance to recapitalize its
troubled banking sector. Euro area finance ministers
indicated they would support the request for up to €100
billion (10 percent of GDP), which is expected to cover
estimated stress-case capital needs plus an additional
safety margin. On June 21, independent consultants
engaged by the Spanish government estimated the
recapitalization needs of Spanish banks at up to €62
billion under an adverse macroeconomic scenario. The
formal request is expected to follow this estimate, which is
within the range of most private estimates of capital needs
(€50 billion to €100 billion). Although the announcement
stipulates that no additional explicit conditionality will be
imposed with regards to fiscal policy, Spain must meet
existing fiscal and structural reform commitments, which
were previously agreed with the EU.
On June 29, euro area heads of government agreed
to use euro area funds to support Spanish banks. The
region’s finance ministers subsequently announced that
the agreement would be signed on July 20 and an initial
tranche of €30 billion would be disbursed by the end
of July. The funds will be channeled through the EFSF
to the Spanish government, and then transferred to
the European Stability Mechanism (ESM) once it is fully
operational. Direct ESM funding to Spanish banks will
become available only after the establishment of a single
supervisory mechanism for euro area banks. It was
further agreed that aid for the Spanish banking sector
would not be subject to the preferred creditor status
embedded in the ESM treaty.

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2 0 1 2 F S O C / / Annual Report

Separately, Moody’s, S&P, and Fitch downgraded the
Spanish sovereign by several notches into the BBB
range within the last two months, largely reflecting
concerns about the Spanish banking sector and fiscal
performance. The sovereign downgrades were followed
by downgrades of the banks themselves. Notably, the
International Monetary Fund (IMF) concluded from
its stress tests that Spain’s largest banks appear
sufficiently capitalized to withstand a significantly weaker
macroeconomic environment, given their substantial
earnings generation from international operations.
Concern about Spanish fiscal performance has persisted,
fueling doubts about the prudence of adhering to strict
budget targets amid deepening recession. As a result,
euro area finance ministers agreed on July 9 to ease
Spain’s deficit objectives, raising the 2012 target by one
percentage point to 6.3 percent of GDP and giving the
government an additional year—to 2014—to lower the
deficit below 3 percent of GDP. The agreement will be
made official at the next Eurogroup meeting on July 20.
The relaxation of fiscal targets follows two revisions to the
2011 fiscal deficit. On May 20, the Spanish government
revised its 2011 budget deficit upward to 8.9 percent
of GDP from a previous 8.5 percent estimate, a major
deviation from the 6 percent target. Both the overrun and
the latest revision were driven by the deficits of regional
governments, exposing the difficulty of reining in these
regional deficits. Market reaction to developments in
Spain subsequent to the assistance request was generally
negative, with yields on 10-year Spanish sovereign debt
exceeding 7 percent, a euro era high.

sovereign and bank funding markets. European
pension funds and insurance companies also
have reduced exposures to the periphery,
including to Spanish and Italian sovereign debt.

Chart 5.1.5	 10-Year Sovereign Debt Yields

Other Sovereign Debt
The decline in yields across a range of
developed countries’ sovereign bonds has
been further reinforced by strong investor
interest in high credit quality assets and more
accommodative monetary policies. Through
early July 2012, 10-year nominal U.S. Treasury
yields had declined more than 150 basis points
since July 2011, in part reflecting both the
lower expected path of short-term interest
rates and a fall in the term premium. The
pattern of decline in yields has been similar
for German, Swiss, and U.K. sovereign debt. In
Japan, 10-year sovereign debt yields, which were
already close to 115 basis points, declined more
modestly to just below 85 basis points over the
same period (Chart 5.1.5).

Chart 5.1.6	 Emerging Market Bond Spreads

Emerging European market spreads to
Treasury yields as measured by the Emerging
Markets Bond Index Plus (EMBI+), have
widened over 100 basis points over the past
year through early July—largely in line with
U.S. BBB corporate credit spreads—reflecting
global growth concerns and the pull-back in
risk appetite, as well as specific developments
in certain countries. The spreads on bonds
for other emerging markets also fluctuated in
response to stresses and policies in external
markets (Chart 5.1.6). Some differences
across emerging market economies are
likely associated with country risk and
growth prospects, as well as their policies for
managing capital inflows and outflows.

5.1.2	

Other Asset Markets

Asset markets outside of sovereign debt have also been
heavily influenced by developments in the euro area
and the growth outlook, with the notable exception of
agricultural land and some commodities. Corporate
debt spreads widened over the past 12 months, with
spreads for financial firms increasing more than for
nonfinancial firms. The dollar appreciated against
the euro, reflecting continued concerns with euro area
peripheral sovereign debt.
Financial Developments

51

Chart 5.1.7	

Price Changes in Selected Equities Indices

Chart 5.1.8	 Global Equities

Equities
U.S. equity markets outperformed other major
equities markets from mid-year 2011 through
early July 2012 after a period of considerable
volatility (Chart 5.1.7). Equity markets in
advanced and emerging economies fell sharply
in the third quarter of 2011 as numerous
concerns—including the unfolding European
crisis, the sustainability of U.S. fiscal policy,
and a slowdown in global growth—weighed
on sentiment (Charts 5.1.8). By early October
2011, the S&P 500 was around 17 percent below
its level at the end of June 2011. The Euro
Stoxx index declined around 27 percent over
the same period, reflecting outsized declines
in peripheral equity markets. As concerns
subsequently eased during the first quarter of
2012, buoyed in part by global central bank
actions and ongoing signs of economic recovery
in the United States, U.S. equity markets
reported strong gains. However, much of these
recent gains in the United States have reversed
following weaker than expected data on the
U.S. recovery, weak global economic data and
renewed concerns about the European crisis. As
of July 6, 2012, the S&P 500 was nearly 4 percent
lower than at the end of the first quarter of
2012, and European stocks fell almost 10
percent over the same period.

Corporate Bonds

Chart 5.1.9	 U.S. Corporate Bond Spreads—Investment Grade

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2 0 1 2 F S O C / / Annual Report

Corporate bond spreads to sovereign
equivalents in the United States and Europe
have generally widened since mid-2011,
although this development has been less
pronounced in the United States. A particular
feature has been the large divergence between
spreads on debt issued by financial firms
versus nonfinancial firms, as investors focus
on risks associated with the financial sector
(Chart 5.1.9). A similar pattern can be found in
the relative increase in CDS spreads of financial
firms over nonfinancial firms. Issuance of
covered bonds has outpaced unsecured debt
issuance in a number of European banking
systems, reflecting increased concerns about the
creditworthiness of these institutions. Overall,
U.S. dollar corporate bond issuance has
rebounded strongly in 2012, particularly among
nonfinancial issuers.

Foreign Exchange
Over the past 12 months, foreign exchange
markets were strongly influenced by euro
area developments and monetary policy
expectations. The euro broadly declined over
the second half of 2011 and first half of 2012,
with downside pressure against the major
currencies particularly evident late in 2011
and 2012:Q2. In dollar-euro markets, bid-ask
spreads widened slightly and options markets
placed above average value on protection from
further euro depreciation. Within Europe,
the sharp depreciation against the safe haven
of the Swiss franc prompted a strong market
intervention by the Swiss National Bank in
August and early September 2011, culminating
with the establishment of a floor for the eurofranc exchange rate. Downside pressure on
the euro against major currencies abated
somewhat in early 2012, particularly against
the yen. The Bank of Japan had intervened
in foreign exchange markets in late October
through early November 2011, selling yen and
buying dollars, and also engaged in further
monetary easing through the end of April 2012.
The improvement in risk tone over that period
was also associated with a partial rebound in
many emerging market currencies, after they
had depreciated sharply in the second half
of 2011 as reflected in the other important
trading partners (OITP) and broad dollar
indices (Chart 5.1.10). More recently many
emerging market currencies fell against the
dollar, prompting intervention by some of these
countries to support their currencies.

Chart 5.1.10	 U.S. Dollar Exchange Rates

Overall, between July 2011 and July 2012, the
U.S. dollar appreciated by nearly 15 percent
against the euro, was broadly unchanged
against the yen, and appreciated against most
emerging markets currencies. Options markets
are again placing a relatively high value on
protection against euro depreciation, as
measured by the price differential between outof-the-money puts and calls.

Commodities
Commodity prices have displayed elevated
volatility for the past several years, driven by
Financial Developments

53

Chart 5.1.11	 Commodities

Chart 5.1.12	 Farm Land Prices and Value of Crop Yield

market-specific fundamental factors as well
as broader global growth concerns and risk
sentiment. Oil prices were near their three-year
highs early in 2012, with continued geopolitical
uncertainty in the Middle East raising concerns
over global supply and limited spare capacity.
More recently, however, prices moderated
slightly. In the United States, nominal gasoline
prices were also near historic highs early in
2012 but have likewise moderated. Natural
gas prices almost halved over the past year
on expectations of increased supply arising
from hydraulic fracturing technology (Chart
5.1.11), though prices increased again through
July 6, albeit from quite a low base, as result of
announced cutbacks in drilling and some signs
of accelerated coal-to-gas switching activity.
Industrial metal prices have also declined
since June 2011, with the majority of the fall
occurring in the third quarter of 2011, when
global growth fears were most pronounced. This
period was also associated with marked strength
in gold prices. Commodity markets continued
to function well with only limited impact from
the bankruptcy of MF Global*, despite its role
as a futures clearing merchant in these markets.
(See Box D: MF Global Bankruptcy.)

Agricultural Land

Chart 5.1.13	 Agricultural Real Estate Debt Outstanding

Agricultural land values are estimated to have
increased further through mid-2011, driven
by increasing crop yields, rising commodity
prices, favorable crop export conditions, and
low interest rates (Chart 5.1.12). Adjusting for
commodity prices and improvements in crop
yields, agricultural land values have retreated
somewhat from the record highs reached in 2005
and 2006. Price-to-rent ratios for agricultural
land are at multi-decade highs for a number of
Corn Belt and Plains states but have moderated
from peaks for the United States as a whole.
Currently, aggregate incomes in the U.S.
farm sector are performing well, forecasts
for production and demand are positive, and
debt levels in general do not appear to have
* Chairman Gensler did not participate in the preparation
or review of the portions of this report specifically regarding
MF Global.

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2 0 1 2 F S O C / / Annual Report

been rising sharply. Adjusting for inflation,
current agricultural real estate debt levels
remain significantly below the levels of the
late 1970s (Chart 5.1.13). The Farm Credit
System and community banks that specialize in
agriculture lending have the bulk of exposures
to agricultural land. Delinquency rates on real
estate farm loans at commercial banks declined
in recent quarters to about 3 percent at the end
of 2011, slightly above the historical average of
about 2.6 percent over the past 20 years.

5.1.3	

Chart 5.1.14	 Large Bank Holding Company Liability Structure

Wholesale Funding Markets

Use of short-term wholesale funding has dropped
significantly, with declines in outstanding volumes of
both repurchase agreements and corporate paper. This
development is likely to enhance stability of funding
for financial institutions, as these entities shift to
more stable funding sources such as retail deposits.
However, this shift is partially due to market reaction
to uncertainty and flight to safety, and it could be
retraced as these uncertainties abate.

Chart 5.1.15	 Wholesale Cash Investors

Short-Term Wholesale Funding Markets Overview
Short-term wholesale funding markets,
which include large time and checking
deposits, repurchase agreements (repos),
and commercial paper, provide financial
intermediaries with funds that supplement
retail deposits to support their activities (Chart
5.1.14). Sources of lending in the wholesale
short-term funding markets are largely
wholesale cash pools, including cash on the
balance sheets of nonfinancial companies,
reinvestments of cash collateral from securities
lending, cash held by long-term mutual funds,
and money market funds. These sources of
funds have grown markedly as a percentage of
GDP over the past two decades, although this
percentage has been declining through the first
quarter of 2012 (Chart 5.1.15). Nonfinancial
corporate cash, in particular, has been growing
at an accelerating rate, a pattern that continued
through early 2012.

Chart 5.1.16	 Retail Deposits vs. Short-Term Wholesale Funding

Measures of reliance on short-term wholesale
funding of domestic banking firms continue
to decline and remain well below their peaks
in 2008 (Chart 5.1.16). Slow growth in loans
Financial Developments

55

relative to large deposit inflows, which have
been bolstered by the FDIC’s temporary
unlimited insurance coverage for noninterest-bearing transaction deposits, also
supported this decline.

Recent LIBOR Investigations
Recent investigations into possible manipulation
of the London Interbank Offered Rate (LIBOR)
underscore the importance of effective control
processes to help ensure the integrity of funding
markets. LIBOR rates serve as reference rates
for most interest rate derivatives and variable
rate loans. However, LIBOR rates are not
transaction rates. Rather, the LIBOR rate for a
given currency and tenor is calculated based on
the rates submitted by a panel of member banks
each morning to the British Bankers’ Association
(BBA). The accuracy of LIBOR as a measure of
interest rates in the London interbank market
depends crucially on the accuracy of banks’
responses to the BBA survey.
While media reports of anomalies in the
LIBOR rates have surfaced as far back as
2007, concerns with the integrity of the
LIBOR process escalated in late June 2012.
Specifically, on June 27, in an internationally
coordinated enforcement effort, the CFTC, U.S.
Department of Justice (DOJ) and the United
Kingdom Financial Services Authority (FSA)
each announced actions finding that Barclays
had provided false information to the BBA
surveys and attempted to manipulate LIBOR
and another benchmark, the Euro Interbank
Offered Rate (Euribor), on numerous occasions
and sometimes on a daily basis over a four‑year
period, commencing as early as 2005. In
addition, certain Barclays euro swaps traders,
led at the time by a senior trader, coordinated
with and aided and abetted traders at other
banks in attempts to manipulate Euribor.
Among other things, Barclays improperly made
submissions both to benefit its derivatives
trading positions and to protect against
negative perceptions of the bank’s health.
Barclays entered into settlement agreements
with the CFTC, DOJ and FSA. The CFTC
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imposed a $200 million penalty and issued
an Order requiring Barclays to implement
measures to help ensure that its submissions
are transaction focused, based upon a rigorous
and honest assessment of information and
not influenced by conflicts of interest. Among
other undertakings in the CFTC Order, in
making submissions, Barclays transactions will
be given the greatest weight subject to certain
specified adjustments and considerations. In
addition, Barclays was ordered to implement
firewalls to prevent improper communications
and submissions. As part of a non-prosecution
agreement, the DOJ ordered Barclays to pay
a $160 million penalty. In its action, the FSA
imposed a penalty of £59.5 million.

Chart 5.1.17	 Estimated Value of the Repo Market

Repo Markets
The overall repo market is composed of both
bilateral transactions negotiated between
two market participants and tri-party repo
transactions in which the exchange of cash and
collateral is administered by a clearing bank.
The size of the overall repo market is difficult
to measure, due to issues related to netting and
accounting conventions. Additionally, existing
data do not provide adequate visibility into
the composition of repo activity. Chart 5.1.17
displays two measures of the size of the repo
market: tri-party repos and primary dealer
repos, which include both tri-party and bilateral
repos. According to both measures, the overall
volume of repo activity remains substantially
below that seen in the run-up to the crisis. In
particular, tri-party repo activity peaked in 2008
at $2.7 trillion and fell below $1.8 trillion in the
years since the end of the recession, well below
pre-crisis levels.
As the volume of tri-party activity has declined,
so has the level of traditional and nontraditional collateral in tri-party since July
2008. Traditional collateral consists of Treasury
securities, agency mortgage-backed securities
(MBS), agency debentures, and agency
collateralized mortgage obligations (CMOs).
Non-traditional collateral includes corporate
bonds, equities, private label CMOs, assetbacked securities (ABS), commercial paper
Financial Developments

57

Chart 5.1.18	 Tri-Party Repo Collateral Distribution

Chart 5.1.19	 Commercial Paper Outstanding

(CP), other money market instruments, whole
loans, and municipal bonds. Non-traditional
collateral accounts for only 16 percent of triparty collateral as of May 2012 (Chart 5.1.18),
down from 21 percent of the total in May 2011
and 25 percent in July 2008. Among traditional
collateral in the tri-party repo market, the
share of Treasury securities has increased at
the expense of agency paper, consistent with
relative shifts in supply and flight-to-quality
in recent years. Most types of non-traditional
collateral have fallen significantly, with private
CMOs declining the most.
There are considerable concerns about
structural weaknesses in the tri-party repo
market. (See Box G: Ongoing Vulnerabilities in
the Tri-Party Repo Market.)

Commercial Paper and Asset-Backed
Commercial Paper
CP outstanding peaked at $2.2 trillion in July
2007 and stood at $1.0 trillion at May-end 2012
(Chart 5.1.19). As of May 2012, asset-backed
commercial paper (ABCP) accounts for 32
percent of the market, financial commercial
paper accounts for 48 percent, and nonfinancial
corporate commercial paper accounts for
20 percent. Financial CP and certificates of
deposit (CDs) outstanding are around 40 to
50 percent below their pre-crisis peaks and,
in recent months, financial commercial paper
outstanding has continued to decline, largely
due to reduced demand from investors for
foreign bank commercial paper.
ABCP was only about 6 percent of the total
commercial paper market in 1990, but it
accounted for about 60 percent of the total
market in mid-2007, or approximately $1.2
trillion. The market has shrunk steadily and,
as of the beginning of July 2012, it is currently
at about $311 billion outstanding, with foreign
bank sponsored conduits comprising the
majority of the market. The Moody’s downgrade
of 15 large U.S. and European banks in June
2012, discussed in Section 5.2, also resulted
in the downgrade of 18 ABCP conduits that
rely on these banks for liquidity support. The
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affected conduits have a combined value of
almost $70 billion. These downgrades elicited a
noticeable market response, with an increase in
the cost of funding these conduits.

Chart 5.1.20	 Value of Securities on Loan

Securities Lending
Securities lending is a transaction involving
the temporary transfer of a security by one
party (the lender) to another (the borrower),
in exchange for collateral in the form of either
cash or non-cash instruments. Institutions
may want to borrow securities to facilitate
short selling, for derivative hedges, or to
avoid failing on a delivery. The main lenders
of securities are institutional investors, such
as pension plans, investment funds, and
insurance companies. The main borrowers are
hedge funds, broker-dealers, asset managers,
derivatives traders, and market makers. Most
domestic securities lending is done against cash
collateral. Typically, the lender of a security
pays an interest rate to the borrower for the
cash collateral. Lenders, in turn, seek to earn
an additional return by investing this cash in a
variety of instruments.

Chart 5.1.21	 Securities Lending Cash Reinvestment

The global value of securities lending
transactions remained fairly flat through June
2012 at an average value below $2 trillion
(Chart 5.1.20). The total market value of
securities on loan in the United States was
about $820 billion at the end of the second
quarter of 2012. About 50 percent of the total
U.S. market is represented by U.S. government
securities, about 40 percent by equities, and the
rest by fixed income securities. Reinvestment
of cash collateral from securities lending
declined in volume over the past year from $775
billion in 2011:Q1 to $670 billion in 2012:Q1. In
addition, the weighted average maturity of such
cash reinvestment declined markedly in late
2011, likely in response to concerns associated
with the euro area debt situation (Chart 5.1.21).

5.1.4	

Housing Markets

The housing market remains stressed. However,
national home prices show signs of stabilizing after
a long-term decline, and some measures of house
prices have shown upticks recently. Housing markets
Financial Developments

59

Chart 5.1.22	 National Repeat Sales Home Price Indices

continue to be weighed down by elevated inventories of
foreclosed homes, homes in the foreclosure process, and
homes in danger of foreclosure, although the latter
has been decreasing over the past year. In addition,
the inventory of existing homes for sale has continued
to decline and now stands at levels comparable to
2004. Despite the overall improvement in economic
and financial market conditions and historically low
interest rates, access to residential mortgages remains
constrained. The public sector continues to offer
solutions aimed at stabilizing the housing markets by
providing refinancing and modification options to
prevent additional foreclosures.

Housing Market Overview

Chart 5.1.23	 Mortgages with Negative Equity

Chart 5.1.24	 Mortgage Delinquency and Foreclosure

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Housing activity remains at a historically
low level. Home prices continued to decline
through late 2011, though early 2012 showed
signs of stabilization, including a rise in some
housing price indices (Chart 5.1.22). National
house prices are still as much as 30 percent
below their peak in 2006. Going into the second
quarter of 2012, nearly 13 million homeowners
had mortgage balances exceeding the values
of their homes, a condition known as “negative
equity” (Chart 5.1.23). Although housing starts
and existing home sales remain significantly
below pre-crisis highs, they have risen by more
than 30 percent from their respective 2009 and
2010 lows through April 2012. The inventory
of existing homes for sale has declined
significantly over the last two years and is
currently comparable to levels last seen in 2004.
Indicators of credit quality in the residential
mortgage sector continue to reflect the
challenges confronting homeowners and
lenders. The fraction of mortgages that
are delinquent more than 90 days but not
yet in foreclosure is sometimes referred
to as the “shadow inventory” of homes in
danger of foreclosure. This measure has
declined from a high of 5 percent to around
3 percent; however, it remains at elevated
levels. Moreover, there has been little change
in the fraction of mortgages that are in
foreclosure, which remains around 4.4 percent
(Chart 5.1.24). The inventory of mortgages

that are in some stage of the foreclosure
process remains high (Chart 5.1.25).

Chart 5.1.25	 Foreclosure Pipeline

Mortgage Credit Flows
Mortgage credit flows remain quite constrained.
High unemployment and heightened
uncertainty contributed to weak provision of
housing credit, but tighter credit standards
have also been a major factor. In particular,
the credit quality of new originations—both
purchases and refinances—is far higher than
prior to the crisis (Chart 5.1.26). According
to the Senior Loan Officer Opinion Survey
(SLOOS) data, the persistent net tightening
in mortgage credit standards from 2007
through 2009 has only recently begun to
ease, and only for prime residential loans.
When asked to indicate their willingness to
originate government-sponsored enterprise
(GSE) eligible mortgages relative to 2006 for
borrowers across a range of creditworthiness,
banks were less likely to lend to all credit
categories except those with pristine credit.
While higher credit scores and larger down
payments tended to increase banks’ willingness
to lend, many banks were unwilling to provide
mortgage credit even when the loans were
within GSE requirements. Higher “put-back
risk” (the risk that the mortgage originator may
have to repurchase the loan if it violates the
GSE’s requirements) and borrower costs, along
with difficulty in obtaining mortgage insurance,
were cited as important factors contributing to
banks’ reluctance to originate such loans. The
events of the last several years also exposed
severe deficiencies in the nation’s housing
finance infrastructure. In areas ranging
from the securitization process to servicing
of delinquent mortgages to the foreclosure
process, a system that was designed for a rising
market was shown to function poorly in a
declining price environment. This increased
the level of uncertainty among market
participants, contributing to constrained
credit availability.

Chart 5.1.26	 Median Credit Score at Mortgage Origination

Measures to Strengthen the Housing Market
To strengthen the housing market, the
government developed a number of programs
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61

Chart 5.1.27	 HARP Refinancings

aimed at providing relief to struggling
homeowners, including Making Home
Affordable (MHA), the Home Affordable
Refinance Program (HARP) and the Hardest
Hit Fund. MHA, which was announced in 2009,
was enhanced in January 2012, with expanded
eligibility to reach a broader pool of distressed
borrowers. As of April 2012, MHA has granted
over 1.1 million homeowner assistance
actions, mostly through the Home Affordable
Modification Program (HAMP), which
provides first lien permanent modifications.
Additional MHA programs include a secondlien modification program, an unemployment
forbearance program, and a short-sale or
deed-in-lieu-of-foreclosure program. The
end-date of MHA, based on the January 2012
enhancements, is December 31, 2013.
In April of 2009, the Home Affordable
Refinance Program (HARP) was established
to help homeowners refinance their GSEguaranteed mortgages if they had a loan-tovalue ratio (LTV) higher than 80 percent. As
of March 2012, 1.2 million loans had been
refinanced out of an estimated 3 to 4 million
HARP-eligible homeowners. In October of
2011, the FHFA announced modifications to
HARP in an effort to increase efficiency and
expand the eligible universe of borrowers who
can benefit from refinancing. The revisions
extended the expiration until December 2013,
removed the 125 percent LTV cap in order to
accommodate more borrowers with negative
equity, and provided additional representation
and warranty relief for same-servicer refinances.
These changes seem to have led to increased
HARP refinancing in early 2012 (Chart 5.1.27).
In 2010, the Hardest Hit Fund was announced,
which provides $7.6 billion to Housing Finance
Authorities in the 18 states most affected by
price declines and unemployment as well as
in the District of Columbia. These funds have
been used to develop a range of programs
tailored to their local housing markets,
including mortgage payment assistance
for unemployed borrowers, reinstatement

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programs, principal reduction, and transition
assistance for borrowers.
In addition to these programs, the government
agencies have made substantial efforts to
address loan servicing and foreclosure abuses.
In early 2012, 49 states and the federal
government announced a $25 billion settlement
with the five largest loan servicers. Under the
terms of the settlement agreement, servicers
are required to pay $5 billion to be allocated to
states, borrowers, and the FHFA. In addition,
servicers are also required to dedicate $20
billion toward various forms of financial
relief to borrowers, including reduction of
principal balances on loans with negative
equity and assistance in refinancing. These
actions complement consent orders and other
actions already being taken by the OCC, the
FDIC, the Federal Reserve, and the FHFA to
address and correct deficiencies in mortgage
foreclosure processing.

Chart 5.1.28	 Mortgage Originations

Chart 5.1.29	 Issuance of RMBS

Government-Sponsored Housing Enterprises
Government support to Fannie Mae and
Freddie Mac has helped keep mortgage credit
markets functioning, as private securitization
largely remains absent. At the end of 2011, GSE
mortgage credit flow accounted for 71 percent
of total mortgage origination (Chart 5.1.28),
considerably higher than pre-crisis levels, with
most of the remaining originations coming
from the Federal Housing Administration
(FHA) and Department of Veterans Affairs
(VA). Residential mortgage-backed securities
(RMBS) continue to be issued solely by housingrelated GSEs and Ginnie Mae (GNMA), with
negligible issuance of securities by non-agency
entities (Chart 5.1.29).

Chart 5.1.30	 GSE Net Income and Losses

The financial position of the GSEs has
improved recently. In 2012:Q1, Fannie Mae
earned $2.7 billion income, and it did not
request additional capital support from the
government. In contrast, Freddie Mac reported
a net income gain of $577 million for the same
quarter and is seeking an additional $19 million
in capital from the Treasury (Chart 5.1.30).
Although the loss rate from single-family
Financial Developments

63

Chart 5.2.1	 Aggregate BHC Pre-Tax Income

loans has been declining, this activity is still
the main driver of losses at the GSEs. As of
March 31, 2012, Fannie Mae and Freddie Mac
reported single-family mortgage delinquency
rates of 3.7 percent and 3.5 percent respectively,
representing the lowest delinquency rates
since 2009.

5.2	 Bank Holding Companies and
Depository Institutions
5.2.1	

Bank Holding Companies

Bank holding companies (BHCs) continue to
enhance their overall strength with improved capital
and liquidity positions. Both the quality and
amount of capital at BHCs continue to improve due
to positive operating results, capital raising, and
regulatory changes. Most of the largest BHCs have
resumed capital distributions after undergoing stress
testing and capital planning under the enhanced
supervision of the Federal Reserve. However,
revenues at the largest BHCs remain challenged by
general market uncertainty, slowing global growth,
and the low interest rate environment; credit default
swap (CDS) spreads remain elevated, and increases
in pretax income continue to be driven largely by
non-recurring items.
A majority of commercial banks are owned
by BHCs, which include the bank and any
nonbank subsidiaries such as broker-dealers,
investment companies, or insurance companies.
As of year-end 2011, there were 4,743 top tier
BHCs in the United States (excluding Puerto
Rico), with aggregate assets of about $17.4
trillion. Aggregate pretax income in 2011
totaled $148 billion, an increase of 26 percent
from 2010 (Chart 5.2.1).

Capital and Liquidity
In aggregate, capital ratios for BHCs improved
from 2010:Q4 to 2012:Q1, with the tier one
common capital ratio under current riskbased capital rules (“Basel I”) increasing 1.4
percentage points to 11.1 percent as of 2012:Q1.
Increases in retained earnings, primarily
from positive operating results, contributed
1.1 percentage points to this increase, while

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additional capital raising contributed 0.4
percentage points (Chart 5.2.2).
For the 19 largest U.S. BHCs, capital ratios
continue to improve from post-crisis levels,
with the aggregate tier one common capital
ratio under Basel I improving 1.5 percentage
points from 2010:Q4 to 2012:Q1 to 10.9
percent (Chart 5.2.3). These 19 BHCs also
underwent additional stress testing as part
of the Comprehensive Capital Analysis and
Review 2012 (CCAR 2012). Similar to the 2011
exercise, CCAR 2012 was a forward-looking
cross-sectional analysis designed to examine the
capital planning processes at these firms. A key
part of the Federal Reserve’s examination was
a supervisory assessment of capital adequacy
under a hypothetical stress scenario. This stress
scenario was intended to help ensure a rigorous
assessment of the BHCs’ capital plans and was
significantly more severe than prior stress tests.
For example, one of the macroeconomic factors
used in the stress scenario is the unemployment
rate, which peaks at just over 13 percent for
CCAR 2012—considerably higher than the
comparable stress scenarios in both the 2009
Supervisory Capital Assessment Program (SCAP)
and the prior year’s CCAR exercise (Chart 5.2.4).
In the hypothetical stress scenario, the Federal
Reserve projected that the 19 BHCs would
have a total of $438 billion in tier one common
capital, implying an aggregate tier one common
ratio under Basel I of 6.3 percent at the end of
the nine-quarter projection period—well above
the 5 percent target established in the Capital
Plans Rule issued by the Federal Reserve in
November 2011. The pro forma capital level
under the stress scenario actually exceeded
the BHCs’ aggregate tier one common ratio
at the start of the 2009 SCAP, reflecting the
more than $300 billion increase in tier one
common equity at these BHCs since early 2009
(Chart 5.2.5). However, 4 of the 19 BHCs had
one or more projected regulatory capital ratios
fall below regulatory minimum levels at some
point over the stress scenario horizon.

Chart 5.2.2	 Change in Tier 1 Common Ratios for Aggregate
U.S. BHCs

Chart 5.2.3	 Change in Tier 1 Common Ratios for 19 Largest BHCs

Chart 5.2.4	 U.S. Unemployment Rate: Actual vs. Stress Scenarios

Financial Developments

65

Chart 5.2.5	 Initial and Stressed Tier 1 Common Capital Ratios

Chart 5.2.6	 Consolidated Liquidity Ratio* for Top 50 BHCs

Chart 5.2.7	 Short-Term Wholesale Funding at Largest BHCs

Along with higher capital levels, balance sheets
at the largest BHCs continue to be more robust,
as assets became more liquid and liabilities
more stable following the financial crisis.
In particular, the fraction of assets on BHC
balance sheets consisting of highly liquid assets
is more than two standard deviations above its
average from 1995 to the end of 2011 (Chart
5.2.6). Less reliance on short-term wholesale
funding (Chart 5.2.7), combined with an
increase in core deposits, offers a more stable
and resilient funding base.
Since some of this rebalancing away from
short-term funding across all banks is a result of
flight to quality by wholesale funding suppliers
and since some of the increase in core deposits
may be associated with the expanded FDIC
guarantee that is scheduled to expire at the
end of 2012, the longer-run persistence of these
balance sheet improvements is unresolved.
Moreover, some banks have large amounts of
wholesale funding that are not necessarily fully
covered by liquidity buffers.
For U.S. BHCs with assets less than $50 billion,
the tier one common ratio under Basel I
improved by approximately 1.6 percentage
points to 12.6 percent over the 2010:Q4 to
2012:Q1 period, primarily due to capital raising
(1.4 percentage points) and positive operating
results contributing to retained earnings
(1 percentage point) (Chart 5.2.8). These
increases were somewhat mitigated by the
increase in risk-weighted assets that reduced the
tier one common capital ratio under Basel I by
0.7 percentage point.
Many BHCs continue to engage in moderate
share repurchases and dividend payouts in spite
of continued economic uncertainty, forthcoming
higher regulatory capital requirements, and
enhanced regulatory scrutiny. Although many
of the 19 largest BHCs that participated in the
CCAR resumed distributions of capital in the
form of dividends and share repurchases in
2011, U.S. BHCs saw only a slight increase in
dividends and a net issuance of common equity
in aggregate (Chart 5.2.9).

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As noted in the Council’s 2011 Annual Report,
the Basel Committee on Banking Supervision
(BCBS) agreed in December 2010 to a further
revised set of capital and liquidity standards
collectively referred to as Basel III. In June
2012, the Federal Reserve, FDIC, and OCC
invited public comment on three proposed
rules that would revise and replace the agencies’
current capital rules. These proposals would
implement, in the United States, the Basel
III regulatory capital reforms from the BCBS
and the changes required by the Dodd-Frank
Act. Among other minimum standards, the
proposals would establish a tier one common
equity requirement equal to 4.5 percent of
risk-weighted assets. It would also establish a
capital conservation buffer above the minimum
risk-based capital requirements, which must
be maintained to avoid restrictions on capital
distributions and certain discretionary bonus
payments. As proposed, and consistent with
Basel III, banking organizations generally
would begin implementing the proposed capital
reforms on January 1, 2013, and would be fully
subject to the new standards by January 1, 2019.
Concurrently, the agencies also approved a
final rule to implement changes to the market
risk capital rule, including those made by the
BCBS in 2005 and 2010, to better capture
positions for which the market risk capital rule
is appropriate. The final rule will be effective
on January 1, 2013.

Chart 5.2.8	 Change in Tier 1 Common Ratios for BHCs < $50B

Chart 5.2.9	 BHC Dividends and Repurchases

In November 2011, the BCBS released its
framework and assessment methodology to
identify globally systemically important banks
(G-SIBs) that are subject to an additional
common equity tier one capital buffer ranging
from 1.0 to 3.5 percent of risk-weighted assets.
Eight U.S. BHCs were designated as G-SIB and
would be subject to the higher capital standards
beginning in 2016, with full implementation
by 2019. As with Basel III standards, the G-SIB
framework would be incorporated by member
jurisdictions into their local capital rules.

Performance
Despite strengthened balance sheets and
liquidity, BHC market indicators have been
Financial Developments

67

Chart 5.2.10	 Return on Average Assets

weighed down by concerns around potential
contagion from Europe, among other
vulnerabilities, discussed further in Section 7.
Within the subset of 69 BHCs with assets greater
than $10 billion, aggregate pretax income
increased by 20 percent in 2011 to $138 billion,
but return on assets still remains lower than the
levels that prevailed in the 10 years before the
crisis (Chart 5.2.10). Trading revenue in 2011
was negatively affected by sharply lower client
activity and volumes amid fears of European
contagion and concerns of slowing global
economic growth. Earnings were also adversely
affected by the interest rate environment
characterized by both low short-term rates and
low term premiums. Furthermore, approximately
40 percent of this pretax income for 2011 was
due to two non-recurring accounting items: (1)
increased releases of reserves against losses on
loans and leases due to improved credit quality;
and (2) so-called “debt valuation adjustments”
(DVAs), whereby decreases in the mark-to-market
value of a BHC’s liabilities is booked as a profit.
It is unclear to what degree these non-recurring
items will contribute to the profitability of U.S.
BHCs going forward, as the pace of reserve
releases continues to decline, and potentially
tightening credit spreads would result in
reversals of these mark-to-market DVA gains.
On June 21, 2012, Moody’s announced the
results of its review of the credit ratings of
large international banks with global capital
markets operations. Fifteen global banks were
downgraded, with 10 of these banks incurring a
two-notch downgrade to their long-term ratings;
Credit Suisse was downgraded three notches.
(In addition, two dealer banks, Nomura and
Macquarie, had been downgraded in March.)
These downgrades reflected a re-assessment by
Moody’s of heightened uncertainties associated
with capital market operations. However,
Moody’s continues to rate more highly those
banks seen to have superior risk-management
capabilities, more conservative funding profiles,
and/or lower reliance on capital markets
activities. These ratings actions were generally
in line with market expectations and with prior
guidance provided by Moody’s in February.

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Market Indicators
Following the heightened level of duress in
capital markets during the second half of
2011, market indicators for BHCs reflected an
improved investor sentiment and greater risk
appetite in early 2012. These improvements
later receded during the second quarter of
2012. The market capitalization weighted priceto-book ratio of the six largest BHCs improved
in 2012, but market valuations remained at a
more than 25 percent discount to book value
in July 2012, which is below both the pre-crisis
level and the average level over the past 12 years
(Chart 5.2.11). In late 2011, an equally weighted
average of CDS spreads for the six largest
BHCs reached levels last seen during the crisis.
Spreads remain elevated relative to early 2011
levels (Chart 5.2.12).

5.2.2	

Chart 5.2.11	 Price-to-Book Ratio of 6 Large Complex BHCs

Chart 5.2.12	 CDS Spreads of 6 Large Complex BHCs

Insured Depository Institutions

Performance within the commercial banking
industry continues to rebound, coinciding with the
general improvement in credit quality within the
economy. Despite the rate of bank failures declining,
the commercial banking sector has become more
concentrated, as larger banks have seen higher levels
of profitability and rebounded faster post-crisis.

Insured Commercial Banks and Savings
Institutions
The banking industry is composed of more
than 7,300 commercial banks and savings
institutions. Of these, approximately 6,600
institutions have assets under $1 billion, 88
institutions have assets between $10 billion and
$100 billion, and 19 institutions have assets over
$100 billion. Failures, mergers, and a decline in
chartering activity have contributed to further
consolidation over the past several years.

Chart 5.2.13	 FDIC-Insured Failed Institutions

Failures of insured depository institutions
continue to decline from crisis levels, as 92
institutions representing $35 billion in assets
failed in 2011 (Chart 5.2.13). An additional
31 insured institutions have failed thus far in
2012 (through July 6) representing $7.6 billion
in assets. As of March 31, 2012, some 772
institutions, accounting for 10.6 percent of all
institutions, were on the FDIC’s problem bank
Financial Developments

69

Chart 5.2.14	 Commercial Bank and Thrift Pre-Tax Income

Chart 5.2.15	 Commercial Property Price Indices

list, with financial, operational, or managerial
weaknesses that threatened their continued
financial viability.
Pretax net income for U.S. commercial banks
and savings institutions totaled $169.3 billion
in 2011, representing a significant increase
over 2010 and a continuation of the rebound
following the crisis. A rebound in credit quality
with the associated reduction of loan loss
provisions and other expenses continues to
drive the improvements in pretax net income
since 2009 (Chart 5.2.14). Although the largest
institutions and community banks benefited
from reductions in loan loss provisions,
community banks have experienced a smaller
increase in net revenue than large banks. In
addition, community banks continue to deal
with credit problems associated with relatively
outsized concentrations in the commercial
real estate sector, which remains depressed
(Chart 5.2.15).

Credit Unions

Chart 5.2.16	 Concentration of Credit Union Assets

The number of credit unions declined to
7,094 institutions by year-end 2011, down
from 7,339 at year-end 2010. This 3 percent
decline in the number of credit unions is in
line with recent trends. As in other parts of
the banking system, assets in the credit union
system have become more concentrated, with
the top 100 credit unions increasing their
share of total credit union assets to 39 percent
(Chart 5.2.16). Corporate credit unions—
which provide critical services to the broader
credit union system—are consolidating and
deleveraging as they refocus their business
models on providing operational support to
consumer credit unions, raising capital, and
adjusting to the new regulatory environment.
As of year-end 2011, there are 24 corporate
credit unions with $34 billion in assets—a
decline from 27 corporate credit unions with
$96 billion in assets in 2007.
The credit union system experienced an
improved return on assets (ROA) in 2011 of 67
basis points, an increase from 50 basis points
in 2010. Improved credit conditions were the

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primary driver behind the provision for loan
losses declining from 0.8 percent of assets in
2010 to 0.5 percent of assets in 2011 (Chart
5.2.17). Aggregate net income increased to $6.3
billion, a 39 percent improvement from 2010.
Overall loan levels within the credit union system
rebounded by 1.2 percent to $571 billion after
experiencing a decline of 1.4 percent in 2010. In
2011 loan growth was driven by increases in real
estate, credit cards, and auto loans.
Profitability continues to vary based on the size
of the institution, with smaller credit unions
historically lagging behind larger credit unions.
The industry still faces some uncertainty over
future losses associated with failed corporate
credit unions; with future resolution costs
projected to total between $2.7 billion and $6.0
billion over the coming years, these assessments
are not likely to curtail industry growth and
profitability. Larger concerns for the industry
are challenges related to the low interest
rate environment and managing through a
transition into a higher rate environment. As
Chart 5.2.18 shows, fixed-rate real estate as a
share of loans and long-term assets as a share of
assets have risen over the past several years.

Chart 5.2.17	 Federally Insured Credit Union Income

Chart 5.2.18	 Credit Union Fixed Rate Real Estate and
Long‑Term Assets

5.2.3	 U.S. Branches and Agencies of
Foreign Banks
U.S. branches and agencies of foreign banks support
lending activity in the United States, but also tend
to rely on a funding mix that is less stable than that
of most U.S. commercial banks. These branches and
agencies are sensitive to the funding and liquidity
needs of their parent organizations and depend on
access to uninsured deposits that pose a heightened
flight risk. Stresses on parent banks and constrained
access to short-term dollar funding impinged on
branch lending and investment in the United States
over the past year, especially by the European branches
and agencies.
In addition to the U.S. BHCs, foreign bank
families have a large presence within the United
States. Together, the U.S. branches and agencies
of foreign banks account for close to $2 trillion
of banking assets, over 15 percent of total U.S.

Financial Developments

71

Chart 5.2.19	 U.S. Branches and Agencies of Foreign
Banks: Assets

Chart 5.2.20	 U.S. Branches and Agencies of Foreign
Banks: Liabilities

banking assets. These entities represent an
important source of credit for U.S. borrowers.
There are different business models in the
operations of branches in the United States,
with a mix of targeted investment and asset
strategies and a range of different funding
approaches. On average, branches and
agencies generally dedicate about 30 percent
of their balance sheets to loans, but can differ
substantially in the composition of their lending
across commercial and industrial (C&I) activity
versus other U.S. domestic customers. Direct
C&I loans outstanding by these banks, which
represents a major source of financing for U.S.
businesses and investment projects, has been
as high as $365 billion, but more recently has
fallen closer to $260 billion, out of total loans
of over $500 billion (Chart 5.2.19). Other
securities held as assets have risen sharply
from about $300 billion pre-crisis to closer to
$1 trillion by 2012:Q1. Some of these branches
and agencies also send dollar flows to their
parent organizations and related affiliates,
as indicated by the levels of Net Due from
Related Depository Institutions in the balance
sheet decompositions in Chart 5.2.19. These
flows support dollar lending and investment
activities in the United States and elsewhere.
European parent banks in particular have
actively used their branches to source dollar
funding. Outstanding positions vis-à-vis parent
banks currently are a smaller percentage of
branch and agency assets than at any point in
recent history.
The liability side of balance sheets of the U.S.
branches and agencies of foreign banks also has
bearing on financial stability (Chart 5.2.20).
Most of these U.S. branches are not allowed to
offer deposits insured by FDIC and thus lack
access to the stable source of funds represented
by households’ checking, savings, and other
transaction accounts. Instead, money market
funds and other noninsured deposits provide
the majority of funding for these institutions.
When such funds and depositors withdraw
from particular banks, which occurred in the
summer of 2011 when European banks were

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viewed as particularly risky, it can destabilize
the balance sheets of those banks, leading to
deleveraging or potential reversals of support
to the parent organization. (See Box H:
Money Market Fund Responses to Euro Area
Uncertainty.) Such dynamics are masked, to
some extent, in the aggregate statistics, as
these deposits may be reoriented to other U.S.
branches and agencies. However, the recent
increases in Net Due to Related Depository
Institutions shows a greater degree of support
from foreign parent banks than previously
had been the case, as investments are made
to maintain the presence of these banks in
U.S. asset classes and reduce contractions of
lending activity and asset sell-offs that could
otherwise occur.

Chart 5.3.1	 Life and Other Insurance: Capital and Income

5.3	

Other Financial Institutions

Chart 5.3.2	 Life Insurers: Impact of Low Rate Environment

5.3.1	

Insurance

Despite a substantial net decline in income in 2011,
capital levels within the insurance industry improved.
The life insurance industry continues to play a
significant role in long-term funding of assets through
the investment of premium income. The low interest
rate environment has proved challenging for life life
insurers to generate sufficient investment returns to
meet high guaranteed benefits promised in prior years.
Property and casualty insurers faced historically
higher catastrophe losses that impeded performance
in 2011.
For life insurance companies, which sell
retirement products such as traditional life
insurance contracts and annuities, book capital
grew modestly, despite net income declining
by over 50 percent or $13.6 billion in 2011
compared to 2010 (Chart 5.3.1). The spread
between the yield that life insurers earn on their
investments and a measure of the interest rate
necessary to maintain policyholder reserves,
also known as the required interest rate, has
narrowed since 2007 (Chart 5.3.2). If this spread
had stayed at 2007 levels, net income would have
been $13.0 billion higher during the period
from 2008 through 2011—$1.2 billion higher in
2011 alone.

Financial Developments

73

Chart 5.3.3	 Commercial Mortgage Origination by Lender Type

The low interest rate environment poses a
significant challenge for life insurers with
sizable blocks of liabilities incorporating
embedded interest rate guarantees, such as
annuities or universal life insurance policies.
The industry has reduced its minimum
guarantees over time, but products sold when
interest rates were higher represent a continued
drag on profits. The share of life and annuity
product account values subject to a minimum
guaranteed rate of return of 5 percent or
higher fell from 20 percent to 10 percent
over the 2006-2010 period, but more than 40
percent of account values were still subject to
a minimum guaranteed rate of return of 3.5
percent or higher in 2010. Life insurers have
exited selected markets due to the inability
to meet the minimum guaranteed returns
associated with the underlying products in this
low rate environment. Of note, life insurers
have increased their use of non-traditional
investments, such as hedge funds and private
equity, perhaps as a response to the low interest
rates that currently prevail.
The role of the life insurance industry in
funding new commercial mortgages has
increased since the collapse of conduit activity
in 2008. Life insurers funded roughly 25
percent of new commercial mortgages in 2011,
compared to 10 percent in 2007 (Chart 5.3.3).
Although the industry is playing a larger role
in financing new loans, commercial mortgages
as a share of total life insurance assets have
decreased modestly from 2007 to 2011 to less
than 1 percent of assets.
Property and casualty insurers, who sell
insurance on homes, cars, and businesses,
are less affected by the low interest rate
environment because they underwrite shorter
duration liabilities without embedded interest
rate guarantees. However, property and casualty
insurers were pressured by large catastrophe
losses in 2011. Insured catastrophe losses were
$33.6 billion in 2011, 135 percent higher than
in 2010 and exceeded only by the extraordinary
losses associated with Hurricane Katrina in
2005. Property and casualty assets fell slightly

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during 2011, although book capital levels were
largely unchanged despite a 46 percent decline
in net income from 2010 to 2011 (Chart 5.3.4).

5.3.2	

Chart 5.3.4	 Property and Casualty Insurance: Capital and Income

Money Market Funds

Total money market fund (MMF) assets declined
over calendar year 2011, reflecting low yields and
concerns over European exposures. Low rates also
reduced revenue flows to fund managers. Substantial
redemptions from MMFs in the summer of 2011 in
response to heightened financial market uncertainty
associated with euro area stresses and federal budget
negotiations in the United States illustrates the
extent to which MMFs are still subject to pro-cyclical
redemption pressures.
Total U.S. MMF assets declined from $2.80
trillion at year-end 2010 to $2.56 trillion as of
May 2012. Prime MMF assets declined from
$1.62 trillion to $1.42 trillion, while government
and Treasury MMF assets increased from $855
billion to $872 billion during this period.
Tax-exempt funds also declined from $330
billion to $272 billion (Chart 5.3.5). During
July and August of 2011, there was significant
redemption activity due to the European debt
crisis and the political uncertainty in the United
States leading up to the debt limit extension
in early August 2011. Between the end of May
and the end of August 2011, prime MMF assets
fell by more than $160 billion (9.8 percent)
(Chart 5.3.6), with some funds diminished by
as much as 50 percent over this period. Prime
fund bank holdings in France continued to
decline through the end of 2011. (See Box H:
Money Market Fund Responses to Euro Area
Uncertainty.) Since that period, prime MMFs
have bolstered their liquidity levels to better
handle redemptions, with daily liquidity levels
ranging from 26 percent to over 30 percent and
weekly liquidity levels holding at over 40 percent
in late 2011 and early 2012 (Chart 5.3.7). MMFs
also reduced maturities since the summer of
2011, with the weighted average life for prime
MMFs falling to around 70 days (Chart 5.3.8).

Chart 5.3.5	 Money Market Mutual Fund Assets by Fund Type

Chart 5.3.6	 Institutional vs. Retail Money Market Fund Assets

Financial Developments

75

Chart 5.3.7	 Prime Funds Liquidity

Chart 5.3.8	 MMF WAL*

The low interest rate environment also affected
revenues of MMF managers. Total expense
ratios for MMFs have fallen from 49 basis points
to 25 basis points for retail MMFs and from 26
basis points to 18 basis points for institutional
MMFs from 2009 to 2011. This significant drop,
particularly among retail MMFs, is primarily
due to fee waivers by MMF sponsors to preserve
a positive net yield for MMF investors. As
the extended low interest rate environment
continues to put pressure on MMF yields, some
MMFs have shown a willingness to take on
additional portfolio risk (Chart 5.3.9), which
increases MMF gross yields and offsets the
pressure to provide fee waivers. Thus, while
on average MMFs have shown a decreased risk
appetite in 2012, some funds have sought to
increase their risk profile.

5.3.3	

Broker-dealers

The broker-dealer (BD) industry contracted
significantly while reducing leverage. Concentration
in the industry increased.
As of year-end 2011, there were 4,679 domesticand foreign-owned BDs operating in the United
States. Coinciding with a sharp decline in
leverage within the industry, assets held within
the U.S. BD industry fell sharply to $4.8 trillion
at 2012:Q1—a decline of 25 percent since 2007
(Chart 5.3.10).

Chart 5.3.9	 Gross Yield of 5 Outlier MMF Families

The U.S. BD sector is relatively concentrated; at
year-end 2011, 60 percent of industry assets were
held by the top 10 BDs, the largest of which
are affiliated with foreign banks and domestic
BHCs. By contrast, the top 10 independent BDs
represented only 6 percent of industry assets. In
late 2011, the third largest independent BD, MF
Global, filed for bankruptcy. (See Box D: MF
Global Bankruptcy.)
Aggregate pretax income declined by 59
percent in 2011 to $14 billion, as trading
revenues declined sharply (Chart 5.3.11).

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5.3.4	

Specialty Lenders

Specialty lenders continue to play a critical role in
providing credit to those markets not served by the
traditional banking industry and providing necessary
funding in certain segments of the mortgage markets.
The specialty lending sector is composed of
a wide range of entities, ranging from real
estate investment trusts (REITs) who invest
a majority of their capital in mortgage and
mortgage-related holdings, to captive finance
arms of major manufacturers who facilitate
the financing of the parent firm’s products.
As of April 2012, specialty lenders owned
approximately $654 billion of consumer loans,
$330 billion of real estate loans, and $434
billion of business loans. Aside from consumer
credit revolving loans and retail business loans
(Charts 5.3.12 and 5.3.13), specialty lenders
experienced a slight decline in loan balances
across a wide variety of loan categories, which
was consistent with overall trends in the
traditional banking industry.

Chart 5.3.10	 Aggregate Broker-Dealer Assets and Leverage

Chart 5.3.11	 Broker-Dealer Revenues

As the GSEs have reduced their investment
portfolios, REITs have been a rapidly
growing source of investment capital for
agency mortgage-backed securities (MBS).
As of 2012:Q1, REITs held $299.4 billion of
agency MBS, a 109 percent increase from
2010 and roughly five times pre-crisis levels
(Chart 5.3.14).

5.3.5	

Investment Funds

Across the various types of investment companies,
fund flows seem to reflect a general shift towards
deleveraging and risk reduction by households
and corporations within the uncertain financial
environment. Performance in this low interest rate
environment tended to be lackluster.

Chart 5.3.12	 Consumer Loans Outstanding

Mutual Funds
Mutual fund flows from year-end 2010 to
2012:Q1 reflect growing investor preference for
capital preservation, income generation, and
lower volatility. Mutual funds had an estimated
$202 billion net inflow for the period, largely
attributable to taxable bond funds, which
received a net $217 billion (Chart 5.3.15). Of
Financial Developments

77

BOX D:  MF GLOBAL BANKRUPTCY
MF Global Holdings Ltd. (MFG) and MF Global Finance
USA Inc. filed on a consolidated basis for relief under
Chapter 11 bankruptcy protection on October 31, 2011.
Of particular interest in the United States was the jointly
registered broker-dealer (BD) and futures commission
merchant (FCM), operating as MF Global Inc., which
entered liquidation proceedings under the Securities
Investor Protection Act (SIPA).
The jointly registered BD-FCM was a clearing member
at several domestic central counterparty (CCP)
clearinghouses, including the Chicago Mercantile
Exchange (CME), the Options Clearing Corporation, and
National Securities Clearing Corporation (NSCC). The BD
was also a primary dealer in government securities with
the Federal Reserve Bank of New York. The BD-FCM
conducted business for its own account, as well as for
customers.

or NSCC. However, later on the same day, the company
reported a shortfall in customer-segregated assets.
The full extent of the shortfall in commodities customer
funds will not be known until the Trustee managing MFG’s
liquidation completes its efforts to recover assets and
finalizes the customer claims process. The Trustee has
distributed approximately $3.9 billion to date to customers
who were trading primarily on U.S. futures markets. This
represents approximately 72 percent of such customers’
account balances. The Trustee also received the approval
of the Bankruptcy Court on April 26, 2012, to distribute
up to an additional $685 million, including $600 million
to customers with claims for accounts trading on U.S.
contract markets.

The Trustee, however, has stated that there is an
approximate $1.6 billion gap between the value of the
Trustee’s estimate of potentially allowable commodities
A series of events led to the bankruptcy of MFG.
claims and the assets that are currently under the
Between March 2010 and March 2011, MFG entered
Trustee’s control. A significant component of the gap in
into repurchase agreement transactions collateralized to
customer funds is attributable to approximately $700
maturity with European sovereign debt securities. During
million of customer assets that were deposited with
2011, the company continued its almost uninterrupted
MF Global UK Limited, an MFG affiliate in the United
series of quarterly operating losses (9 of 11 quarters
Kingdom, for trading on non-U.S. markets. The Trustee
through September 2011) that resulted partly from
is disputing the treatment of these funds under English
declining interest income earned from investing customer law with the Joint Special Administrators of MF Global
funds. On October 24, Moody’s downgraded MF Global
UK Limited, and the likelihood of such assets being
Holdings Inc., citing exposure to European sovereign debt, repatriated is uncertain at this time and is expected to be
high leverage, and its likely inability to achieve financial
subject to future litigation or further United Kingdom court
targets. The following day, MFG announced a $192
action. In addition, multiple federal agencies are reviewing
million quarterly loss. MF Global Holdings Inc.’s debt was
the circumstances surrounding the transfers of monies
subsequently downgraded to junk. Industry observers
out of customer-segregated bank accounts (particularly
believe that the ratings downgrade also precipitated the
certain transfers that occurred during the week prior to
lowering of the collateral advance rate on the term to
the bankruptcy filing).
maturity repurchase agreements, prompting a margin call.
The earnings report and credit-rating downgrade also
An SIPC-led liquidation was initiated on October 31. The
impacted MFG’s liquidity, as certain counterparties and
firm had 200 to 300 securities accounts totaling less
clearing organizations assessed their credit exposure to
than $500 million in assets and over 38,000 commodity
MFG and imposed increased collateral requirements.
customer accounts totaling over $7 billion. The SIPA
Trustee managing the liquidation is responsible for returning
On the day of the bankruptcy, the company did not
customers’ property as quickly as possible, including
default to the CME, the Options Clearing Corporation,
both securities and commodities customers. As stated
previously, approximately 72 percent of U.S. segregated
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customer property has been distributed to commodities
customers trading on U.S. designated futures markets as
of April 25 on a pro rata basis. As a result of a distribution
of funds recently approved by the bankruptcy court, that
number should increase to over 80 percent.

defaulting customers of the FCM but not the collateral of
the non-defaulting customers, as is permitted today with
exchange-traded futures.

The missing customer money highlights the issue of
customer protection for commodities accounts. FCM
accounts at custodians that contain customer property
are under the control of the account holder, the FCM.
FCMs routinely keep substantial amounts of their own
capital in their customer accounts in order to protect
against any possibility of a shortfall in customer accounts
that may result from daily market moves, margin
requirements, and other activity. Accordingly, it is critical
for custodians to monitor the transfer of any money out of
segregated accounts.
The CFTC has taken steps to enhance customer
protection. In December 2011, the CFTC amended its
regulations governing derivatives clearing organizations
(DCOs) and FCM investment of customer funds. Among
other things, the CFTC eliminated from the list of
permitted investments BD-FCM in-house transactions that
are the economic equivalent of repurchase agreements,
repurchase agreements with affiliates, corporate notes
and bonds that are not federally guaranteed, and foreign
sovereign debt instruments. The amended regulations
also imposed asset-based concentration limits and repo
counterparty concentration limits, in addition to mandating
stricter issuer-based concentration limits than had been
applied previously.
The CFTC has also issued a new rule for customer
segregation of cleared swaps, called legal segregation
with operational commingling (LSOC). Under this model,
each FCM will provide the DCO with position and
collateral valuation information at the customer account
level. The DCO can hold customer collateral provided by
FCMs in the same commingled manner as it holds margin
assets for exchange traded products. In a situation of
“double default,” where the default of an FCM customer
causes the FCM to default to the DCO, the DCO would
be able to then identify and access the collateral of the
Financial Developments

79

Chart 5.3.13	 Business Loans Outstanding

note, the strong asset growth rates in highyield funds (17 percent growth rate, relative to
2011 year-end net assets) and emerging market
bonds (55 percent growth rate) over this period
may reflect investor preference for yield among
lower volatility fixed income products (Chart
5.3.16). In contrast, U.S. equity funds had
net outflows of $86 billion, with net monthly
outflows since May 2011.

Pension Funds
As of the fourth quarter 2011, the combined
assets under management of private and public
pensions were over $15.3 trillion (Chart 5.3.17).

Chart 5.3.14	 Real Estate Investment Trust (REIT) Assets

Chart 5.3.15	 Mutual Fund Flows by Asset Class (2011 to 2012 Q1)

Both public and private defined benefit plans
remain significantly underfunded relative
to the present value of their liabilities due to
inadequate past contributions, low interest
rates, and losses incurred in 2007 and 2008.
As of year-end 2011, public defined benefit
plans were only 76 percent funded, while
private defined benefit plans were 79 percent
funded (Chart 5.3.18). Some private pension
funds have received contributions to make up
shortfalls or have been able to adjust their plans
to reduce future outlays.
A number of state and local pension funds
continue to grapple with structural shortfalls
between their assets and liabilities. While
these pension funds face pressure to reduce
their expected return assumptions, many
are reluctant to change assumptions in a
meaningful way, reducing expected returns
by only 25 to 50 basis points over the past
three years. Currently the median assumed
expected return across public plans is 8
percent, while private sector estimates of
returns are closer to 6 percent.
Over the past three years, many states and
localities have increased efforts to address
long-term pension funding issues by curtailing
benefits and increasing employee contributions,
among other measures. Analyst views on the
impact of these changes on pension funding
profiles differ, with some viewing them as
positive for long-term plan sustainability, while

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others regard them as insufficient to address
medium-term funding needs. To reduce fiscal
pressures, state and local pension funds may
seek to further curtail benefits for current
and future retirees or seek increased financial
support from their respective sponsors. If
successful, these developments could lead to
lower expected payouts for employees, reduced
services, higher taxes, or some combination of
all three. However, public pension benefits are
often legally guaranteed, and amending them
remains challenging.

Chart 5.3.16	 Mutual Fund Taxable Bond Flows (2011 to 2012 Q1)

Private Equity Funds
U.S. private equity assets under management
increased to $1.7 trillion in 2011 (Chart 5.3.19).
The growth in assets continued to be supported
by allocations from institutional investors such
as pension funds, which comprise 43 percent of
U.S. private equity capital. Although leveraged
buyouts and venture capital account for over
half of private equity assets under management,
advisers continue to diversify their investment
strategies into areas such as real estate, natural
resources, distressed assets, and emerging
market opportunities (Chart 5.3.20).
The high volume of fund-raising and robust
deal activity that signified pre-crisis private
equity activity created the conditions that
currently prevail, with advisers now focused
on exiting existing investments and deploying
committed capital. Given the constrained initial
public offering (IPO) environment and tepid
mergers and acquisitions activity amid ongoing
economic uncertainty, private equity firms are
focused on realizing returns on historically
high levels of existing portfolio investments.
They are also seeking investment opportunities
for over $500 billion in undeployed capital
commitments stemming from record
levels of fund-raising from 2005 to 2007.
(See Chart 5.3.19.)

Chart 5.3.17	 Retirement Funds by Type

Chart 5.3.18	 Public and Private Pension Funding Level

Hedge Funds
Institutional investors continue to be interested
in hedge funds as an asset class in part because
of the perception that the correlations between
hedge funds and broad asset classes are low.
Financial Developments

81

Chart 5.3.19	 U.S. Private Equity AUM

Chart 5.3.20	 U.S. Private Equity AUM by Strategy

At year-end 2011, assets managed by hedge
funds were approximately $2.13 trillion, which
represents a 3.5 percent increase from year
2010. This growth in assets under management
primarily reflected inflows, rather than fund
performance in 2011 (Chart 5.3.21). In fact,
hedge funds had lackluster performance across
the major strategies for the calendar year
(Chart 5.3.22). Similar to other investment
options, hedge fund performance has
rebounded slightly in early 2012.
Following the crisis, institutional investor
preferences for larger, more established funds
with longer track records led to a greater
concentration of industry assets at larger
firms. This trend continued through 2011 and
into 2012 as larger funds benefitted from the
perception of increased stability.

Exchange Traded Funds
Exchange traded funds (ETFs) remain a
popular means of achieving exposure to various
market indices, as evidenced by their continued
growth in terms of product launches and asset
growth (Chart 5.3.23). In 2011, the number of
U.S.-listed ETFs grew by 28 percent to 1,353
products, and ETF assets grew by 6 percent to
$1.06 trillion. Compared to 2010, net inflows
in 2011 remained flat at $121 billion with
higher concentrations of funds moving into
ETFs with taxable bond, U.S. stock, and sectorspecific strategies.

Chart 5.3.21	 Change in Hedge Fund AUM

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The U.S. ETF market remains populated
predominately by passively managed
products that track widely followed indexes
in equity, fixed income, and commodity
markets. Recently, alternative index strategies
have emerged as ETF providers adapt to
an increasingly saturated market. These
“fundamental indexing” products rebalance
their holdings according to proprietary
methodologies that seek to extract value that is
either not captured, or is obscured by, existing
index construction. For example, among equitybased ETFs, such products may focus on lower
volatility, lower beta to the broader market,
higher earnings quality, higher dividend yield,

and so forth. On a related note, fixed income is
widely viewed by industry observers as a likely
avenue of growth for passively managed funds.
In addition to the growth of fundamental
indexing, actively managed ETFs are cited
by some as a potential new avenue for the
ETF industry to grow. ETFs are required to
disclose their holdings daily, while traditional
mutual funds generally disclose their holdings
quarterly. The requirement for daily disclosure
is a matter of concern to some active managers,
who fear the exposure of their strategies in
the ETF structure may adversely affect the
values of their funds. However, 2012 has seen
notable launches of and filings for new actively
managed ETFs, particularly for fixed income
products, indicating that active management
may indeed overcome the disclosure issue.

Chart 5.3.22	 Hedge Fund Performance by Strategy

Chart 5.3.23	 Growth in ETF Assets and Number of Funds

Despite the continued robust growth of the
global ETF market, market participants remain
attentive to some potential risks pertaining to
ETFs, which may not yet be fully understood. In
particular, some market participants continue
to highlight the synthetic ETF structure as a
potential transmission mechanism for risks
between the United States and European
financial systems. A synthetic ETF generates
the return of an index through a total return
swap with a bank, whereas a “physical” ETF
holds the actual index constituents. Synthetic
ETFs are common in Europe but not in the
United States. Synthetic ETFs may manage
to track indexes with lower trading costs and
lower tracking error—particularly for less
liquid markets—compared to an ETF. However,
despite their potential advantages, some market
participants continue to voice concerns over the
potential for this structure to amplify financial
market stresses in the event that a bank
engaging in swaps with a synthetic ETF sponsor
should be unable to meet its obligation. In
addition, the emergence of new types of ETFs
and similar products, such as leveraged and
inverse-leveraged ETFs, actively managed ETFs,
and ETFs based on very particularized asset
classes, is a growing trend in the market and a
focus of regulators.
Financial Developments

83

BOX E:  CURRENT STATUS OF REMAINING STABILIZATION FACILITIES
INAUGURATED DURING THE CRISIS
During the crisis, various federal agencies set up facilities
to help stabilize the financial system when private market
functioning was severely disrupted. While several of these
facilities still hold net balances, most have been wound
down in a manner that protects the U.S. taxpayer.

Troubled Asset Relief Program Bank Support Programs
Key parts of the federal government’s response to the
financial crisis were carried out by Treasury under the
Troubled Asset Relief Program (TARP). Among several
TARP programs targeting the banking system, the largest
was the Capital Purchase Program (CPP), under which
Treasury invested approximately $205 billion in over 700
banking organizations. The CPP is now closed. As of June
29, 2012, repayments—along with interest, dividends,
and other income—exceeded the original disbursement.
Treasury estimates that the total gain to taxpayers from the
$245 billion disbursed under all bank support programs
under TARP will ultimately exceed $20 billion (Chart E.1).

Chart E.1	

TARP Bank Support Program Status

provided unlimited deposit and share insurance coverage
for non-interest-bearing transaction accounts beginning
December 31, 2010, is scheduled to expire December 31,
2012. As of March 31, 2012, $1.3 trillion in non-interestbearing accounts at over 7,000 institutions exceeded the
basic coverage limit of $250,000 per account but was fully
insured by temporary coverage. Under the TLGP, the FDIC
guaranteed newly issued senior unsecured debt of insured
depository institutions, their holding companies, and certain
affiliates. No new debt can be guaranteed under the TLGP,
but approximately $109 billion in guaranteed debt remained
outstanding as of May 31, 2012.

Term Asset-Backed Securities Loan Facility
The Term Asset-Backed Securities Loan Facility (TALF),
which the Federal Reserve and Treasury began operating
in 2009, was created to help market participants meet
the credit needs of households and small businesses by
supporting the issuance of asset-backed securities (ABS)
collateralized by certain consumer and business loans.
Under the TALF, the Federal Reserve provided eligible
borrowers with three-year and five-year non-recourse loans,
collateralized by ABS.
In total, $71 billion in loans were provided under the TALF,
but many were repaid early. The outstanding amount of
TALF loans fell from $24.7 billion at the start of 2011 to
$5.3 billion as of June 20, 2012. As of the end of March
2012, all collateral pledged against outstanding TALF loans
maintained their AAA ratings, and all loans were performing
as scheduled. Treasury committed to provide the Federal
Reserve up to $20 billion under TARP in credit protection for
the TALF. This amount was later reduced to $4.3 billion in
July 2010 and subsequently reduced to $1.4 billion in June
2012. Treasury expects to incur no losses on this balance.

Temporary Liquidity Guarantee Program
The federal government’s response to the financial crisis
also included the FDIC’s Temporary Liquidity Guarantee
Program (TLGP). The Transaction Account Guarantee
(TAG) portion of the TLGP guaranteed deposits in
non-interest-bearing transaction accounts at insured
depository institutions. The TAG expired on December
31, 2010. Section 343 of the Dodd-Frank Act, which

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Maiden Lane LLC
Outside of and prior to TARP, the Federal Reserve Board
authorized the Federal Reserve Bank of New York (FRBNY)
to form Maiden Lane LLC (ML LLC) to facilitate the merger
of Bear Stearns with JPMorgan Chase (JPM). The Federal
Reserve Board authorized FRBNY to extend credit to
ML LLC, which it did through a $28.8 billion senior loan,

to partially fund the purchase of certain assets and
associated hedges from Bear Stearns. As of June 14,
2012, ML LLC fully repaid the loan (including interest) made
by FRBNY.

Assistance to American International Group
The Federal Reserve Board and the Treasury provided
a coordinated response to alleviate capital and liquidity
pressures on American International Group (AIG). At its
peak, the amount committed to support AIG through
FRBNY and Treasury was approximately $180 billion.
FRBNY support included a secured revolving credit facility
to AIG, as well as the formation and extension of credit to
Maiden Lane II LLC (ML II) and Maiden Lane III LLC (ML III).
To date, all of FRBNY’s loans to AIG and to MLII and ML III
have been repaid with interest.
As of June 29, 2012, only Treasury’s TARP investment
in AIG remained outstanding. The $30.44 billion unpaid
balance is less than the $34 billion market value of the
AIG common stock that Treasury holds. This stake and
FRBNY’s residual interest in assets held by ML II and ML
III holdings related to FRBNY’s investments in AIG are
likely to produce an additional profit for the U.S. public
(Chart E.2).
Chart E.2	

AIG Investments Committed and Returned

market by purchasing mortgage-backed securities (MBS)
issued by Fannie Mae and Freddie Mac. In 2008 and
2009, Treasury purchased MBS on the secondary market
at a cost of $225 billion and completed the liquidation of
these holdings in March 2012. The proceeds of sales,
in addition to principal and interest received, were $250
billion, exceeding the program’s cost by approximately
$25 billion.

Auto Industry
Treasury created the Automotive Industry Financing
Program (AIFP) in December 2008 to prevent a
significant disruption of the U.S. automotive industry
because of the risks such a disruption could pose to
financial stability and the U.S. economy. Under the AIFP,
Treasury invested approximately $80 billion in General
Motors (GM), Chrysler, and their respective financing
arms. As of 2012:Q1, GM and Chrysler, after substantial
reorganizations, reported nine and five consecutive
profitable quarters, respectively.
Treasury has made substantial progress toward exiting
its investments in automotive companies and continues
to monitor the performance of these firms and evaluate
options to exit its investments. As of June 30, 2012,
Treasury’s investment in GM stood at $23.39 billion and
in Ally Financial at $13.75 billion. Treasury has fully exited
its investment in Chrysler and Chrysler Financial, which
resulted in a $1.3 billion loss unlikely to be fully recovered.

Mortgage-Backed Security Purchase Program
Using its authorities under the Housing and Economic
Recovery Act of 2008, Treasury supported the housing
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Chart 5.4.1	 Average Trade Size—U.S. Equities

5.4	

Financial Market Infrastructure

5.4.1	 Electronic Trading of Exchange-Traded
Instruments
Technology has dramatically changed the market
for exchange-traded instruments, with the growth
in computerized trading algorithms resulting in
smaller trade sizes, higher volumes, and potentially
more complex trading strategies. At the same time,
a proliferation of trading venues outside traditional
exchanges has resulted in increased fragmentation of
equities markets and could have broader implications
for the financial system.
Advances in computing and communication
technology, along with regulatory changes, have
transformed electronic trading. High-speed
computerized trading has been a hallmark of
modern equities, futures, and foreign exchange
markets and has spread in recent years to
markets for derivatives and fixed income
instruments. Computerized trading is used to
facilitate a wide array of activities, including
automated order routing and so-called highfrequency trading. (See Box F: Algorithmic and
High-Frequency Trading.) A vast expansion of
market data supports these activities.
Along with decimalization of U.S. equity and
equity options markets, electronic trading has
resulted in smaller tick sizes and decreasing
trade sizes. In particular, a common use of
computerized trading algorithms is to split
trades into multiple smaller transactions. As
seen in Chart 5.4.1, average size per trade
in U.S. equities markets declined 81 percent
since 1997, while volumes increased more than
500 percent through May 2012. This practice
of trade splitting has become increasingly
evident over the past 15 years. Its likely
purpose is to minimize the price impact of
trading, but decreased trade sizes may also be
a component of more complex computerized
trading strategies.
More generally, liquidity has been fragmented
among various equity trading modalities,
including exchanges, alternative trading
systems, broker-dealer internalizers, and
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so‑called “dark pools.” The latter are trading
systems that are not openly available to the
public in which buyers and sellers submit orders
anonymously, with neither order size nor price
revealed publicly until the trade has been
completed. In May 2012, almost a third of all
trading in the equities market occurred outside
exchanges in such dark pools and brokerdealer internalizers, where customer orders
are matched against each other or against
proprietary orders of the internalizing brokerdealer (Chart 5.4.2).
More recently, equities exchanges have been
competing for market share in an environment
of narrowing spreads, lower commissions,
greater competition, and declining share
volumes. Specifically, average daily volume of
U.S. shares trading has declined 20 percent
since a peak of 9.82 billion shares in 2009 to
7.83 billion at the end of 2011 (Chart 5.4.3).
Also noteworthy is the growth of trading in
the Asia Pacific region. From 2000 through
2009, Asia’s share of global trading more than
doubled (Chart 5.4.4). This growth in Asian
trading is a by-product of the rapid economic
growth in this region, with a concomitant
growth in demand for financial services.

5.4.2	

Chart 5.4.2	 Average Daily Volume Shares by Venue

Chart 5.4.3	 U.S. Equities Share Volume

Wholesale Payments and Settlements

Activity within the wholesale payments utilities has
rebounded as both volumes and values continue
to increase since the crisis. Robustness for the
largest of these utilities, the Fedwire® Funds
Service, has improved, with earlier settlement times
and reduced operational risk. In addition, new
and more demanding international standards
have been released for large value payments and
settlement utilities, as well as for other financial
market infrastructures.

Chart 5.4.4	 Regional Market Share of Trades

The major wholesale payments utilities
supporting U.S. financial markets are the
Fedwire Funds Service, a real-time gross
settlement system operated by the Federal
Reserve Banks, and the Clearing House
Interbank Payments System (CHIPS), a
continuous net settlement system operated
by The Clearing House Payments Company
Financial Developments

87

BOX F:  ALGORITHMIC AND HIGH-FREQUENCY TRADING
Advancements in technology have had a profound effect
on trading, as activity has become faster, more complex,
and highly automated. Although computer-based
algorithms have been utilized in U.S. equities markets for
quite a while, the expansion into other markets and the
proliferation of high-speed algorithmic trading—along with
the current fragmented market structure—could lead to
unintended errors cascading through the financial system.
Regulators and market participants must help ensure that
adequate controls and risk-management practices are in
place to mitigate these risks.
High-speed algorithmic trading utilizes computer
algorithms to determine the timing, price, and quantity
of trades. High-frequency trading (HFT) is one particular
type of algorithmic trading. While there is no standard,
commonly accepted definition of HFT in the industry, HFT
typically refers to the use of computerized trading to move
in and out of positions rapidly, generally ending the day
flat with little or no exposure to the market on an overnight
basis. In contrast, other styles of algorithmic trading allow
positions to be held over longer time horizons. HFT is
widely used in U.S. equities, global futures, and global
foreign exchange, accounting for nearly 56 percent, 52
percent, and 35 percent of total trading, respectively, in
2011 (Chart F.1).
Chart F.1	

HFT % Use in Various Asset Classes

Algorithms have long been used in U.S. equities markets,
notably to route orders to the trading venue with the best
execution price in compliance with the SEC’s Regulation
National Market System (NMS). Over the past decade,
algorithms have been adapted for trading in other
asset classes. A notable class of computerized trading
algorithms is so-called “black box” strategies, which are
fully automated and preprogrammed, and which generally
have trades initiated directly by the algorithm itself. Black
box trading algorithms are capable of reacting to market
data, transmitting thousands of order messages per
second directly to electronic trading venues, cancelling
and replacing orders based on changing market
conditions, and capturing price discrepancies with little or
no human intervention.
Given the speed with which these transactions are
executed, errors can propagate rapidly through systems
and across markets. Such errors could include unintended
accumulation of large positions, out-of-control algorithms,
and erroneous “fat finger” trades. As a result, prudent
and timely risk management is of paramount importance
in these markets. Appropriate pre- and post-trade risk
controls are desirable at all levels of the trade life cycle,
from trade submission to trade matching, clearing, and
settlement. Therefore, trading firms, exchanges, brokerdealers (BDs), future commission merchants (FCM), foreign
exchange prime brokers (FXPB), service providers, and
clearing organizations each have an important role to
play in preventing, detecting, and responding to potential
computer-generated trading errors.
The desire for faster execution has prompted changes
within the marketplace to minimize latency. Latency is a
measurement of the time it takes to send an order to a
trading venue and for a trading venue to acknowledge
the order. Participants seek to minimize latency in
order to increase the chances of getting prompt
order execution at the best price. Factors affecting
latency include geographical distance and response
time from the exchange’s matching engine and the
speed at which market data and other signals from the
marketplace are processed.

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Reducing latency is particularly important for highfrequency traders because the passage of time, even for
an instant, exposes them to market risk. Price makers
are exposed to the risk that their orders could remain
in the order book after the market has moved in the
opposite direction of their trading strategy and before their
cancellations are processed. Price takers are exposed
to the risk that a resting order they want to capture could
be cancelled prior to execution or could be captured by
another, faster trader.

trading halt and shorten the amount of time that trading
is halted. Among other things, these mechanisms would
help mitigate the impact of any algorithmic orders that
could otherwise rapidly drive the price of a stock up or
down. In the futures market, the CFTC has adopted rules
to bolster risk management at the exchange, clearing firm
and other levels. In the foreign exchange market, prime
brokers are increasingly making use of post-trade services
designed to help prime brokers manage client risk on a
real-time, intraday basis across multiple trading venues.

In response to demand for faster execution, some trading
venues allow “direct access” (sometimes referred to
as “sponsored access”), through which certain trading
firms access the exchange’s matching engine directly,
bypassing the systems of their sponsoring BD, FCM, or
FXPB. It is important that sponsoring entities offering
direct access have proper controls in place for monitoring
their clients’ activity across the relevant platforms. Another
way trading firms can reduce latency is to place (colocate) their servers as near as possible to the trading
venue’s matching engine(s). An important policy issue
is the extent to which trading firms have equal access
to co-location or direct access services. BDs, FCMs,
and FXPBs are financially responsible for the trades
of all their customers, including those that engage in
algorithmic trading. To help ensure prudent customer risk
management in the equity market, the SEC implemented
Rule 15c3-5 in July 2011, which (among other things)
requires BDs to maintain a system of controls and
supervisory procedures reasonably designed to limit
the financial exposures arising from customers that
access the markets directly. In addition, the SEC recently
approved two proposals by the SRO and FINRA. The
first proposal would update, on a pilot basis, the existing
single-stock circuit breaker mechanism with an additional
“limit-up” and “limit-down” mechanism that effectively
prohibits trades from being immediately executed at
prices outside of prescribed rolling bands. The second
proposal would update, also on a pilot basis, the existing
market-wide circuit breakers that, when triggered, halt
trading in all exchange-listed securities throughout
the U.S. markets. The proposed changes lower the
percentage-decline threshold for triggering a market-wide
Financial Developments

89

Chart 5.4.5	 Annual Payment Clearing Volumes

LLC. The Fedwire Securities Service
provides securities issuance, settlement,
and transfer services for the U.S. Treasury,
U.S. government agencies and governmentsponsored enterprises, and certain
international organizations.
There was a sharp decline in 2009 in annual
payment clearing volume and value for the
Fedwire Funds Service, CHIPS, and the
Fedwire Securities Service from pre-crisis peaks
(Charts 5.4.5 and 5.4.6). From 2009 through
2011, volume and values continued to modestly
decline for the Fedwire Securities Service and
showed a moderate rebound for Fedwire Funds
Service and CHIPS.

Chart 5.4.6	 Annual Payment Clearing Values

Chart 5.4.7	 Fedwire Funds Daylight Overdrafts

Two noteworthy developments in U.S. large
value payment systems are the reduced use
of daylight overdrafts (Chart 5.4.7) and the
earlier submission of payments (Chart 5.4.8).
Before 2008, only 20 percent of Fedwire Funds
Service payments (by value) were settled by
1:00 p.m. (Eastern), and only 50 percent were
settled by 4:00 p.m. (Eastern). As of May 2012,
some 20 percent of Fedwire Funds Service
value settled by 10:00 a.m., and 50 percent
settled before 2:00 p.m. (Eastern). Both of
these developments appear to be driven largely
by the increase in the quantity of reserves on
bank balance sheets (Chart 5.4.9). From an
operational risk perspective, earlier payment
submission decreases the potential magnitude
of liquidity dislocations and risk in the financial
industry should an operational disruption
occur near the close of the Fedwire day at 6:30
p.m. (Eastern). An open question is whether
payments will revert back to late-in-the-day
settlements if and when reserve balances revert
to the pre-crisis norm.
A final noteworthy development in wholesale
payments and settlements is the release by
the Committee on Payment and Settlement
Systems (CPSS) and the Technical Committee
of the International Organization of Securities
Commissions (IOSCO) of a new package of
standards called Principles for Financial Market
Infrastructures, subject to adoption by regulators

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in individual jurisdictions. The principles
are intended to apply to all systemically
important payment systems, central securities
depositories, securities settlement systems,
central counterparties, and trade repositories
(collectively “financial market infrastructures”).
These principles contain new and more
demanding international requirements that are
designed to help ensure that the infrastructure
supporting global financial markets is more
robust and thus well placed to withstand
financial shocks. The CPSS and IOSCO
members (including the Federal Reserve, the
CFTC, and the SEC) will strive to implement the
new standards by the end of 2012.

5.4.3	

Chart 5.4.8	 Deciles of Fedwire Value Time Distribution

Derivatives Infrastructure

Global use of over-the-counter (OTC) derivatives
expanded in 2011. Increasingly, these derivatives are
centrally cleared, and data on these derivatives trades
are reported to trade repositories, developments which
enhance robustness of these markets.

Chart 5.4.9	 Reserve Balances

Global Derivatives Volumes
As measured by notional value, the global OTC
market has grown considerably faster than the
exchange-traded derivatives markets (Chart
5.4.10). Comparing the second half of 2011
to the second half of 2010, the OTC market
grew at an 8 percent pace, reflecting continued
strong demand by end users for customized
risk-management products. In contrast, the
exchange-traded markets declined by 17
percent over this period. Notional volumes
for both exchange-traded and OTC interest
rate products declined sharply in the second
half of 2011, with notional amounts for OTC
interest rate swaps dropping from $553 trillion
(U.S. dollars) to $504 trillion from 2011:H1
to 2011:H2, and exchange-traded numbers in
the same period declining from $76 trillion to
$53 trillion (Chart 5.4.11). It is likely that these
declines were due to less need for interest-rate
hedging in an environment of low interest rates
and diminished credit growth.

Chart 5.4.10	 Global OTC and Exchange-Traded Derivatives
Growth

As measured by number of contracts, over
two-thirds of exchange traded derivatives
were traded outside the United States in
Financial Developments

91

Chart 5.4.11	 Global Exchange-Traded Derivatives

2011 (Chart 5.4.12). The share of derivatives
volume traded on non-U.S. exchanges has been
increasing over the past several years.

Central Clearing of Derivatives

Chart 5.4.12	 Exchange-Traded Derivatives Globalization

Chart 5.4.13	 SwapClear Volume

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A major trend in OTC markets over the past
few years is the increasing numbers of OTC
derivatives cleared by central counterparty
(CCP) clearinghouses. CCP provide credit risk
mitigation for market participants by acting as
buyer to every seller and seller to every buyer.
Prior to 2009, there had been central clearing
of OTC derivatives, including clearing of
interest rate swaps (IRS) by LCH.Clearnet’s
SwapClear and clearing of various energy
derivatives by the ClearPort system operated
by the New York Mercantile Exchange (now
part of Chicago Mercantile Exchange, or CME)
and by IntercontinentalExchange’s (ICE)
ICE Clear Europe. In 2009, ICE Clear Credit
(formerly known as ICE Trust) and ICE Clear
Europe, as well as CME, began clearing credit
default swaps (CDS). Since the 2009 G-20
commitment, which calls for central clearing
of all standardized OTC derivative contracts
by the end of 2012, clearing activity has grown
dramatically in all such asset classes. Subsequent
legislation in the United States (the DoddFrank Act) and regulation in the European
Union (the European Market Infrastructure
Regulation) are consistent with the spirit of the
G-20 commitment.
A good deal of progress has been made
toward central clearing of standardized OTC
derivatives contracts, although there is still
progress to be made. LCH.Clearnet’s SwapClear
reports that the outstanding notional value of
cleared IRS has grown from about $70 trillion
in 2007 to almost $300 trillion going into
June 2012 (Chart 5.4.13). The number of new
IRS contracts cleared per month (“monthly
registration” in Chart 5.4.13) has risen from
a bit over 20,000 in 2007 to nearly 150,000.
SwapClear now estimates that 52 percent of new
IRS trades are presented to it for clearing. As of
June 29, 2012, 40 percent of the notional value
of IRS cleared by SwapClear is denominated

in euros, with 36 percent denominated in U.S.
dollars (Chart 5.4.14).
CDS markets also show a substantial increase
in centrally cleared contracts. According to the
International Swaps and Derivatives Association
(ISDA), centrally cleared CDS contracts
represented 10.6 percent of the notional
amounts outstanding as of December 2011. The
two major CCPs for CDS both show significant
growth in clearing: ICE Clear Credit’s open
interest has grown from de minimis amounts
three years ago to $905 billion notional as of
June 15, 2012, comprising $470 billion in index
products, $390 billion in corporate singlename contracts, and $45 billion in sovereign
single names. ICE Clear Europe reports similar
growth (Charts 5.4.15 and 5.4.16).
CCPs have added numerous new products to
clearing. For example, the various clearing
entities associated with the ICE added over 125
new OTC derivatives to their lists of products
accepted for clearing, including energy swaps,
emission swaps, and additional index, singlename and sovereign CDS over the past few
months. Eurex Clearing has announced its
intention to begin clearing OTC IRS in the
second half of 2012. In mid-March 2012,
LCH.Clearnet’s ForexClear began clearing
OTC foreign exchange (FX) non-deliverable
forwards (NDFs). CME Group is also now
clearing OTC FX, and NDFs. ICE announced
their plans to begin NDF clearing as well.
Finally, the Options Clearing Corporation is
developing a Standard & Poor’s (S&P) 500 OTC
option for clearing.

Chart 5.4.14	 Outstanding SwapClear Volumes

Chart 5.4.15	 ICE Clear Credit

Chart 5.4.16	 ICE Clear Europe

One of the expected benefits of centralized
clearing of OTC derivatives is the possibility
of netting offsetting contracts that accumulate
through repeated trading. LCH.Clearnet’s
SwapClear reports a reduction of about 25
percent of the notional value presented to it
for clearing through netting, tearing up of
offsetting contracts, and other processes to
eliminate redundant contracts. ICE Clear
Credit reports a much larger netting efficiency.
They achieved a reduction of about 90 percent
Financial Developments

93

Chart 5.4.17	 Interest Rate Derivatives

of the notional value of the original CDS trades
presented for clearing through netting, tearups, and other compression processes.

Trade Repositories

Chart 5.4.18	 CDS and Other Credit Derivatives

A relatively new feature in the market
infrastructure for swaps is the development of
trade repositories (TRs). Under Title VII of
the Dodd-Frank Act, the details of all swaps
(and security-based swaps) will have to be
reported to a TR (or to the CFTC or SEC, as
appropriate, if no TR is available). The major
global swaps market participants are working to
establish a trade repository for each asset class
and have voluntarily provided information to
the repositories on their ongoing and, in some
instances, legacy trades. TRs are operational
in the United States, United Kingdom, and/
or Luxembourg for interest rate swaps, credit
default swaps, equities swaps, commodities
swaps, and FX swaps. Additional TRs are
expected to be operational by year-end 2012.
TRs data can be used to measure the size and
composition of different swaps markets. For
example, according to TriOptima, a TR that
served the interest rate derivatives market
through mid-2012 (before being replaced
by a unit of Depository Trust and Clearing
Corporation), some $495.9 trillion (notional)
interest rate derivatives contracts have been
reported to the TR by the so-called G-14
dealers, of which a bit over one-half are cleared
by a CCP (Chart 5.4.17). The vast majority
of these centrally cleared swaps are dealerto-dealer contracts. In addition, another 17
percent reported as non-centrally cleared
dealer-to-dealer contracts were among the
G-14 major swaps dealers. Similarly, the Trade
Information Warehouse, a TR for CDS, reports
that $25.0 trillion (notional) CDS contracts
were reported to the TR, of which $15.7 trillion
(approximately 63 percent) are dealer-todealer (Chart 5.4.18). This preponderance of
dealer-to-dealer swaps, especially those among
the largest dealers, appears to be an ongoing
feature of these markets. Industry contacts

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report that these interdealer trades are mostly
for the purpose of hedging the risks associated
with market-making activities. It is of interest
that, in aggregate, dealer positions as seller
of CDS protection ($20.343 trillion notional)
approximately equal dealer positions as buyer of
such protection ($20.341 trillion notional). In
other words, the dealer community in aggregate
has approximately a flat CDS book without a
pronounced directional tilt.

Financial Developments

95

6
	

Regulatory Developments; Council Activities
Over the last year, Dodd-Frank Act implementation included introducing
stronger supervision, risk management, stress testing, and disclosure standards;
establishing resolution plans and an orderly liquidation regime for financial
companies; regulating the derivatives markets to reduce risk and increase
transparency; reforming the securitization markets; enhancing standards and
disclosure requirements for hedge fund advisers; and implementing measures to
enhance consumer and investor protection.
In addition, the Council has continued to make progress in fulfilling its mandate.
It has issued a final rule and guidance relating to the designation of nonbank
financial companies for Federal Reserve supervision and enhanced prudential
standards, and has finalized the designation of an initial set of eight systemically
important financial market utilities that will be subject to enhanced riskmanagement standards. The Council also continued to monitor potential risks
to U.S. financial stability; fulfilled explicit statutory requirements, including
the completion of three reports; and served as a forum for discussion and
coordination among the member agencies implementing the Dodd-Frank Act.
The following is a discussion of the significant implementation progress the
Council and its member agencies have achieved since the Council’s previous
annual report.

6.1	

Safety and Soundness

6.1.1	

Enhanced Prudential Standards and Dodd-Frank Act Stress Tests

Sections 165 and 166 of the Dodd-Frank Act require the Federal Reserve to establish
enhanced prudential standards and early remediation requirements for certain large
bank holding companies (BHCs) and for nonbank financial companies designated
for Federal Reserve supervision. In December 2011, the Federal Reserve issued,
for public comment, a proposal to implement the enhanced prudential standards
and early remediation requirements. The Dodd-Frank Act requires the enhanced
standards established by the Federal Reserve for covered companies under Section
165 to (1) be more stringent than those standards applicable to other BHCs and
nonbank financial companies that do not present similar risks to U.S. financial
stability and (2) increase in stringency based on the systemic footprint and risk
characteristics of individual covered companies.
The Federal Reserve’s proposal includes risk-based capital, leverage, liquidity, singlecounterparty credit exposure limits, supervisory and company-run stress testing,
risk management and a risk committee, and early remediation requirements.
The proposal would generally apply to all U.S. BHCs with consolidated assets of
$50 billion or more and any nonbank financial company that is designated by the
Council for supervision by the Federal Reserve. The requirements to establish a
risk committee of the board of directors and to conduct a company-run stress test
R e g u l a to r y D e v e l o p m e n t s; C o u n c i l A c t i v i t i e s

97

would also apply to BHCs with total consolidated assets of $10 billion or more. With
the exception of the requirements related to company-run stress tests, savings and
loan holding companies (SLHCs) that are not designated by the Council would not
be subject to the requirements under this proposal. The Federal Reserve’s proposal
addresses the following:
Risk-based capital and leverage requirements. These rules would be
implemented in two phases. In the first phase, the institutions would be subject
to the Federal Reserve’s capital plan rule, which was published in December 2011.
That rule requires covered companies to develop annual capital plans, conduct
stress tests, and maintain adequate capital, including a tier one common riskbased capital ratio greater than 5 percent, under both expected and stressed
conditions. In the second phase, the Federal Reserve would issue a proposal
to implement a risk-based capital surcharge based on the framework and
methodology developed by the Basel Committee on Banking Supervision (BCBS).
Liquidity requirements. These measures would also be implemented in multiple
phases. First, covered companies would be subject to qualitative liquidity
risk-management standards generally based on the interagency liquidity riskmanagement guidance issued in March 2010. These standards would require
covered companies to conduct internal liquidity stress tests and set internal
quantitative limits to manage liquidity risk. In the second phase, the Federal
Reserve would issue one or more proposals to implement quantitative liquidity
requirements based on the Basel III liquidity requirements.
Stress tests. Stress tests of the covered companies would be conducted annually
by the Federal Reserve using three economic and financial market scenarios. A
summary of the results, including company-specific information, would be made
public. In addition, the proposal would require covered companies to conduct
one or more company-run stress tests each year and to make a summary of their
results public.
Single-counterparty credit limits. These requirements would limit credit
exposure of a covered financial company to a single counterparty as a percentage
of the firm’s regulatory capital. Credit exposure between the largest financial
companies would be subject to a tighter limit.
Risk management requirements. The proposal would require covered
companies to establish a stand-alone risk committee of the board of directors,
and appoint a chief risk officer to oversee enterprise-wide risk management.
BHCs with $10 billion or more in consolidated assets would also be required to
establish an independent risk committee of the board.
Early remediation requirements. These measures would be put in place for all
firms subject to the proposal so that financial weaknesses are addressed at an early
stage. The Federal Reserve has proposed a number of triggers for remediation—
such as capital levels, stress test results, and risk-management weaknesses—in
some cases calibrated to be forward-looking. Required actions would vary based

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on the severity of the situation but could include restrictions on growth, capital
distributions, and executive compensation, as well as capital raising or asset sales.
The Federal Reserve consulted with members of the Council in developing this
proposal. The comment period for the proposal closed on April 30, 2012.
In addition to the stress-testing requirements to be conducted by the Federal
Reserve, Section 165(i)(2) of the Dodd-Frank Act also requires certain financial
institutions to conduct stress tests based on regulations issued by that institution’s
primary federal regulator. In January 2012, the OCC, Federal Reserve, and FDIC
issued proposed rules to implement these stress test requirements for institutions
where they are the primary federal regulator. The comment period on these rules
closed in April 2012. The Federal Reserve, OCC, and FDIC are coordinating their
respective rulemakings to implement these provisions.

6.1.2	

Transfer of Office of Thrift Supervision Functions

Title III of the Dodd-Frank Act transferred various powers and functions of
the former Office of Thrift Supervision (OTS) to the OCC, FDIC, and Federal
Reserve. This transfer of functions occurred on July 21, 2011, with the Federal
Reserve assuming responsibilities for SLHCs, the OCC assuming responsibilities
for federal savings associations, and the FDIC for state savings associations. The
OCC, FDIC, and Federal Reserve coordinated their efforts to help ensure a smooth
transfer of these functions and affected OTS employees. To clarify which agency
will be enforcing the OTS rules, the Dodd-Frank Act required the OCC, FDIC,
and Federal Reserve to publish a notice in the Federal Register identifying those
regulations of the OTS that the agencies will enforce. The FDIC and OCC issued
a joint notice on July 6, 2011, and the Federal Reserve issued its notice on July 21,
2011. The OCC has taken a number of additional actions to incorporate applicable
OTS regulations in the OCC’s chapter of the Code of Federal Regulations and
to integrate OTS and OCC regulations and supervisory guidance. The Federal
Reserve has similarly taken several steps to establish regulations and supervisory
guidance for SLHCs. On July 21, 2011, the Federal Reserve issued supervisory
guidance discussing the Federal Reserve’s transitional supervisory approach for
SLHCs. The Federal Reserve also published an interim rule to incorporate SLHCs
into the Federal Reserve’s chapter of the Code of Federal Regulations and notices
outlining the regulatory reporting requirements for SLHCs.
As of December 31, 2011, there were 417 top tier SLHCs with estimated
total consolidated assets of approximately $3 trillion. These SLHCs include
approximately 48 companies engaged primarily in nonbanking activities, such
as insurance underwriting (approximately 27 SLHCs), commercial activities
(approximately 11 SLHCs), and securities brokerage (10 SLHCs).
The 25 largest SLHCs accounted for more than $2.6 trillion of total consolidated
assets. Of the SLHCs engaged primarily in depository activities, only five
institutions were in the top 25, yet approximately 88 percent of the total SLHCs
were engaged primarily in depository activities. The depository firms, however, held
only 13 percent or $388 billion of the total SLHC consolidated assets.

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6.1.3	 Capital Standards, Comprehensive Capital Analysis and Review, and
Supervisory Guidance Regarding Stress-Testing Practices
In June 2012, the federal banking agencies invited comment on three joint
proposed rules that would revise and replace the agencies’ current capital
rules. The proposals would implement, in the United States, certain aspects
of Basel II and 2.5, the Basel III capital reforms, and the Dodd-Frank Act, and
would address shortcomings in regulatory capital requirements that became
apparent during the recent financial crisis. The first Basel III notice of proposed
rulemaking (NPR) would apply to all insured banks and savings associations,
top-tier BHCs domiciled in the United States with more than $500 million in
assets, and SLHCs that are domiciled in the United States. Provisions of this NPR
that would apply to these banking organizations include implementation of a new
common equity tier one minimum capital requirement, a higher minimum tier
one capital requirement, and, for banking organizations subject to the advanced
approaches capital rules, a supplementary leverage ratio that incorporates a
broader set of exposures. Additionally, consistent with Basel III, the agencies
propose to apply limits on a banking organization’s capital distributions and
certain discretionary bonus payments if the banking organization does not hold a
specified “buffer” of common equity tier one capital in addition to the minimum
risk-based capital requirements. This NPR also would revise the agencies’
prompt corrective action framework by incorporating the new regulatory capital
minimums and introducing common equity tier one capital as a new regulatory
capital component. Prompt corrective action is an enforcement framework that
constrains the activities of an insured depository institution based on its level of
regulatory capital.
In the second capital NPR, also known as the “standardized approach,” the
agencies propose to revise and harmonize rules for calculating risk-weighted
assets to enhance risk sensitivity and address weaknesses identified over recent
years, including by incorporating aspects of the Basel II standardized framework,
and alternatives to credit ratings, consistent with Section 939A of the DoddFrank Act. The revisions include methods for determining risk-weighted assets
for residential mortgages, securitization exposures, and counterparty credit risk.
The NPR also would introduce disclosure requirements that would apply to U.S.
banking organizations with $50 billion or more in total assets. This NPR would
apply to the same set of institutions as the first NPR.
The third Basel III NPR would revise the advanced approaches risk-based capital
rules consistent with Basel III and other changes to the BCBS’s capital standards.
The agencies also propose revising the advanced approaches risk-based capital
rules to be consistent with Section 939A and Section 171 of the Dodd-Frank Act.
Additionally, in this NPR, the OCC and FDIC propose that the market risk capital
rules apply to federal and state savings associations, and the Federal Reserve
proposes that the advanced approaches and market risk capital rules apply to
top-tier SLHCs domiciled in the United States if stated thresholds for trading
activity are met. Generally, the advanced approaches rules would apply to such
institutions with $250 billion or more in consolidated assets or $10 billion or more

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in foreign exposure, and the market risk capital rule would apply to SLHCs with
significant trading activity.
In March 2012, the Federal Reserve disclosed summary results of the 2012
Comprehensive Capital Analysis and Review (CCAR). The CCAR is an exercise
to evaluate the capital planning processes and capital adequacy of the largest
BHCs. This exercise includes both company-run and supervisory stress tests to
evaluate whether firms would have sufficient capital in times of severe economic
and financial stress to continue to lend to households and businesses. The Federal
Reserve estimated revenue and losses under the stress scenario based on detailed
data provided by the firms and verified by supervisors. (See Section 5.2 for a more
detailed discussion of the CCAR.)
As a part of the CCAR, the Federal Reserve evaluates institutions’ capital plans
across a range of criteria, including a stress test that examines whether a firm
could make all the capital distributions included in its plan, such as dividends
and stock repurchases, while still maintaining capital above the Federal Reserve’s
standards in a hypothetical supervisory stress scenario. Other considerations for
capital distributions include an evaluation of the firms’ capital planning processes
and plans to meet the new Basel III requirements that are scheduled to be phased
in beginning 2013, assuming the final adoption of the Basel III NPR.
Under the Federal Reserve’s proposed stress-testing rules (noted in Section
6.1.1), the results of the company-run stress test would be incorporated into the
analysis supporting a company’s capital plan submission. The supervisory stress
test would be conducted by the Federal Reserve during the annual capital plan
review process and would be used as a tool to help the Federal Reserve assess the
adequacy of the company’s capital plan.
In April 2012, the Federal Reserve announced the formation of the Model
Validation Council (MVC). The MVC will provide the Federal Reserve with
expert and independent advice on its process to rigorously assess the models
used in stress tests of banking institutions. The MVC is intended to improve the
quality of the Federal Reserve’s model assessment program and to strengthen the
confidence in the integrity and independence of the program.
In May 2012, the Federal Reserve, OCC, and FDIC issued final supervisory
guidance regarding stress-testing practices at banking organizations with
total consolidated assets of more than $10 billion. The guidance highlights
the importance of stress testing at banking organizations as an ongoing
risk-management practice that supports a banking organization’s forwardlooking assessment of its risks and better equips it to address a range of
adverse outcomes. While the guidance does not implement the stress-testing
requirements of the Dodd-Frank Act for certain large BHCs and nonbank
financial companies designated for supervision by the Federal Reserve (see
Section 6.1.1), the guidance is intended to provide entities subject to the
Dodd-Frank Act or other stress-testing requirements with principles to follow

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when conducting stress tests in accordance with the Dodd-Frank Act or other
statutory or regulatory requirements.

6.1.4	

Volcker Rule

Section 619 of the Dodd-Frank Act, commonly known as the Volcker Rule,
generally prohibits banking entities from engaging in proprietary trading and
from investing in or sponsoring hedge funds and private equity funds, subject to
certain exceptions.
Section 619 requires implementation in several stages. First, the Council was
required to conduct a study and make recommendations on implementing
the Volcker Rule. The Council study, which was issued on January 18, 2011,
recommended principles for implementing the Volcker Rule and suggested a
comprehensive framework for identifying activities prohibited by the rule, including
an internal compliance regime, quantitative analysis, reporting, and supervisory
review. Second, the Federal Reserve was required to publish a rule to implement
the conformance period during which banking entities, and nonbank financial
companies supervised by the Federal Reserve, must bring their activities and
investments into compliance with Section 619 of the Dodd-Frank Act. The Federal
Reserve published a final conformance rule on February 14, 2011.
By statute, following completion of the Council’s study, authority to adopt
implementing regulations is divided among the Federal Reserve, FDIC, OCC, SEC,
and CFTC. The statute requires the rulemaking agencies to consult and coordinate
with each other, as appropriate, for the purposes of assuring, to the extent
possible, that their rules are comparable and provide for consistent application and
implementation. The Chairperson of the Council is responsible for coordination
of the regulations. On October 11 and 12, 2011, four of the rulemaking agencies
invited the public to comment on proposed rules implementing the Volcker Rule’s
prohibitions and requirements. The CFTC requested comment on a substantively
identical proposal on January 11, 2012. The agencies received over 18,000
comments from the public on the proposal and are working to finalize their rules.
Pending issuance of final rules, the Federal Reserve issued a statement of policy on
April 19, 2012, clarifying that entities subject to the Volcker Rule have the full twoyear conformance period provided by statute, which would be until July 21, 2014,
to conform their activities and investments to the requirements of the Volcker Rule
and the final implementing rules. By statute, that deadline may be extended by
the Federal Reserve. The Federal Reserve’s statement of policy noted that banking
entities should engage in good-faith planning efforts to enable them to comply
with the Volcker Rule and final implementing rules by no later than the end of
the statutory conformance period. The rulemaking agencies also announced that
they plan to administer their oversight of banking entities under their respective
jurisdictions in accordance with the Federal Reserve’s conformance rule and
statement of policy.

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6.1.5	

Resolution Plans and Orderly Liquidation Authority

Resolution Plans
Section 165(d) of the Dodd-Frank Act requires nonbank financial companies
designated by the Council for supervision by the Federal Reserve and BHCs with
total consolidated assets of $50 billion or more (“covered companies”) to prepare
and submit to the Federal Reserve, the FDIC, and the Council plans—sometimes
referred to as “living wills”—for their rapid and orderly resolution under the U.S.
Bankruptcy Code. The Federal Reserve and the FDIC must review each plan and
may jointly determine that a resolution plan is not credible or would not facilitate
an orderly resolution of the company under the U.S. Bankruptcy Code. Failure
to resubmit a credible plan within the timeframe set by the Federal Reserve and
FDIC may result in the agencies jointly imposing more stringent capital, leverage,
or liquidity requirements, or restrictions on the growth, activities, or operations
of the company, or any subsidiary thereof, until the company resubmits a
plan that remedies the deficiencies. If the company has failed to resubmit
an acceptable plan within two years after the imposition of more stringent
requirements or restrictions, the Federal Reserve and FDIC, in consultation with
the Council, may jointly require divestiture of certain assets or operations to
facilitate an orderly resolution under the U.S. Bankruptcy Code in the event of
the company’s failure.
In November 2011, the FDIC and the Federal Reserve published a joint final rule
that implements the resolution plan requirement. In accordance with the joint
final rule, covered companies with $250 billion or more in total nonbank assets
(or, in the case of a foreign-based covered company, $250 billion or more in total
U.S. nonbank assets) were required to submit their resolution plans to the Federal
Reserve and the FDIC by July 1, 2012. Covered companies with at least $100
billion (but less than $250 billion) in total nonbank assets (or at least $100 billion
but less than $250 billion in total U.S. nonbank assets, for a foreign-based covered
company) must submit their initial plans by July 1, 2013. Covered companies with
less than $100 billion in total nonbank assets must submit their initial plans by
December 31, 2013.
As a complement to this rulemaking, the FDIC issued a final rule requiring any
FDIC-insured depository institution with assets of $50 billion or more to develop,
maintain, and periodically submit plans outlining how the FDIC would resolve it
through the FDIC’s resolution powers under the Federal Deposit Insurance Act.
These two rulemakings are designed to work in tandem by covering the full range
of business lines, legal entities, and capital structure combinations within a large
financial firm. Their overarching objective is to promote stability, but they should
also improve contingency planning and risk management at a covered institution
and improve the outcomes for an institution’s constituencies and stakeholders if
the institution fails. Importantly, as covered companies prepare and submit their
living wills and those plans are reviewed, the process is expected to result in an
ongoing dialogue between the supervisors and the firms that allows for continual
improvements as the plans develop.

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Orderly Liquidation Authority
Title II of the Dodd-Frank Act establishes a new framework—the orderly
liquidation authority (OLA)—to address the potential failure of a BHC or other
financial company when the failure of the financial company1 and its resolution
under the bankruptcy code or otherwise applicable federal or state law would
have serious adverse effects on financial stability in the United States. Under
OLA, the FDIC would act as receiver of the financial company, and would resolve
the company subject to OLA.2
In July 2011, the FDIC board approved a final rule implementing its Title II
authority. The rulemaking, among other things, clarified the claims process and
priorities for unsecured creditors as well as the treatment of secured creditors in
a Title II resolution. In March 2012, the FDIC published a proposed rule setting
forth the conditions and requirements that would govern the FDIC’s exercise
of its authority under the OLA to enforce certain contracts of subsidiaries or
affiliates of a financial company notwithstanding contract clauses that purport
to terminate, accelerate, or provide for other remedies based on the insolvency,
financial condition, or receivership of the financial company. The comment
period on the proposed rule closed on May 29, 2012. It is anticipated that a final
rule will be issued in the near future.
Under Title II, the FDIC has the authority to borrow funds from the Treasury and
to incur other obligations in connection with the orderly liquidation of a financial
company, subject to a maximum obligation limitation (MOL). In June 2012,
the FDIC and Treasury published, after notice and comment, a joint final rule
governing the calculation of the MOL. Also, in April 2012, the FDIC adopted,
after notice and comment, a final rule that sets forth the conditions under
which a mutual insurance holding company would be treated as an insurance
company for purposes of Title II. The FDIC also intends to propose additional
rules to implement the OLA, including (1) rules governing the minimum right of
recovery and (2) joint rules with the SEC, after consultation with the Securities
Investor Protection Corporation, governing the orderly resolution of certain
broker-dealers (BD).
Furthermore, Section 210 of the Dodd-Frank Act requires the FDIC “to
coordinate, to the maximum extent possible” with appropriate foreign regulatory
authorities in the event of a resolution of a covered company with cross-border
operations. The FDIC has been working diligently on both multilateral and
bilateral bases with foreign counterparts in supervision and resolution to
address these crucial cross-border issues. Although U.S. firms have operations
in many countries, those operations tend to be concentrated in a relatively small
number of key jurisdictions, particularly, the UK. The FDIC and UK authorities
have made substantial progress in identifying and overcoming impediments
to resolution. To facilitate bilateral discussions and cooperation, the FDIC is
negotiating memoranda of understanding with certain foreign counterparts
that will provide a formal basis for information sharing and cooperation relating
to resolution planning and implementation under the legal framework of the
Dodd‑Frank Act.

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6.1.6	

Removal of References to Credit Ratings

Section 939 of the Dodd-Frank Act removes references to credit ratings in certain
statutes, while Section 939A requires each federal agency to review its regulations
that require the use of an assessment of creditworthiness of a security or money
market instrument and any references to or requirements in such regulations
regarding credit ratings. Each agency must modify its regulations as identified by
the review to remove references to or requirements of reliance on credit ratings
and to substitute appropriate standards of creditworthiness.
As required by Section 939A, after enactment of the Dodd-Frank Act, federal
agencies reported to Congress on the review of their regulations that use credit
ratings and a description of any of the regulations. Numerous federal agencies
have proposed or finalized rules that would modify their regulations to comply
with the Section 939A requirements. For example, the federal banking regulators,
in June 2012, finalized revisions to the market risk capital rules that implement
alternatives to credit ratings for debt and securitization positions. Concurrently,
the federal regulators invited public comment on three proposed rules to revise
and replace the agencies’ current capital rules, including implementing the
changes required by Section 939A. The SEC adopted rule amendments removing
credit ratings as conditions for companies seeking to use short-form registration
when registering non-convertible securities for public sale and proposed several
other rules that would remove credit rating agency references from many of its
investment company rules and its rules applicable to BD financial responsibility,
distributions of securities, and confirmations of transactions; the FDIC issued
a final rule removing credit ratings from the calculation of deposit insurance
risk-based assessments for large insured depository institutions; and the OCC
issued a final rule to remove references to credit ratings in the OCC’s rules for
investments in securities, securities offerings and foreign bank capital equivalency
deposit regulations. In December 2011, the FDIC proposed revisions to part 362
of the FDIC’s regulations that would prohibit an insured savings association from
acquiring and retaining any corporate debt security unless it determines, prior to
acquiring such security and periodically thereafter, that the issuer has adequate
capacity to meet all financial commitments under the security for the projected
life of the investment. The FDIC’s December 2011 NPR is consistent with the
OCC’s final rule noted above regarding permissible investments.

6.1.7	

Insurance

Section 111 of the Dodd-Frank Act, which established the Council, also
provides that one of the ten voting members, in addition to the nine named
heads of federal agencies, shall be “an independent member appointed by the
President, by and with the advice and consent of the Senate, having insurance
expertise.” On September 28, 2011, the President’s appointee, referred to as the
“independent member,” was sworn in and seated as a member of the Council for a
six-year term. Since that time, the independent member has established an office
and has actively engaged in the work of the Council and its committees with the
assistance of a staff of two employees with insurance expertise. The independent
member has also actively consulted with state insurance regulators and Federal
Reserve System staff responsible for the development and implementation of the
supervisory framework for insurance companies.
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The Federal Insurance Office (FIO) within the Treasury was established by the
Dodd-Frank Act with the authority, among others, to monitor all aspects of the
insurance industry, including identifying issues or gaps in the regulation of
insurers that could contribute to a systemic crisis in the insurance industry or the
U.S. financial system. FIO is authorized to coordinate federal efforts and develop
federal policy on prudential aspects of international insurance matters, including
representing the United States, as appropriate, in the International Association
of Insurance Supervisors (IAIS). In exercising its authorities, FIO consults with
federal agencies, insurance regulators, and interested parties.
This past year, FIO joined the IAIS and its executive and other committees, all
of which also include U.S. state insurance regulators as members. Through the
IAIS, insurance regulators, supported by the National Association of Insurance
Commissioners (NAIC), and FIO work with the insurance supervisors of other
countries on international regulatory initiatives such as a common framework
for regulating internationally active insurance groups. Through the IAIS, FIO
and U.S. state insurance regulators are also working collaboratively with other
insurance supervisors to develop a sound approach to the identification and
oversight of global systemically important insurers.
In addition to its existing responsibility for supervision of a BHC that is a
major life insurance company, on July 21, 2011, the Federal Reserve assumed
responsibility for over 25 SLHCs that engage in significant volumes of life,
property and casualty, or title insurance underwriting. The unique aspects of
the insurance industry are addressed in various regulations that have been
published for the BHC and SLHC populations. The Federal Reserve developed
and implemented a specialized supervisory approach and customized supervisory
guidance that reflects the risks and characteristics of the industry. This approach
includes communication and coordination with state insurance regulators.
Insurance regulators, through the NAIC, continue work on updating the
Insurance Financial Solvency Framework. Two of the more important initiatives
relate to the continued work of the Solvency Modernization Initiative, which led
to the adoption of the Own Risk and Solvency Assessment (ORSA) Guidance
Manual in March 2012 and the revised Credit for Reinsurance Model Law in late
2011. Later this year, state regulators are expected to finalize the ORSA Model
Law to establish the ORSA filing requirement and the Valuation Manual, which
will allow states to consider adoption of the Standard Valuation Law to implement
principles-based reserving.

6.2	

Financial Infrastructure, Markets, and Oversight

6.2.1	

Over-the-Counter Derivatives Reform

Title VII of the Dodd-Frank Act establishes a comprehensive regulatory
framework for the over-the-counter (OTC) derivatives marketplace. The
regulatory structure for derivatives set forth in the Dodd-Frank Act is intended
to promote, among other things, exchange trading and centralized clearing of
swaps and security-based swaps, as well as greater transparency in the derivatives
markets and enhanced monitoring of the entities that use these markets.
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The CFTC and SEC have proposed and begun to finalize numerous rules
pursuant to the public notice and comment process and have engaged in
extensive public outreach and interagency coordination, including public
roundtables with agency staff, market participants, and other concerned members
of the public; meetings involving staff from multiple regulators, both domestic
and international; and agency staff meetings with members of the public.
The SEC and CFTC have jointly adopted rules further defining the terms “swap,”
“security-based swap,” “security-based swap agreement,” and have also adopted
final joint rules defining the terms “swap dealer,” “security-based swap dealer,”
“major swap participant,” and “major security-based swap participant.”
In addition, the CFTC and the federal banking agencies issued proposed
rules on capital and margin requirements for entities within their respective
jurisdictions (for the CFTC, certain swap dealers and major swap participants;
for the federal banking agencies, certain securities-based swap dealers and major
swap participants as well). The proposed rules would impose initial margin and
variation margin requirements for uncleared swaps held by entities under each
agency’s jurisdiction. With respect to capital requirements, the federal banking
agencies’ existing regulatory capital rules take into account and address the
unique risks arising from derivatives transactions and would apply to transactions
in swaps and security-based swaps. The CFTC has proposed capital requirements
for entities under its jurisdiction.
The CFTC has adopted several final rules, including reporting requirements
to swap data repositories for swap dealers, major swap participants, and swap
counterparties; rules that establish the process by which the CFTC will review
swaps to determine whether the swaps are required to be cleared; and business
conduct standards and other regulatory requirements for swap dealers and major
swap participants.
The SEC has proposed rules to implement corresponding requirements for
security-based swaps, and has adopted final rules that establish the process by
which the SEC will review security-based swaps to determine whether the securitybased swaps are required to be cleared.
The SEC and the CFTC are considering the structural and systems changes
market participants will have to make to satisfy the new derivatives regulatory
framework. The agencies are also considering a phased-in approach to
implementing the new rules. In June 2012, the SEC issued a policy statement
describing the order in which it expects the rules regulating the security-based
swap market to take effect. This ordering is intended to give security-based swap
market participants adequate, but not excessive, time to come into compliance
with the new rules applicable to them.
On an international level, U.S. regulators are working as part of a group
composed of representatives of the BCBS, the Committee on the Global
Financial System, the Committee on Payment and Settlement Systems, and the
International Organization of Securities Commissions to develop international
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standards for margin on non-centrally cleared derivatives. This group took an
important first step when it issued a consultative report in July 2012.

6.2.2	

Private Fund Adviser Registration and Oversight

Title IV of the Dodd-Frank Act closes a regulatory gap by making numerous
changes to the registration, reporting, and recordkeeping requirements of the
Investment Advisers Act of 1940 (Advisers Act). These provisions are designed to
provide the SEC with oversight authority over previously unregistered investment
advisers to certain types of private funds, including hedge funds and private
equity funds, and the authority to require recordkeeping and reporting by
advisers to venture capital funds.
Sections 404 and 406 of the Dodd-Frank Act authorize the SEC to collect data
from investment advisers about their private funds to enable the Council to
assess systemic risk and require a joint rulemaking of the SEC and CFTC for
investment advisers that are registered with both the SEC and CFTC. The
agencies implemented this provision in October 2011 by adopting a rule that
requires certain advisers to hedge funds, private equity funds, and liquidity
funds to report non-public data regarding their operations and the risk profiles
of the private funds they manage. Under the rule, SEC-registered investment
advisers with at least $150 million in private fund assets under management
must periodically file a new reporting form (Form PF). Private fund advisers that
are also registered with the CFTC as commodity pool operators or commodity
trading advisers may satisfy systemic risk reporting requirements of the CFTC
by filing Form PF with the SEC. The first filings of Form PF, covering private
fund advisers with $5 billion or more in private fund assets, are due in July 2012
for liquidity fund advisers and in August 2012 for hedge fund advisers. Smaller
liquidity fund and hedge fund advisers, as well as private equity fund advisers, will
be required to begin filing Form PF for the period ending December 31, 2012.
In addition, in June 2011, the SEC adopted a rule that requires advisers to certain
types of private funds, including hedge funds and private equity funds, to register
with the SEC. To enhance the SEC’s ability to oversee these advisers and enable
the public to better assess the activities of private funds, the SEC requires private
fund advisers to provide basic public information on Form ADV about the funds
they manage, including information about the amount of assets held by the
fund and identification of fund service providers (e.g., auditors, prime brokers,
custodians, administrators, and marketers). In addition, the SEC requires all
advisers to provide further information on Form ADV about an adviser’s clients,
employees, and advisory activities. Investment advisers that had previously
relied on the Investment Advisers Act exemption for private advisers, which was
eliminated by the Dodd-Frank Act, were required to register with the SEC by
March 2012. Registered investment advisers are required to adopt and implement
policies and procedures to prevent violation of the Advisers Act and SEC rules.

6.2.3	

Office of Financial Research

The purposes of the Office of Financial Research (OFR) are to support the
Council in fulfilling the Council’s purposes and duties and to support the
Council’s member agencies. The OFR serves as a data and research resource for
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the Council and its member agencies, and it is working with those agencies to
mitigate reporting burdens and increase market transparency. In this context,
the OFR serves as a shared resource for Council members and their agencies
and staffs.
The OFR provides data and analysis to support that work, either as a participant
in Council activities or in response to requests from Council members or their
agencies or staffs. The OFR will have the capacity to provide in-depth, longterm research, as well as rapid analyses of significant financial events to inform
the Council’s policy discussions. The OFR also has a responsibility to evaluate
and report on stress tests and other stability-related assessments of financial
entities overseen by member agencies, provide advice to member agencies on the
impact of their policies as they relate to financial stability, investigate disruptions
and failures in the financial markets, and provide its analysis to the Council,
Congress, and the public.
The OFR is working with Council member agencies to support an international
initiative to establish a unique, global standard for identifying parties to
financial transactions. This Legal Entity Identifier (LEI) will allow for a better
understanding by both regulators and market participants of true exposures
and counterparty risks across the system. In July, the OFR publishes its first
annual report to Congress on its research and data-related work to assess risks to
financial stability.
The Dodd-Frank Act provides that the OFR would be headed by a Director
appointed by the President and confirmed by the U.S. Senate. In December 2011,
President Obama nominated Richard B. Berner to serve as the first Director of
the OFR. That nomination is pending before the Senate.

6.2.4	

Market Structure

Over the past several years, the SEC has been considering a range of issues
relating to developments in equity market structure. As a part of this process, the
SEC issued a concept release in January 2010 to seek public comment on a wide
range of market structure issues, including high-frequency trading, order routing,
market data linkages, and undisplayed, or “dark,” liquidity. The SEC continues
to consider the issues raised in the 2010 concept release and whether additional
regulatory actions are needed in this area.
Recently, the SEC has taken specific actions to address market structure issues.
For example, in July 2012, the SEC adopted a rule that would require SROs to
develop a plan to create a consolidated audit trail. Such a consolidated audit
trail would improve the timeliness and breadth of the information available
to regulators for surveillance, investigations, and analysis of equity market
activity. In June 2012, the SEC approved two proposals submitted by the national
securities exchanges and FINRA that are designed to address extraordinary
volatility in individual securities in the broader U.S. stock market. One initiative
establishes a “limit-up” and “limit-down” mechanism that prevents trades in
individual exchange-listed stocks from occurring outside of a specified price
band. The second initiative updates existing market-wide circuit breakers that,
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when triggered, halt trading in all exchange-listed securities throughout the U.S.
markets. The changes lower the percentage-decline threshold for triggering a
market-wide trading halt and shorten the amount of time that trading is halted.
The exchanges and FINRA will implement these changes by February 4, 2013;
the SEC approved both proposals for a one-year pilot period, during which the
exchanges, FINRA, and the SEC will assess their operation and consider whether
any modifications are appropriate.
Further, in July 2011, the SEC adopted a new large-trader reporting rule that is
designed to provide the SEC with a valuable source of useful data to support its
investigative and enforcement activities, to facilitate the SEC’s ability to assess
the impact of large-trader activity on the securities markets, to reconstruct
trading activity following periods of unusual market volatility, and to analyze
significant market events for regulatory purposes. Additionally, in June 2011, the
SEC adopted Rule 15c3-5, which, among other things, requires BDs to maintain
a system of controls and supervisory procedures reasonably designed to limit
the financial exposures arising from customers that access the markets directly
through the BD.
Recent CFTC actions have addressed risk controls by requiring futures
exchanges to establish risk controls that prevent and reduce the potential for
price distortions and market disruptions, including pauses or halts on trading
when necessary. The CFTC has also required clearing member firms to conduct
automated, pre-trade screening of orders and required futures exchanges to
have automated, pre-trade systems that facilitate firms’ management of financial
risk. The CFTC also adopted measures that require swap dealers and major swap
participants to implement policies and procedures for testing and supervising
trading programs and requires “straight-through processing” by futures
commission merchants, swap dealers, and major swap participants of trades
submitted for clearing. Each of these measures responds to the increased speed
and automation of CFTC-regulated financial markets by requiring a parallel
increase in the speed and automation of pre-trade risk controls, post-trade
processing, and other steps designed to reduce risk and increase trade certainty.

6.2.5	

Financial Market Utilities

Financial market utilities (FMUs) manage or operate multilateral systems for the
purpose of transferring, clearing, or settling financial transactions.
Title VIII of the Dodd-Frank Act establishes a new supervisory framework for
systemically important FMUs. It authorizes the Council to designate an FMU as
systemically important if the failure of or a disruption to the functioning of the
FMU could create or increase the risk of significant liquidity or credit problems
spreading among financial institutions or markets and thereby threaten the
stability of the U.S. financial system. The Council proposed the designation of a
set of FMUs as systemically important at its May 22, 2012, meeting. As discussed
further in Section 6.4.1, the Council designated eight FMUs as systemically
important at its July 18, 2012, meeting.

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The Federal Reserve, CFTC, and SEC, in consultation with each other and
with the Council, have published proposed rules regarding risk-management
standards for designated FMUs subject to their respective supervisory authority.
The CFTC published its final rule with respect to all FMUs that are derivatives
clearing organizations in November 2011. The Federal Reserve’s, CFTC’s, and
SEC’s final rules on risk management standards that will apply to designated
FMUs are expected in 2012.

6.2.6	

Securitization

Risk Retention
Section 941 of the Dodd-Frank Act added a new Section 15G to the Securities
Exchange Act of 1934, requiring a securitizer to retain at least 5 percent of the
credit risk for loans or other assets that a securitizer, through the issuance of an
asset-backed security (ABS), transfers, sells, or conveys to a third party. On April
29, 2011, the OCC, Federal Reserve, FDIC, SEC, FHFA, and the Department of
Housing and Urban Development (HUD) jointly published proposed rules to
implement this risk-retention requirement. The rulewriting agencies are carefully
assessing the provisions of the proposed rule in light of the public comments
received and are working to develop a final rule. The Chairperson of the Council
is coordinating the rulemaking.
As required by Section 15G, the proposed rules would, in general, require
securitizers of ABS to retain at least 5 percent of the credit risk of the assets
underlying the securitization. The credit risk retained generally could not
be directly or indirectly transferred or hedged. The proposed rule includes a
menu of risk-retention options designed to meet the statutory risk-retention
requirement in a way that takes into account the wide variety of established
securitization structures and market practices. Section 15G specifically provides
that a securitizer is not required to retain the 5 percent credit risk if all of the
loans that collateralize the ABS are qualified residential mortgages (QRMs), as
defined by the rulewriting agencies. The definition of a QRM in the proposed
rule takes into account underwriting standards and loan features that historically
indicate a lower risk of default, as required by the statute. These include loan
documentation and verification of the borrower’s ability to repay the loan, the
loan-to-value ratio of the loan, and the debt-to-income ratio of the borrower. In
addition, if certain other loan underwriting standards are met, the proposed rule
would exempt ABS collateralized exclusively by commercial loans, commercial
mortgages, or automobile loans from the 5 percent risk-retention requirement.
In crafting the proposed rule, the agencies sought to ensure that the amount
of credit risk retained is meaningful, while reducing the potential for the
proposed rules to negatively affect the availability and cost of credit to consumers
and businesses.

SEC Rules Related to ABS
Other provisions of the Dodd-Frank Act require SEC rulemaking for ABS.
Pursuant to Section 943 of the Dodd-Frank Act, the SEC adopted final rules
in January 2011 that require securitizers to disclose, in tabular form, fulfilled
and unfulfilled repurchase requests made in connection with outstanding
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ABS. Repurchases often result from a loan that does not comply with the
representations and warranties made in an underlying transaction pooling
agreement. The rules also require that nationally recognized statistical rating
organizations include information regarding the representations, warranties, and
enforcement mechanism available to investors in an ABS offering in any report
accompanying a credit rating issued in connection with such offering. Pursuant
to Section 945, the SEC also adopted final rules in January 2011 requiring an
issuer of ABS registered under the Securities Act of 1933 to perform a review of
the assets underlying the ABS and to disclose information about the nature of
the review. Under the rules, the issuer must also disclose information about (1)
how the loans in the pool differ from the loan underwriting criteria disclosed in
the prospectus, (2) loans that did not meet the disclosed underwriting criteria
but were included in the pool, and (3) the entity that made the determination
that loans be included in the pool even though they did not meet the disclosed
underwriting standards.
Section 942(b) of the Dodd-Frank Act requires the SEC to adopt regulations to
require issuers of ABS, at a minimum, to disclose asset-level or loan-level data
regarding the assets backing the ABS, if such data are necessary for investors
independently to perform due diligence. In April 2010, the SEC had proposed
significant revisions to rules regarding the offering process, disclosure, and
reporting for asset-backed securities, including revisions to Regulation AB.
As part of its April 2010 proposal, to augment existing pool-level disclosure
requirements, the SEC had proposed to require that standardized asset-level
data points regarding each asset in the underlying pool be provided at the
time of securitization and on an ongoing basis. In July 2011, the SEC issued a
release requesting additional comment on whether the April 2010 proposals
appropriately implement Section 942(b) of the Dodd-Frank Act.
In September 2011, the SEC proposed rules under Section 621 of the Dodd-Frank
Act that would prohibit securitization participants of an ABS for a designated
time period from engaging in certain transactions that would involve or result in
a material conflict of interest.

6.2.7	

Audit Standards

In the last year, the Public Company Accounting Oversight Board (PCAOB)
has engaged in several projects related to auditing and professional practice
standards. The PCAOB proposed a new auditing standard, Related Parties, and
amendments to existing standards regarding significant unusual transactions,
intended to enhance audit procedures in areas that have, at times, been used
to engage in fraudulent financial reporting; proposed a new standard and
amendments intended to enhance the relevance and quality of the communications
between an auditor and a company’s audit committee; proposed auditing and
attestation standards that would apply to the audits of SEC-registered BDs and to
the supplemental information accompanying audited financial statements; and
proposed amendments to improve the transparency of public company audits
by requiring the disclosure of the audit engagement partner’s name in the audit
report and the disclosure of other independent public accounting firms and other
persons that took part in the audit.
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In addition, on June 21, 2011, the PCAOB issued a concept release seeking public
comment on the potential direction of a standard-setting project on the content
and form of auditors’ reports on financial statements.
Finally, on August 16, 2011, the PCAOB issued a concept release seeking public
comment on ways that auditor independence, objectivity, and professional
skepticism can be enhanced, including through mandatory rotation of audit firms.
Mandatory audit firm rotation would limit the number of consecutive years for
which a registered public accounting firm could serve as the auditor of a public
company. The PCAOB received over 600 public comments on its release and is
continuing to evaluate these ideas.

6.2.8	

Accounting

The Financial Accounting Standards Board (FASB) and International Accounting
Standards Board (IASB) are continuing their work to finalize converged
standards in several major areas, including revenue recognition, lease accounting,
financial instruments, and insurance contracts. In their revenue-recognition
project, the FASB and IASB are working to clarify and align the principles for
recognizing revenue. The FASB and IASB are considering comments from
constituents on their joint 2011 proposal, and a final joint standard on revenue
recognition is expected by early 2013. In their lease-accounting project, the FASB
and IASB are working to provide greater transparency to lease arrangements by
requiring balance sheet recognition of the rights and obligations associated with
leases. The FASB and IASB are considering comments on their 2010 proposal,
and a new joint proposal for public comment is expected in the second half of
2012. In the area of financial instruments, the FASB and IASB are seeking to
more closely align key aspects of their classification and measurement models and
to develop a new approach to impairment for financial instruments. The FASB
and IASB are expected to release a new proposal on impairment for financial
instruments in the second half of 2012. For insurance contracts, the IASB
currently does not have a comprehensive insurance model in IFRS. The FASB is
evaluating this issue, including joint discussions with the IASB regarding whether
to propose changes to the existing U.S. insurance accounting model to provide
users of financial statements with more useful information. Further documents or
proposals from FASB and IASB are expected in the second half of 2012.

6.3	

Consumer and Investor Protection

6.3.1	

Consumer Protection

On January 4, 2012, President Obama appointed former Ohio Attorney General
Richard Cordray as the Director of the CFPB. The CFPB is an independent
bureau within the Federal Reserve System. It has rulemaking authority under
specifically listed statutes, as well as specified supervisory and enforcement
authority for very large depository institutions and non-depository (nonbank)
entities and other duties relating to consumer financial products and services.
The CFPB is the primary federal regulator exclusively focused on, and
accountable to Congress and the public for, consumer financial protection. The
CFPB has launched its supervision program for very large depository institutions
(in coordination with prudential regulators) and for nonbanks; established its
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consumer response function; assumed rulemaking responsibility for federal
consumer financial laws transferred to the CFPB on July 21, 2011; and issued a
variety of rules and reports required under the Dodd-Frank Act. In addition, the
CFPB continues to work to ensure that consumers have the information they need
to understand the costs and risks of consumer financial products and services, so
they can compare products and choose the ones that are best for them. Moreover,
the CFPB is taking steps to clarify and streamline regulations and guidance
to reduce unnecessary burdens on providers of consumer financial products
and services.
One of the CFPB’s first rulemaking initiatives is consolidation of mortgage loan
disclosure forms under the Truth in Lending Act (TILA) and the Real Estate
Settlement Procedures Act (RESPA) to make the information more useful to
consumers and to reduce burdens on lenders. The Dodd-Frank Act consolidates
rulemaking authority for the two statutes in the CFPB. The CFPB proposed
regulations and model disclosures in July 2012. As part of its “Know Before
You Owe” initiative, the CFPB has been testing prototype disclosure forms that
contain information required to be disclosed to consumers who apply for a loan
to purchase a house or refinance an existing mortgage loan.
In addition, the CFPB has been testing a prototype for a monthly mortgage
statement designed to make it easier for borrowers to understand costs and
fees associated with mortgage loans. The Dodd-Frank Act amends the TILA
and requires creditors, assignees, or servicers to send the borrower a periodic
statement for each billing cycle; the statement must include information about
the mortgage’s principal loan amount, current interest rate, date on which the
interest rate may next reset, and a description of any late payment fees, among
other items. The CFPB plans, in the summer of 2012, to propose a rule, including
a proposed form, to implement this requirement and several other servicingrelated requirements under the Dodd-Frank Act.
The Dodd-Frank Act also amends the Electronic Fund Transfer Act to provide
protections to consumers who transfer funds to recipients located in another
country (remittance transfers), and the CFPB adopted a rule implementing
these consumer protections. In general, the rule requires remittance transfer
providers to disclose to a consumer the exchange rate, fees, and amount to be
received by the recipient when the consumer sends a remittance transfer. The
CFPB also requested public comment on whether the rule should include a safe
harbor to exempt community banks, credit unions, and other companies that
process less than a certain number of remittance transfers per year from the
new requirements. The final rule, with any adjustments, will go into effect on
February 7, 2013.
The CFPB has supervision authority over certain nonbank entities, including
mortgage companies, private education lenders, payday lenders, and “larger
participants” of a market for other consumer financial products or services. On
February 17, 2012, the CFPB published its initial proposed rule to define larger
participants in the consumer reporting and debt collection markets. The CFPB
indicated that it will issue additional rules to define criteria for larger participants
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in other consumer financial markets, selecting the appropriate criteria and
thresholds for each of those markets.
The Federal Reserve, FDIC, OCC, and NCUA have worked closely with the CFPB
to help ensure a smooth transition of the CFPB’s examination and rulemaking
authorities. These activities have included the transfer of certain staff to the CFPB
and the development of information and examination coordination memoranda
of understanding. For its part, the CFPB consults actively with the Federal
Reserve, FDIC, OCC, and NCUA in the rulemaking process to help promote
regulatory effectiveness and to meet the goals and requirements of the DoddFrank Act regarding consultation.

6.3.2	

Mortgage Transactions and Housing

Title XIV of the Dodd-Frank Act, the “Mortgage Reform and Anti-Predatory
Lending Act,” contains several measures designed to protect consumers in
mortgage transactions. Many of these measures were enacted as amendments
to the TILA and the RESPA. Prior to July 21, 2011, the Federal Reserve was
responsible for regulations implementing the TILA requirements and HUD was
responsible for RESPA, but those rulemaking authorities transferred to the CFPB
on that date. In addition to the CFPB’s efforts to develop improved mortgage
servicing disclosure standards (see previous text), the prudential regulators are
working to develop regulations under safety and soundness authority that address
the servicing of performing and nonperforming mortgage loans, which would
supplement the CFPB’s TILA and RESPA rulemaking. Certain additional rules
concerning appraisals must be promulgated on an interagency basis. The CFPB
expects to issue proposals to implement a number of Title XIV requirements in
the summer of 2012 and to finalize several rules by January 2013, including the
rules described in the following text.
Under new standards regarding residential mortgages, a lender is required to
make a reasonable, good faith determination of an applicant’s ability to repay
before issuing a closed-end mortgage loan. In general, the “ability to repay”
standard can be met if the loan is a “qualified mortgage,” as defined under the
Dodd-Frank Act and by regulation. A lender receives certain protections from
liability if a loan is a “qualified mortgage.” The CFPB is responsible for finalizing
a proposed rule that was issued by the Federal Reserve in May 2011. The DoddFrank Act also requires escrow accounts to be established for certain mortgage
loans and mandates certain new disclosures regarding escrow accounts. The
Federal Reserve issued a proposed rule to implement these requirements in
March 2011, and the CFPB is responsible for finalizing that rule. In addition,
the Dodd-Frank Act expands the range of mortgage loans that are subject to the
Home Ownership and Equity Protection Act and imposes new requirements on
high-cost mortgages. These include mandatory counseling and other protections.
For mortgage servicers, there will be requirements concerning provision of
monthly statements, disclosures for hybrid adjustable rate mortgages, force-placed
insurance, prompt crediting of payments, pay-off amounts, and error resolution.
There also will be new requirements concerning compensation and qualification
of mortgage loan originators, such as brokers and loan officers, and, for certain
purposes, the companies that hire them. The Dodd-Frank Act also amends the
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Equal Credit Opportunity Act to require mortgage lenders to provide certain
disclosures and copies of appraisal documents to consumers.
Subtitle F of Title XIV of the Dodd-Frank Act relates to appraisal reform, and
certain additional rules concerning appraisals must be promulgated on an
interagency basis. For higher-risk mortgages, the Dodd-Frank Act generally
requires written appraisals based on a physical inspection of the property and, in
some cases, second appraisals. The FDIC, Federal Reserve, OCC, NCUA, FHFA,
and CFPB have authority under the Dodd-Frank Act to issue joint regulations
and guidance on appraiser independence and are required to issue regulations
on the appraisal requirements for higher-risk mortgages, appraisal management
companies, and automated valuation models.

6.3.3	

Investor Protection

The Dodd-Frank Act includes various provisions to strengthen investor
protection. These provisions include regulation of the over-the-counter
derivatives markets and governance and compensation reform. Under Section
926 of the Dodd-Frank Act, the SEC is required to adopt rules that disqualify
securities offerings involving certain felons and other “bad actors” from relying
on the safe harbor from Securities Act registration provided by Rule 506 of
Regulation D. The SEC proposed rules to implement the requirements of
this provision in May 2011. In addition, the SEC adopted rule amendments in
December 2011 implementing Section 413(a) of the Dodd-Frank Act, which
requires the value of an individual’s primary residence to be excluded when
determining if that individual’s net worth exceeds the $1 million threshold
required for “accredited investor” status.
The investing public should benefit from increased oversight of investment
advisers. Approximately 2,500 investment advisers with assets under management
between $25 million and $100 million are transitioning from oversight by the SEC
to oversight by state securities regulators. This transition, mandated by Section
410 of the Dodd-Frank Act and implemented by June 2011 rulemakings by the
SEC, is expected to result in more frequent examinations of the approximately
17,000 smaller, local advisers, while also allowing the SEC to focus its resources on
the approximately 10,000 larger, national advisers.
The securities laws also were modified in a number of ways to facilitate SEC
enforcement actions. These changes include enhancing the application of
antifraud provisions and providing authority to bring actions against aiders
and abettors. For example, the Dodd-Frank Act established a whistleblower
program that requires the SEC to pay an award to eligible whistleblowers that
voluntarily provide the SEC with original information about a violation of the
federal securities laws that leads to the successful enforcement of certain judicial
or administrative actions. In May 2011, the SEC adopted rules to implement this
provision. Since the rules went into effect in August 2011, the SEC has received
hundreds of tips through the program, and the quality of the information
received has, in many instances, been particularly helpful to the SEC’s
investigative staff.

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6.3.4	

Governance and Compensation

To facilitate prudent risk management at financial institutions and to align
the interests of executives and other employees with the long-term health of
their organizations, Section 956 of the Dodd-Frank Act requires the Federal
Reserve, FDIC, FHFA, NCUA, OCC, and SEC to jointly prescribe rules or
guidelines that require certain covered financial institutions to disclose to their
appropriate federal regulator the structure of the incentive-based compensation
arrangements offered by such covered financial institution sufficient to determine
whether the compensation structure (1) provides an executive officer, employee,
director, or principal shareholder of the covered financial institution with
excessive compensation, fees, or benefits; or (2) could lead to material financial
loss to the covered financial institution. Further, Section 956 requires the
appropriate federal regulators jointly to prescribe regulations or guidelines that
prohibit any types of incentive-based payment arrangement, or any feature of
such arrangement, that the regulators determine encourages inappropriate risks
by providing an executive officer, employee, director, or principal shareholder of
the covered financial institution with excessive compensation, fees, or benefits, or
that could lead to material financial loss to the covered firm. The proposed rule
would impose additional requirements on the payment of incentive compensation
to executive officers of certain larger covered financial institutions.
In April 2011, the agencies published a three-part proposed rule for public
comment. First, a financial institution with $1 billion or more in total
consolidated assets (a covered financial institution) would be required to
file an annual report with its appropriate federal regulator describing the
structure of the firm’s incentive-based compensation arrangements. Second, the
proposed rule would prohibit a covered financial institution from establishing
or maintaining an incentive-based compensation arrangement that could lead
to material financial loss or that encourages inappropriate risks by providing
certain “covered persons” (which include all executives, employees, directors, and
principal shareholders) with excessive compensation. Finally, the proposed rule
would require each covered financial institution to adopt specific policies and
procedures approved by its board to help ensure and monitor compliance with
the rule.
Section 952 of the Dodd-Frank Act requires the SEC to, by rule, direct the
national securities exchanges and national securities associations to prohibit
the listing of any equity security of an issuer that does not comply with new
compensation committee and compensation adviser requirements. In June
2012, the SEC adopted rules to implement Section 952 that require, among
other things, that the exchanges establish listing standards that require each
member of a listed issuer’s compensation committee to be a member of the
board of directors and to be “independent.” The SEC also is required by
the Dodd-Frank Act to adopt several additional rules related to corporate
governance and executive compensation, including rules mandating new
listing standards relating to specified “clawback” policies, and new disclosure
requirements about executive compensation and company performance,
executive to median employee pay ratios, and employee and director hedging.
These provisions of the Dodd-Frank Act do not contain rulemaking deadlines,
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but SEC staff is working to develop recommendations for the SEC concerning
the implementation of these provisions.

6.4	

Council Activities

6.4.1	 Determination of Nonbank Financial Companies to Be Supervised by the
Federal Reserve and Designation of Financial Market Utilities
Nonbank Financial Companies
One of the Council’s statutory purposes is to identify risks to financial stability
that could arise from the material financial distress or failure, or ongoing
activities, of nonbank financial companies. Under Section 113 of the Dodd-Frank
Act, the Council is authorized to determine that a nonbank financial company’s
material financial distress—or the nature, scope, size, scale, concentration,
interconnectedness, or mix of its activities—could pose a threat to U.S. financial
stability. Such companies will be subject to consolidated supervision by the
Federal Reserve and enhanced prudential standards.
The Dodd-Frank Act provides a list of 10 considerations the Council must
use in making determinations under Section 113. In fall 2010, the Council
began a rulemaking process to further clarify these statutorily mandated
considerations. The Council issued an advance notice of proposed rulemaking
(ANPR) in October 2010 and an NPR in January 2011. The Council received
significant input from market participants, nonprofits, academics, and members
of the public about the need to develop an analytic framework for making
determinations that would provide a consistent approach and incorporate both
quantitative and qualitative judgments. In response to comments the Council
received on the NPR, the Council sought public comment on a second NPR
and proposed interpretive guidance in October 2011 to provide (1) additional
details regarding the framework that the Council intends to use to assess whether
the material financial distress or failure, or ongoing activities, of a nonbank
financial company could pose a threat to U.S. financial stability; and (2) further
opportunity for public comment on the Council’s proposed approach to the
determination process. In April 2012, the Council adopted a final rule and
interpretive guidance.
The Council’s interpretive guidance includes an analytic framework that
organizes the 10 statutory considerations into six broad categories that reflect
a company’s role in the financial system and its potential to experience
material financial distress. In addition, the interpretive guidance describes the
three-stage process that the Council intends to use in evaluating companies
in non-emergency situations, defines key terms related to the Council’s
determination authority, and sets forth uniform quantitative thresholds
that the Council intends to use to identify companies for further evaluation.
While the Council’s assessments of companies will be based on a fact-specific
evaluation of the statutory considerations, the rule and interpretive guidance
describe the characteristics of companies the Council likely will evaluate for
potential determination and the factors the Council intends to use when
analyzing companies.
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In non-emergency situations, before a Council vote on any proposed
determination, the company under consideration will have an opportunity to
submit written materials to the Council regarding the proposed determination.
Council members will vote on a proposed determination only after they have
reviewed that information, and the proposed determination will proceed only
if approved by two-thirds of the Council, including the affirmative vote of the
Chairperson. Upon a proposed determination, a company may request a hearing,
and the determination will be finalized only after a subsequent two-thirds vote
of the Council, including the affirmative vote of the Chairperson. Any final
determination will be subject to judicial review, and the Council must submit
a report to Congress on, among other things, all determinations made under
Section 113 of the Dodd-Frank Act and the basis for such determinations.
As of the date of this report, the Council has not made any determinations under
Section 113 of the Dodd-Frank Act.

Financial Market Utilities
The Dodd-Frank Act authorizes the Council to designate an FMU as “systemically
important” if the Council determines that the failure of or a disruption to the
functioning of the FMU could create or increase the risk of significant liquidity
or credit problems spreading among financial institutions or markets and thereby
threaten the stability of the U.S. financial system.
Designated FMUs will become subject to the heightened prudential and
supervisory provisions of Title VIII, which promote robust risk management and
safety and soundness, including conducting their operations in compliance with
applicable risk-management standards; providing advance notice and review of
changes to their rules, procedures, and operations that could materially affect
the nature or level of their risks; and being subject to relevant examination
and enforcement provisions. Title VIII also requires the supervisory agencies
to consult with each other when they are prescribing their respective riskmanagement standards, jointly develop risk-management supervisory programs,
and consult and coordinate in planning and conducting examinations. To further
strengthen settlement processes, the Federal Reserve Board may authorize a
Federal Reserve Bank to provide accounts and settlement services to designated
FMUs. Additionally, under unusual or exigent circumstances, designated FMUs
could potentially gain access to the Federal Reserve’s discount window.
Following the publication of its final rule outlining the criteria, processes, and
procedures for the designation of FMUs on July 27, 2011, the Council proposed
the designation of an initial set of FMUs on May 22, 2012. At its July 18, 2012,
meeting, the Council voted unanimously to designate eight FMUs as systemically
important under Title VIII of the Dodd-Frank Act.
The FMUs that the Council designated perform a variety of functions in the
market, including the clearance and settlement of cash, securities, and derivatives
transactions; many of them are central counterparties and are responsible for
clearing a large majority of trades in their respective markets. The Council
believes that the completion of the FMU designations process for this initial set
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of FMUs is a major milestone in the implementation of the Dodd-Frank Act and
that the designation of these entities will instill confidence in their respective
markets. The basis for the Council’s designation determination for each of these
systemically important FMUs is described in Appendix A.

6.4.2	

Risk Monitoring

One of the Council’s central purposes is the ongoing identification of risks to U.S.
financial stability. To help identify risks, promote market discipline, and respond
to emerging threats, the Council facilitates information sharing, coordination,
and communication among member agencies, among other things.
In the past year, the Council examined significant market developments and
structural issues within the financial system, including topics discussed elsewhere
in this report. The Council will continue to monitor potential threats to financial
stability, whether from external shocks or structural weaknesses.
To facilitate this risk monitoring process, the Council established the Systemic
Risk Committee (SRC), composed primarily of member agency staff in
supervisory, surveillance, examination, and policy roles. The SRC serves as a
forum for member agency staff to identify and analyze potential risks that may
extend beyond the jurisdiction of any one agency.

6.4.3	

Reports Required Under the Dodd-Frank Act

Prompt Corrective Action
In December 2011, the Council released a report to Congress on prompt
corrective action (PCA). Section 202(g)(4) of the Dodd-Frank Act required
the Council to issue a report on actions taken in response to the Government
Accountability Office (GAO) study on PCA required by Section 202(g)(1) of the
Dodd-Frank Act. The Council’s report discusses the existing PCA framework
and the findings and recommendations of the GAO study. The Council’s report
also highlights some lessons learned from the financial crisis and outlines
actions taken that could affect PCA, as well as additional steps to modify the PCA
framework that could be considered.

Report on Actions Taken in Response to the GAO’s Report on the NCUA
In June 2012, the Council released a report to Congress on actions taken
in response to a GAO report on the NCUA’s supervision of corporate credit
unions and implementation of PCA, as required by the National Credit
Union Authority Clarification Act. The report discusses the findings and
recommendations of the GAO study and outlines NCUA activities that relate to
the GAO’s recommendations.

Contingent Capital
Section 115(c) of the Dodd-Frank Act requires the Council to study the feasibility,
benefits, costs, and structure of a contingent capital requirement for nonbank
financial companies supervised by the Federal Reserve and large, interconnected
bank holding companies. In July 2012, the Council submitted a report to
Congress regarding the study, as required by Section 115(c). The Council’s report
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concludes that contingent capital instruments should continue to be an area for
private sector innovation, and encourages the Federal Reserve and other financial
regulators to continue to study the advantages and disadvantages of including
contingent capital and bail-in instruments in their regulatory capital frameworks.

6.4.4	

Rulemaking Coordination

As Chairperson of the Council, the Treasury Secretary is required to coordinate
two major rulemakings under the Dodd-Frank Act.
To facilitate the joint rulemaking on credit risk retention for asset-backed
securities, as described previously, certain member agencies participated in
an interagency working group to develop the NPR for public comment. The
Federal Reserve, FDIC, SEC, OCC, HUD, and FHFA issued a joint NPR on March
30, 2011, that proposes rules to implement this requirement and represents
a significant step toward strengthening securitization markets. The agencies
extended the comment period for the proposed rule from June 10, 2011, to
August 1, 2011.
The Chairperson of the Council is also required to coordinate the issuance of
final regulations implementing the Volcker Rule, as described in Section 6.1.4.
The Chairperson has played an active role in coordinating the agencies’ work to
develop regulations that are comparable and provide for consistent application,
to the extent possible. The Federal Reserve, FDIC, OCC, and SEC sought public
comment on a proposed rule in October 2011, and the CFTC requested comment
on a substantively identical NPR in January 2012. The comment period closed
February 13, 2012, for the proposed rules issued by the Federal Reserve, FDIC,
OCC, and SEC, and closed on April 16, 2012, for the CFTC’s proposed rule.
The Chairperson of the Council continues to coordinate the development of a
final rule.

6.4.5	

Operations of the Council

The Dodd-Frank Act requires the Council to convene no less than quarterly. In
the last year, the Council met 12 times.3 The meetings bring Council members
together to discuss and analyze emerging market developments and financial
regulatory issues. The Council is committed to conducting its business as openly
and transparently as practicable, given the confidential supervisory and sensitive
information at the center of its work. Consistent with the Council’s transparency
policy, the Council opens its meetings to the public whenever possible. The
Council held a public session at three of its meetings in the last year.
Approximately every two weeks, the Council’s Deputies Committee, which
is composed of senior representatives of Council members, has convened to
discuss the Council’s agenda and to direct the work of the SRC and the five
other functional committees. The other functional committees are organized
around the Council’s ongoing statutory responsibilities: (1) identifying nonbank
financial companies and financial market utilities for designation; (2) making
recommendations to primary financial regulatory agencies regarding heightened
prudential standards for financial firms; (3) consulting with the FDIC on
orderly liquidation authority and reviewing the resolution plan requirements for
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designated nonbank financial firms and the largest BHCs; and (4) collecting data
and improving data-reporting standards.
In the last year, the Council adopted regulations implementing its Freedom of
Information Act obligations,4 adopted hearing procedures for nonbank financial
companies and FMUs subject to proposed designations, and passed its second
budget. The Council also complied with its transparency policy by conducting its
business in an open and transparent manner whenever possible. 5

Financial Research Fund Assessments
Section 155 of the Dodd-Frank Act requires the Treasury, with the approval
of the Council, to establish assessments to fund the OFR’s budget, which
includes the expenses of the Council and the FDIC’s implementation
expenses associated with OLA. To implement this provision, on May 21, 2012,
the Treasury issued a final rule that establishes an assessment schedule for
semiannual collections from bank holding companies with total consolidated
assets of $50 billion or greater and an interim final rule that applies to nonbank
financial companies supervised by the Federal Reserve. The first payments
under the rule will be made on July 20, 2012.

6.4.6	

Section 119 of the Dodd-Frank Act

Section 119 of the Dodd-Frank Act provides that the Council may issue
nonbinding recommendations to member agencies on disputes about the
agencies’ respective jurisdiction over a particular BHC, nonbank financial
company, or financial activity or product. (Certain consumer protection matters,
for which another dispute mechanism is provided under Title X of the Act, are
excluded). To date, no member agency has approached the Council to resolve a
dispute under Section 119.

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7
	

Potential Emerging Threats

7.1	 Framework: Threats as a Combination
of Shocks and Vulnerabilities
Episodes of financial disruption typically arise when
adverse developments unforeseen by most market
participants, commonly referred to as shocks,
interact with financial system vulnerabilities. A
shock that potentially threatens stability is typically
one that induces substantial losses on a class of
assets over a short period of time. Recent history
provides examples of shocks that created challenges
for financial stability, such as the bursting asset
price bubbles in stock markets (2000) and housing
markets (2007), rapid increases in interest rates
(1994), defaults on sovereign debt (for example,
Mexico in 1982 or Russia in 1998), or severe
operational stress in financial markets (for example,
the so-called “flash crash” of May 2010). Shocks
can also emerge from, or be exacerbated by, the
failure of a specific firm, infrastructure events, or
breakdowns in market functioning that create or
aggravate losses on a class of assets.
Not all such disturbances necessarily affect the
stability of the financial system or the real economy.
However, if the financial system is particularly
vulnerable to shocks, for example, due to excessive
leverage or excessive use of short-term wholesale
funding of illiquid assets, a shock could have
extreme balance sheet consequences and threaten
institutions with insolvency. Market participants
in general may not know which specific firms have
balance sheets that are most at risk, so they may
respond by avoiding exposure to any potential
counterparty that might be at risk of insolvency.
The resulting attenuation of credit provision could
lead to disorderly liquidation of assets by all affected
firms, inducing losses in other asset classes, thereby
spreading and magnifying the effects of the initial
disturbance. Credit flows to the non-financial
sector could be disrupted, reducing the pace of
real economic activity. In extreme cases, total
economic losses could far exceed the original drop
in asset value.

Given the inherent difficulty in predicting shocks,
perhaps the most important line of defense is to
reduce vulnerabilities by ensuring that institutions
have sufficient capital and liquidity resources, sound
risk-management practices, and strong internal
and regulatory controls. Policy efforts can also
strengthen financial markets’ ability to withstand
shocks by promoting greater informational
transparency, for example, by addressing gaps
in the availability of data and by producing
consolidated audit trails. Additional policy measures
that serve to enhance robustness of markets and
institutions include comprehensive resolution
planning, procedures for orderly liquidation of
insolvent institutions, constraints on concentration
in financial services, disciplined underwriting
standards for credit origination, and exercising
due diligence on emerging financial products.
Finally, markets can be made more resilient if public
authorities can respond to financial stresses in a
flexible and timely manner. An example would
be the central bank’s role as lender of last resort,
accompanied by appropriate safeguards against the
risk of moral hazard.
The public policy goal is not to reduce financial
market vulnerabilities to zero. Many of the key
tasks performed by financial markets inherently
involve a degree of vulnerability to certain kinds of
risk. Credit provision to risky borrowers, maturity
transformation, and the clearing of financial
transactions are all activities that can generate
vulnerabilities. Accordingly, the goal of public policy
is to design regulatory and institutional frameworks
that reduce vulnerabilities of markets, institutions,
and infrastructures to acceptable levels, while
allowing the financial system to continue to serve
the needs of the real economy.
Destabilizing shocks are more likely to occur
when markets have undergone structural changes,
including those from technological development
and financial innovation. These changes may be
slow moving, occurring over a period of years. For
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Chart 7.2.1	

Sovereign Yields

example, the proliferation of mortgage-backed
securities backed by subprime mortgage debt
occurred over approximately eight years.
Structural changes that occur during periods
of low volatility can be particularly problematic,
since such low-volatility episodes can lead to
complacency on the part of risk managers and
may lead to riskier behaviors in search of higher
returns. The full implications of such structural
changes are rarely recognized in real time.
In particular, so-called “model risk” becomes
more of a problem as market participants fail
to adjust their risk-management models in
response to the structural shifts. As a result,
market participants are likely to underestimate
the probability of shocks and to be unprepared
when a shock actually occurs.

7.2	

Areas of Heightened Uncertainty

There are several noteworthy aspects of the
current economic environment in which
structural change has elevated the level of
uncertainty. A clear instance is the trajectory of
growth, asset prices, and institutional change
resulting from euro area sovereign stresses.
The introduction of the euro represented a
significant structural change that ushered in a
related set of new developing institutions and
policies. Initially, the unified monetary policy
was associated with a convergence of sovereign
yields across euro area countries (Chart 7.2.1),
although this was not accompanied by a full
convergence of macroeconomic fundamentals,
such as productivity growth.
The financial crisis and recession of 2007-2009
drew attention to cross-sectional differences
in growth prospects, competitiveness, and
default risk among euro area countries, with
yield spreads widening for some sovereigns.
These structural tensions were exacerbated by
the cyclical downturn and by the fiscal burdens
arising from bank support programs.
Meanwhile, euro area integration on various
fronts remained incomplete, complicating
the crisis response. While euro area leaders
have expressed a desire to deepen European
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unification, there is continued uncertainty
about how European official entities will resolve
these fiscal strains and the extent to which euro
area institutions may change as a result. Markets
continue to believe that exits from the common
currency cannot be ruled out, with attendant
legal and other uncertainties. In particular,
the threat of a breakup of the euro area carries
with it redenomination risk—the risk that
obligations due in euros will be repaid in an
alternative, less valuable, currency.
Direct exposures of U.S. institutions to the
most stressed euro area countries appear to be
low (Charts 7.2.2, 7.2.3, and 7.2.4). However,
U.S. banks, money market funds (MMFs), and
the insurance industry have indirect exposures
through other non-periphery countries
and through asset markets. This generates
heightened uncertainty about the extent to
which evolving conditions could spill over to
U.S. markets and institutions.
Another key structural shift interacting with
cyclical factors is the increased importance
of emerging markets in global growth and
the global financial system. The growth
trajectories of emerging market economies
(EMEs), notably the potential for a marked
deceleration of growth in China as discussed
in Section 4.4, could have a significant impact
on growth and financial stability in the United
States. In particular there continues to be
uncertainty about the health and robustness of
some of these economies, including concerns
about banking and financial stability; the
sustainability of regional real estate trends; the
ability of policymakers to manage inflationary
pressures; and the possibility of social unrest.
The implications of these uncertainties for the
U.S. financial system are primarily driven by the
role of the EMEs as global providers of capital
and as contributors to global growth.

Chart 7.2.2	 U.S. MMF Exposure to Europe

Chart 7.2.3	 Large U.S. Banks’ Exposure* to Europe

Chart 7.2.4	 Insurance Industry Exposure to Europe

Uncertainty is also elevated in U.S. housing
markets. The 30 percent decline in house prices
since January 2006 continues to weigh on U.S.
real estate markets, with 12 million mortgages
having negative equity and continued high
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Chart 7.2.5	 Real Private Residential Investment

levels of foreclosure activity. Additional
mortgage losses are possible over the next
five years due to increased monthly payments
on home-equity loans. The current sluggish
growth in the housing sector contrasts with
the historical post-recession patterns, where
residential investment typically would display
solid growth during recoveries (Chart 7.2.5).
While there are signs of stabilization in housing
prices, and the inventory of existing homes
for sale has declined significantly, the overall
weakness in the macroeconomy carries with it
the risk of further declines in real estate prices,
with additional stresses on household and
institutional balance sheets.
In addition, the crisis exposed deep flaws in
the structure of housing finance that need to
be reformed, such as the incentives around
securitization, the design of governmentsponsored enterprises (GSEs), and the overall
quality of mortgage-servicing standards.
Financial institutions continue to work
through legacy mortgage assets and apply
conservative credit standards to new mortgage
activity. Given the scarcity of private capital
in mortgage markets, federal government
support continues to dominate the provision
of residential mortgages. While some progress
has been made in addressing mortgage loan
servicing and foreclosure abuses, as well as
gaps in protections for homeowners, lack of
uniform servicing standards with appropriate
safeguards for consumers, such as single points
of contact, continue to create potential adverse
consequences for distressed homeowners and
their surrounding communities. The structural
and cyclical problems of the housing finance
market constitute a vulnerability of the financial
system that makes the U.S. economy more
susceptible to adverse shocks. For example, the
effect of a slowdown in economic growth could
be amplified by the mortgage market, leading
to larger-than-expected declines in home prices
and sales.
Another area of uncertainty is the fiscal policy
outlook in the United States. A number of
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the end of 2012, including expiration of the
tax cuts originally enacted in 2001 and 2003,
expiration of payroll tax cuts, expiration of
extended unemployment benefits, the Budget
Control Act-mandated sequester, and the need
to raise the debt ceiling once again. As was
the case with the debt ceiling debate in the
summer of 2011, market volatility may increase
as these fiscal deadlines approach, possibly
weighing on growth. Furthermore, the longterm trajectory of U.S. fiscal policy is generally
regarded as unsustainable, given the aging of
the population and the likely path for health
care expenditures. The way in which these longterm imbalances eventually will be resolved
is unclear, representing yet another source
of uncertainty for financial markets and the
real economy.

Chart 7.3.1	

Aggregate BHC Capital Ratios

Chart 7.3.2	 Core Deposits as a Percent of Total Liabilities

7.3	 Robustness of Financial
Institutions and Markets
While some indicators point to an increased
level of robustness of financial institutions and
markets over the past year, there continue to
be areas of serious concern. The aggregate
tier one capital ratio of domestically owned
bank holding companies (BHCs) was 13.3
percent of risk-weighted assets as of the first
quarter of 2012, the highest level in more than
10 years (Chart 7.3.1). Increased robustness
can also be seen in the broker-dealer (BD)
industry, which shows a sharp decline in
leverage since 2007. Stress test results from
the 2012 Comprehensive Capital Analysis and
Review (CCAR) demonstrated the increase in
capital, particularly common equity, held by
the largest U.S. banking institutions since the
onset of the financial crisis. Even so, 4 of the
19 BHCs had post-stress capital ratios that fell
below one or more regulatory minimums after
including all planned capital distributions.
The aggregate BHC funding profile has been
strengthened by increased reliance on core
deposits (Chart 7.3.2), continued reduction in
short-term wholesale funding (Chart 7.3.3),
and a substantial increase in the fraction of
assets that are highly liquid. There is concern,
however, that these funding and liquidity

Chart 7.3.3	 Short-Term Wholesale Funding

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Chart 5.2.12	 CDS Spreads of 6 Large Complex BHCs

developments may be short-lived implications
of the low interest rate environment and the
temporary unlimited coverage for non-interestbearing transaction accounts under Section
343 of the Dodd-Frank Act, which is scheduled
to expire on December 31, 2012.
Other indicators suggest a less sanguine view
of U.S. financial institutions. The average
cost of buying credit protection on the six
largest U.S. BHCs started to rise in August
2011, with increasing concerns about the euro
area stability. (See Chart 5.2.12, displayed
here for convenience.) While credit default
swap (CDS) spreads on these BHCs have
come down somewhat since their peak in
November 2011, they remain above the levels
that prevailed from mid-2009 through mid2011. Similarly, market valuations of the large
BHCs are well below book value. Revenues
at these institutions remain challenged by
general market uncertainty and the low
interest rate environment, and BHC earnings
growth is largely dependent on non-recurring
accounting items. In addition, approximately
12 percent of all institutions within the
commercial banking sector still remain on
the FDIC’s problem bank list, accounting for
approximately 2 percent of sectoral assets.
Changes in financial market infrastructures
are likely to make the derivatives market less
vulnerable to shocks. In recent years, there have
been substantial increases in the volume of
swaps contracts being centrally cleared, which
represents a significant step toward improved
management of credit risks in these markets.
In addition, informational transparency
to regulators has been enhanced by the
expansion of trade repositories (TRs). The
availability of data from the Trade Information
Warehouse, the TR for CDS, proved extremely
useful to regulators in determining patterns
of exposures to Greek sovereign default risk
during the period leading up to the Greek
debt restructuring in March 2012. Finally, it is
anticipated that, pursuant to Title VII of the
Dodd-Frank Act, many types of swaps will be
traded on swap execution facilities (SEFs) and

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security-based SEFs in the near future. This
development should significantly enhance both
pre- and post-trade transparency of price and
volume information on executed transactions to
swaps market participants. While the SEC and
CFTC have not yet finalized rules relating to
the regulation of SEFs and security-based SEFs,
both agencies have issued detailed proposals.
Another form of vulnerability has been
highlighted by the failure of segregation
procedures to fully protect customers of MF
Global. (See Box D: MF Global Bankruptcy.)
For decades, segregation of customer funds
has been the lynchpin of customer protection
in futures markets. While MF Global customers
recovered 72 percent of the value of their
accounts for trading on U.S. futures exchanges
within a few months of the bankruptcy, they
lost use of those funds for critical weeks and
are still owed hundreds of millions of dollars
in the aggregate. MF Global customers
trading on foreign exchanges have received
a much lower percentage of recovery. The
CFTC has taken steps to enhance customer
protection and has solicited input on further
possible actions.
Financial reform efforts are essential in
restoring the strength and stability of financial
institutions and markets. Nevertheless, lessregulated institutions and markets could be
perceived to hold competitive advantages.
Accordingly, vulnerabilities could continue
or increase if some participants choose to
move business lines or activities to take
advantage of perceived gaps or inconsistencies
in regulation. This is particularly a concern
when comparable financial activities are not
subject to a comparable degree of regulatory
stringency. This could occur, for example, if
a lightly regulated swaps participant were to
expand its business to approximate a full swaps
dealership without the requisite regulatory
oversight. The Dodd-Frank Act provides
mechanisms to address such regulatory gaps,
for example, by requiring oversight of all swap
dealers and major swaps participants and
improving regulatory oversight on nonbank
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129

financial companies that could pose a threat to
U.S. financial stability.

7.4	 Continuing Vulnerabilities in the
Financial System
A number of characteristics of the current
financial system continue to render it
vulnerable to a variety of shocks and create
the potential to amplify the destructive
effects of such shocks.
Different types of vulnerabilities can arise in
financial systems. First, some vulnerabilities
are inherent to the role that financial systems
play in the economy. For example, maturity
transformation (turning short-term savings
into long-term capital investment) is an
essential service of financial markets. But
such transformation carries certain potential
instabilities, such as the risk that short-term
debt may not be rolled over or even the
possibility of a run on a financial institution.
Similarly, providing credit to risky borrowers is
an important function of financial institutions.
However, some degree of credit losses
associated with such lending is inevitable. These
sorts of vulnerabilities can be mitigated by
appropriate public policy structures, including
prudential regulation and supervision, robust
capital and liquidity requirements, deposit and
share insurance, orderly liquidation authority,
and the role of the central bank as lender of last
resort, but they cannot be fully eliminated.
A second type of vulnerability arises from
control weaknesses in operations, risk
management, and governance. Examples
would include the possibility of erroneous
trade completion in a high-speed trading
environment, the danger of cybersecurity
breaches, and risk-management deficiencies
in financial institutions. Such vulnerabilities
highlight the importance of regulatory
measures, such as prudential capital and
liquidity requirements and risk-management
standards, as well as private-sector risk controls.

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Finally, a third class of vulnerabilities is
generated by the behavioral responses of market
participants to financial developments, which
could lead to undesirable vulnerabilities in the
aggregate. An example would be the tendency
for some investors to take on additional risk
in a low interest rate environment in an effort
to reach for yield. Another example would
be the spillovers from the actions of firms in
highly concentrated market segments or asset
classes. Regulatory measures can be useful in
addressing these sorts of vulnerabilities. For
example, appropriate compensation regulation
can deter firms from providing incentives to
take on excessive risk. Equally important is to
help ensure that stakeholders bear losses in
downside scenarios and are subject to market
discipline on an ongoing basis.

Chart 5.2.7	 Short-Term Wholesale Funding at Largest BHCs

Chart 7.4.1	

Less-Stable Funding Sources at 6 Largest BHCs

These three types of vulnerabilities are not
mutually exclusive: a given source of market
vulnerability might be associated with all three
types to varying degrees, so any classification
of specific vulnerabilities is to some extent
arbitrary. In the following text, we discuss
specific vulnerabilities of each of these
types in the current environment, with the
vulnerabilities classified according to which
characteristics are most predominant.

7.4.1	

Inherent Vulnerabilities

Run Risk in Wholesale Short-Term Funding
Markets
Broker-dealers (BDs) and other market
participants typically fund some of their
portfolio holdings and securities inventories
using short-term funding, obtained through
repos, commercial paper, and unsecured shortterm lending. While use of short-term wholesale
funding has decreased overall (Chart 5.2.7,
displayed here for convenience), the very large
BHCs, especially those with large BD operations,
continue to display a substantial dependence
on short-term, less stable funding sources
(Chart 7.4.1). Moreover, as discussed in Section
5.2, the U.S. branches and agencies of foreign
banks also rely heavily on short-term funding
through MMFs and uninsured wholesale
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131

depositors. In practice, institutions that rely
on short-term funding must maintain strong
short-term credit ratings. In June 2012, Moody’s
reduced its short-term ratings by one notch for
three large dealer banks: Barclays, Goldman
Sachs, and Morgan Stanley. Markets will be
monitoring the impacts of the downgrades on
these banks’ funding models.
This continued reliance on short-term funding
for illiquid assets can be a source of instability
if borrowers have difficulty rolling over their
maturing short-term debt on economically viable
terms. This dynamic could force borrowers
to sell long-duration assets under fire-sale
conditions, generating a self-reinforcing negative
feedback loop by putting downward pressure on
prices that, in turn, stresses the balance sheets of
a wider range of institutions.
The vulnerabilities associated with the use of
short-term funding for illiquid assets may be
exacerbated by ongoing structural weaknesses
in the tri-party repo market and in MMFs. The
tri-party repo market relies heavily on intraday
credit extensions from the clearing banks,
is exposed to weaknesses in the credit and
liquidity risk-management practices of market
participants, and lacks a mechanism to help
ensure orderly liquidation of tri-party repo
collateral by creditors of a defaulting dealer.
(See Box G: Ongoing Vulnerabilities in the
Tri-Party Repo Market.) MMFs can be subject to
runs if the $1.00 net asset value (NAV) is believed
to exceed the liquidation value of the fund.
(See Box H: Money Market Fund Responses
to Euro Area Uncertainty.)

7.4.2	

Potential Control Weaknesses

High-Speed Trading
High-speed automated trading has become
common in equity and derivatives markets, and is
also spreading to markets for Treasury securities
and foreign exchange. (See Section 5.4, Box
F: Algorithmic and High-Frequency Trading.)
It is likely that high-speed trading increases
market liquidity in normal market conditions.
However, any market in which liquidity is
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BOX G:  ONGOING VULNERABILITIES IN THE TRI-PARTY REPO MARKET
While regulators have gained much better visibility into
the activity of the tri-party repo market in recent years,
it remains a significant source of potential contagion.
Despite the recent steps taken by participants to
advance changes in the market’s infrastructure to
mitigate key vulnerabilities, progress is taking longer
than initially anticipated. Three specific sources of
vulnerability remain of great concern to the Council:
•	

•	

•	

Heavy reliance by market participants on
intraday credit extensions from the
clearing banks,
Weakness in the credit and liquidity risk
management practices of many market
participants, and
Lack of a mechanism to ensure orderly
liquidation of tri-party repo collateral by
creditors of a defaulting dealer.

Over-reliance on intraday credit. Currently,
tri-party repo trades “unwind” every day, meaning that
the clearing bank returns cash to the lender’s account
and returns collateral to the borrower’s account. Trades
are not settled until several hours later. For several hours
each afternoon, dealers require funding of their entire
tri-party repo book that lenders do not provide. This
$1.7 trillion funding need is provided by the two
clearing banks.

less liquid collateral, such as asset-backed securities
or corporate bonds. In addition, some lenders do
not exercise sufficient rigor in setting haircuts and
in evaluating appropriate asset types as collateral,
particularly for less liquid assets. This can create a
destabilizing cycle: if lenders do not feel protected by
the haircuts they have in place, they may respond to a
dealer stress event or rising price volatility by increasing
haircuts sharply, further reducing the dealer’s ability to
obtain needed funding. Instability is also intensified by
the fact that some lenders (notably MMFs subject to
Rule 2a-7 under the Investment Company Act) accept
collateral that they are unable to hold and liquidate
gradually following a default. These lenders are likely to
pull back their funding altogether if they are subject to
redemptions to avoid being forced to take possession
of the collateral—further destabilizing market conditions.
Presently, there is no process in place to prevent
lenders from taking on collateral that they could not
properly manage or permissibly hold outright.

Absence of a mechanism to facilitate orderly
liquidation of a defaulted dealer’s collateral.
A large dealer’s default could leave lenders with billions
of dollars of collateral that they would likely seek to
liquidate quickly. The resulting large volume of asset
sales could depress prices, significantly impair market
liquidity, and erode the capital of many financial firms
through mark-to-market losses. This erosion of capital
This is a potentially unstable situation. In times of market could, in turn, create intense pressure for holders to
stress, the clearing bank faces a conflict of interest
shrink their balance sheets by selling additional assets,
between its own risk-management needs and the role
creating a downward spiral. There is currently no
it performs as a lender to dealers experiencing funding
mechanism in place to ensure that lenders will be able
problems. Given its intraday exposure to dealers, the
to liquidate the collateral of a defaulted dealer gradually
clearing bank could have a strong incentive, in the face
over time in a manner that avoids this sort of fire
of a dealer’s deteriorating credit quality, to refrain from
sale dynamic.
unwinding in order to avoid extending credit and taking
on exposure to the dealer’s collateral.
Poor risk management practices. Some dealers
remain very dependent on short-term repo funding
and are heavily exposed to rollover risk. Of particular
concern is the use of short-term borrowing to finance

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BOX H:  MONEY MARKET FUND RESPONSES TO EURO AREA UNCERTAINTY
Vulnerabilities from reliance on short-term funding can be
compounded by structural problems with money market
funds (MMFs). MMFs are promoted to institutional and
retail investors as stable investments that provide cash
on demand at a constant net asset value (NAV) of $1
per share, very much like bank deposits. However, these
funds are prone to runs, as investors have an incentive
to exit a fund at $1 per share if they suspect that its
NAV is likely to decline below $1 (that is, they expect the
fund to “break the buck”). A clear example is the wave
of redemptions from MMFs after the Reserve Primary
Fund broke the buck in September 2008 because of its
Lehman exposures.
A more recent episode of large-scale MMF redemptions
is the response of MMFs to increased uncertainty about
euro area stability in June 2011. This episode provides
an opportunity to examine potential vulnerabilities in the
MMF industry. In June 2011, the potential for European
bank downgrades and rising concern about the euro
area periphery debt crisis prompted concerns about
MMF exposures to European banks. Prime MMFs began
experiencing substantial redemptions, with assets falling
by $165 billion (or 5.1 percent) in June 2011 and with
some MMFs losing as much as 20 percent of their assets
during this period.
MMFs were able to satisfy these redemptions with
internally generated liquidity. (See Chart 5.3.7,
displayed here for convenience.) In addition, while
MMFs’ euro area exposures had generated negative press
attention, these positions had not actually experienced
any losses affecting the mark-to-market value of MMFs’
portfolios. MMFs were also better able to absorb these
redemptions because they occurred on a steady basis
over a period of weeks, as opposed to the sort of run on
MMFs that occurred in 2008, where investors withdrew
over $300 billion in a matter of days from prime MMFs,
several of which were simultaneously experiencing markto-market losses in their portfolios. These mitigating
circumstances allowed MMFs to absorb redemptions in
the summer of 2011 while maintaining a stable NAV.

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Chart 5.3.7	 Prime Funds Liquidity

Following this period of redemptions, MMFs rapidly
reduced their exposure to euro area counterparties.
For example, prime MMF exposures to French issuers
declined from a peak of $274 billion at May 31, 2011, to
$176 billion (or 36 percent) by July 31, 2011, and to as low
as $48 billion by December 31, 2011. Overall euro area
exposures of prime MMFs decreased considerably from
nearly 30 percent of prime MMF assets to 18 percent
of assets between May 31, 2011, and May 31, 2012
(Chart H.1).
While this rapid reduction in short-term dollar funding
for euro area banks reduced MMF exposure to the debt
crisis, it added to strains in the global financial system. For
those institutions in which MMFs continue to invest, credit
has been provided at shorter maturities and increasingly
in secured form through repurchase agreements. From
March 2011 to May 2012, the weighted average life for
prime MMFs declined from 81 to 71 days. As of June
2012, MMFs have a relatively small direct exposure of
approximately $1 billion to Spanish banks, with no direct
exposure to Italian or Greek banks. Prime MMFs also, on
average, reduced their overall credit exposure, shifting
portfolio assets from bank certificates of deposit into
government debt and repos (Chart H.2).

Chart H.1	

Prime Fund Bank Holdings

Chart H.2	

Prime Fund Portfolio Composition

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provided by automated trading strategies could
find significant amounts of liquidity suddenly
withdrawn if those automated strategies pause
due to changes in market conditions. Evidence
suggests that the so-called “flash crash” of May
2010 involved a temporary liquidity withdrawal
of this type. Attenuated market liquidity, in
turn, can adversely affect market functioning
more generally. Risk controls must keep pace
with these developments. Unfortunately, the
risk arising from high-speed trading is difficult
to assess because it is opaque and difficult to
monitor (particularly in real time).

Complex Trading Strategies and Risk
Management
The effects of advances in technology and
financial innovation have also resulted in
financial firms employing trading and hedging
strategies that rely increasingly on complex
assumptions regarding the performance and
interrelationships of financial instruments
and contracts. Recent events, including the
publicly announced trading losses at JPMorgan
Chase (JPM), highlight the risks that can
develop in the use of such complex strategies.
This incident reinforces how essential it is
that assumptions underlying trading and risk
management models be properly validated
and monitored on an ongoing basis to help
ensure that risks of complex trading strategies
are appropriately measured and understood.
Institutions also should establish a process to
review the effect of approved model changes to
help ensure that such changes are appropriate.

Cybersecurity
Cyberattacks represent an increasing threat to
financial institutions and the infrastructure
components on which financial systems depend
for communicating, sharing information,
and conducting business. The number and
sophistication of malicious incidents continue
to grow as business and financial institutions
continue to adopt Internet-based commerce
systems. Account takeovers can occur, including
fraudulent money transfers and counterfeiting
of stored value cards. Third-party payment
processor breaches represent a continuing risk,
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whereby the computer networks of large payment
processors are targeted, potentially leading to
financial losses and compromised personally
identifiable information.
Cyber criminals are becoming more
sophisticated, and attack vectors are evolving.
Social-engineering techniques used in attempts
to gain unauthorized access into networks
and systems are shifting from generalized and
random to highly targeted. Another cyber threat
can emerge from individuals with direct access
to core processing centers. Such individuals may
be in a position to steal intellectual property,
insider information, or data that can damage the
reputation of the company. Market participants
report that attacks targeting data and assets are
increasingly focused on institutional aspects of
infrastructure as opposed to retail operations.
These types of attacks are associated with
increased severity of potential losses and could
be increasingly disruptive. Cyber threats also
pose a potentially significant risk to the stability
of financial markets through the disruption of
critical payment, clearing, and settlement systems
for key financial institutions.

Robustness of Operational, Risk
Management, and Governance Controls at
Central Counterparties
In its 2009 meeting in Pittsburgh, the G-20
established the goal of having standardized
swap contracts centrally cleared by the end of
2012. This objective was codified in Title VII
of the Dodd-Frank Act. Central clearing of
swaps will enhance the stability and soundness
of over-the-counter (OTC) derivatives markets
in a variety of ways, including improved
counterparty risk management and multilateral
netting of contracts. However, it could also lead
to an increased number of financial contracts
cleared by a relatively small number of central
counterparty (CCP) clearinghouses, which
mitigate counterparty credit risk between
market participants by becoming the universal
counterparty and providing time-specific
settlement of transactions. As a result, these
clearing institutions have become associated

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with even more critical concentration of risk
than before.
The default of a major participant could impair
the liquidity available to a CCP, requiring
that liquidity for settlement be replaced from
the CCP’s own resources if it is to meet its
obligations in a timely fashion. The Principles
for Financial Market Infrastructures, finalized
this past April by the Committee on Payment
and Settlement Systems (CPSS) and the
International Organization of Securities
Commissions (IOSCO), provides a set of
international standards for CCPs and other
financial market utilities that address these
issues. In addition, Title VIII of the DoddFrank Act provides an enhanced regulatory
framework for CCPs through the Council’s
authority to designate financial market utilities
as systemically important.

Data Standards and Analytics
The financial crisis revealed that lack of
data standards and poor data management
threatened financial stability in several ways.
Those who created, collected, and relied upon
financial data found that financial data quality
and scope simply had not kept up with the
increasing complexity of, and innovation in,
modern financial markets. That was especially
the case as financial activity migrated from
traditional depository institutions into the
capital and securitization markets and across
national borders. Consequently, during the
crisis, a lack of consistent and high-quality
data made it difficult or impossible for some
market participants and their regulators to
monitor risks in trading books, gauge overall
exposures to specific counterparties, price
complex securities, or even assess the potential
losses that individual firms might face due to
falling house prices. Different data systems
using different naming conventions made
comparisons difficult or impossible, even within
the same firm. Resolving a large, complex
financial institution like Lehman Brothers was
hobbled by the snarled nature of insufficient,
conflicting, and inconsistent data.

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Since then, policymakers have broadened the
scope of data they collect and have made efforts
to improve their quality. Examples include
the new Form PF (for private funds) and data
to be collected by swap data repositories and
security-based swap repositories for swaps and
other derivatives, as well as international efforts
by the International Monetary Fund (IMF)
and the Financial Stability Board (FSB) to
close data gaps, particularly for derivatives and
nontraditional funding activities. Yet significant
gaps remain in both the scope and quality of
data needed to monitor and enhance financial
stability. More needs to be done, particularly
in the activities that have traditionally
resided outside the regulators’ sphere such as
securitization markets and OTC derivatives.
Data standards facilitate improvements in
data quality. For instance, efforts to establish
a global legal entity identifier (LEI) have
made significant progress in the last year,
including the establishment of the CFTC
Interim Compliant Identifier (CICI) initiative,
but work remains to be done to complete this
important effort. The Office of Financial
Research (OFR), established in Title I of the
Dodd-Frank Act, is tasked with improving the
quality of financial data and data analytics
along multiple dimensions, including LEI
implementation and enhancement.

7.4.3	

Behavioral Vulnerabilities

Managing Risk in a Low Interest
Rate Environment
An unusually low rate environment, such as
that currently in place, is prone to several
behavioral vulnerabilities. Market participants
may have an incentive to take on additional
leverage, credit risk, and duration risk in an
effort to boost yields. While increased risk
taking is one possible transmission mechanism
for expansionary policies, such reach for
yield behavior without appropriate risk
management could leave many participants with
portfolios that are more vulnerable to adverse
market moves.

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Chart 7.4.2	 Credit Quality of High-Yield New Issues

The tendency to reach for yield may be
especially pronounced for entities such as
pension funds or insurance companies that face
a stream of quasi-fixed nominal liabilities. For
example, the investment yield for life insurers
in aggregate is only around 1.1 percentage
points above the minimum yield needed to
maintain policyholder reserves, leaving these
insurers with a relatively small margin of error.
Hedge funds also may have an incentive to
reach for excess yield if they manage to specific
hurdle rates expected by their investors or if
the value of their fund is considerably below
the high-water mark that would trigger a large
payout. In addition, money market funds may
have an incentive to increase their risk profiles,
especially if the low interest rates do not provide
sufficient yield to cover their expenses.
We do not see much evidence of such behaviors
currently. Risky assets do not exhibit signs of
overvaluations associated with widespread
reach-for-yield behavior. If anything, measures
of risk premia for equities and corporate bonds
are very wide by historical standards. However,
indicators of such behaviors should be watched
carefully, including leverage, contractual terms,
borrower characteristics, the use of levered
instruments for funding, issuance of “covenant
lite” loans, and the rate of original issue,
CCC‑rated high-yield bonds (Chart 7.4.2).
Eventually, interest rates will move up to
more normal levels. If market participants are
adequately prepared for such an increase in
rates, and if this increase occurs gradually,
it is unlikely that financial stability would be
adversely affected. However, a rapid increase
in interest rates could be disruptive. For
example, interest rates could increase rapidly
following a loss in investor confidence in the
sustainability of U.S. fiscal policy. It is unclear
how well prepared fixed income markets are
to the possibility of such rapid interest rate
movements. Those especially vulnerable would
be market participants with highly leveraged
carry-trade positions. It is important to
recognize that while any institution in isolation
can insulate itself from movements in interest

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rates via swaps and derivatives, these contracts
are in zero net supply in the aggregate. As
a result, some market participants must be
exposed to interest rate risk.

Chart 7.4.3	 Complex Financial Institutions in 2012

Moral Hazard Issues for Large, Complex
Financial Institutions
Behavioral vulnerabilities of large, complex
financial institutions could increase with the
complexity and size of these institutions. These
vulnerabilities occur because an expectation
of government support could generate more
risk taking by institutions that are perceived
as too big or too complex to fail. Indeed,
many observers interpret actions taken by
government authorities during the recent crisis
as evidence that the public sector provides an
implicit guarantee to large complex financial
institutions. Such beliefs, if widespread,
could lead to increased concentration in
financial services and greater risk taking by
those institutions deemed protected, as the
implicit government guarantee reduces market
discipline. The result could be higher overall
risk in financial markets with attenuated
risk management.
Large financial institutions continue to have
a high degree of operational complexity and
interconnectedness. These complexities may
reflect the diverse lines of businesses and
locations in which these firms operate, but
lead to legal structures with activities spread
over hundreds, and in some cases thousands,
of subsidiaries (Chart 7.4.3). Market
participants could believe that the complexity
and interconnectedness of these companies
could make them harder to resolve and induce
further likelihood of government support
in a stress environment. Such beliefs could
therefore promote continued moral hazard
problems for such complex financial entities.
In addition, there may continue to be
perceptions that some institutions may
receive special treatment by virtue of their
size. Such beliefs could be exacerbated
by greater concentration in the financial
services industry. The financial industry
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Chart 7.4.4	 Assets of the 10 Largest Depository Institutions

has become increasingly concentrated for
decades, a trend enhanced in part by such
legislative developments as the Riegle-Neal
Interstate Banking and Branching Efficiency
Act of 1994 permitting interstate branching,
and the Gramm-Leach-Bliley Act, enacted
in 1999, that allowed affiliations among
commercial banks, investment banks, and
insurance companies. This trend continued
through the crisis (Chart 7.4.4) in part due
to acquisitions of failing firms. As of the
first quarter of 2012, the 10 largest banks
held 52 percent of industry assets, worth
approximately 47 percent of GDP, compared
with 45 percent of industry assets, worth
approximately 40 percent of GDP at the end
of 2006. Notwithstanding this trend towards
greater concentration, the U.S. banking system
remains significantly less concentrated than
that of most developed countries.
These moral hazard problems are partially
addressed by raising capital requirements.
An additional important priority is to develop
credible and robust failure resolution
procedures for large complex institutions—
procedures that would allow the institution to
be liquidated or restructured, as appropriate,
with minimal damage to the markets as a
whole. The FDIC is authorized to resolve
certain failing financial companies under
the Dodd-Frank Act and has developed a
resolution strategy for such firms that will
promote financial stability by minimizing
contagion and requiring accountability by
forcing the firms’ shareholders and creditors
to bear losses.
The credit rating agencies appear to have
recognized that the Dodd-Frank Act limits
the ability of the government to provide
extraordinary support to shareholders
and creditors of large complex financial
institutions. This recognition can be seen in
the reduced uplift the major rating agencies
incorporate into the long-term ratings for
a number of large financial institutions,
many of which have been downgraded or

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assigned a negative rating outlook as a result
(Chart 7.4.5). However, a degree of ratings
uplift still remains for the largest banks,
typically 1 to 2 notches for large bank holding
companies and 2 to 3 notches for large bank
subsidiaries. In addition, there is evidence that
market-derived indicators of credit quality
tend to be lower than the levels assigned by
ratings agencies (Chart 7.4.6). While ratings
agencies typically report uplifts only for
long-term ratings, these uplifts also support
the short-term ratings that help firms access
short-term unsecured wholesale funding.
Vulnerabilities can arise when a financial
institution’s funding model depends in part
on the belief that the government will provide
support, rather than only on the intrinsic
strength of the institution and its portfolio.

Chart 7.4.5	 Moody’s BHC Systemic Support Uplift

Chart 7.4.6	 S&P Current Actual Rating & Market
Derived Signal*

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Appendix A
Designation of Systemically Important Financial Market Utilities
On July 18, 2012, the Financial Stability Oversight Council (Council) designated
eight financial market utilities (FMUs) as systemically important under Title VIII
of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act).
The designated FMUs are:
•	

•	
•	
•	
•	
•	
•	
•	

The Clearing House Payments Company L.L.C. (PaymentsCo) on the
basis of its role as operator of the Clearing House Interbank Payments
System (CHIPS)
CLS Bank International (CLS Bank or CLS)
Chicago Mercantile Exchange, Inc. (CME)
The Depository Trust Company (DTC)
Fixed Income Clearing Corporation (FICC)
ICE Clear Credit LLC (ICE Clear Credit)
National Securities Clearing Corporation (NSCC)
The Options Clearing Corporation (OCC)

Title VIII provides four specific factors the Council must take into consideration
when determining whether an FMU is, or is likely to become, systemically
important.1 These factors are also incorporated with more detail provided in
the Council’s regulations regarding the designation of FMUs.2 The four specific
factors are (A) the aggregate monetary value of transactions processed by the
FMU; (B) the aggregate exposure of the FMU to its counterparties; (C) the
relationship, interdependencies, or other interactions of the FMU with other
FMUs or payment, clearing, or settlement activities; and (D) the effect that the
failure of or a disruption to the FMU would have on critical markets, financial
institutions, or the broader financial system. Title VIII also requires the Council
to take into consideration any other factors that the Council deems appropriate.
The Council believes that the four identified factors provided an appropriate
basis for making determinations, and thus the Council did not explicitly rely on
any other factors.
This appendix provides a description of each FMU, as well as an analysis of its
systemic importance based on the factors listed here. Each FMU received a letter
on May 22, 2012 informing it that the Council had proposed its designation and
providing it with the same rationale for the Council’s determination provided
in this appendix. This appendix does not, however, include any confidential
data that were part of the Council’s analysis, though such confidential data
were included in the May 22 letters to each FMU. The FMUs each had 30 days
to request a hearing if they disagreed with the proposed determination of the
Council or the Council’s proposed findings of fact, but no FMU requested such

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145

a hearing. Accordingly, the Council has unanimously voted in favor of final
designations on the following FMUs based on the analyses described here:

A. The Clearing House Payments Company L.L.C.
Description of the Clearing House Payments Company L.L.C.
PaymentsCo, a Delaware corporation, is the legal person that operates CHIPS,
which is a multilateral system operated for the purpose of transferring payments
among its 52 participants. Therefore, PaymentsCo, as a person that operates a
multilateral system whose purpose is transferring payments among financial
institutions, meets the definition of FMU set out in Title VIII.3
CHIPS is the only private sector system in the United States for settling largevalue U.S. dollar payments continuously throughout the day. Large-value
payment systems play a key role in financial markets by providing a means for
banks to discharge payment obligations related to important financial market
activities such as money market and commercial transactions. Payments settled
by such systems are often high in value and require secure, reliable, and timely
settlement. For example, two banks might use a large-value payment system to
settle a time-sensitive interbank loan. For commercial transactions, a corporation
may instruct its bank to use a large-value payment system to make critical
payments to its suppliers.
Large-value payments settled over CHIPS often represent the U.S. dollar sides
of transfers between U.S. money center banks and foreign banks operating in
the United States, such as foreign exchange and Eurodollar transactions. CHIPS
traffic also includes an increasing share of payments for transactions such as the
adjustment of correspondent balances and payments associated with commercial
transactions, bank loans, and securities transactions.
The 52 CHIPS participants are U.S. commercial banks, foreign banks with offices
in the United States, and one private banker. These participants constitute some
of the largest banks in the world by asset size and include bank subsidiaries of
22 financial institutions considered to be global systemically important financial
institutions by the Financial Stability Board.4 Participants also send and receive
payments over CHIPS on behalf of thousands of customers, including a large
number of correspondent banks. U.S. depository institutions account for a
substantial percentage of all value sent. Forty participants are headquartered
outside the United States.
An important feature of CHIPS is that it can bilaterally and multilaterally net
payments for settlement, which permits CHIPS to settle its daily average of
payments with a fraction of funding. A disruption to CHIPS could therefore have
a multiplier effect on the liquidity needs of participants.
Participants do not bear credit risk within CHIPS, as they do not extend credit
to each other over the system. They do, however, bear liquidity risk. Because
payment messages in the CHIPS queue are not guaranteed to settle, participants
may not receive, either during the day or at the end of the day, payments they
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are expecting to receive over CHIPS. Liquidity risk is high during the end-of-day
settlement process when participants have a final expected position that depends
on other participants meeting their final funding requirements. If a participant
fails to fulfill its final funding requirement, CHIPS will net and release as many
of the payments remaining in the queue as possible and then delete the rest
from the system. The participants that were expecting to receive those deleted
payments must then arrange to receive that liquidity outside of CHIPS.

Analysis of Systemic Importance
(A) Aggregate monetary value of transactions processed by CHIPS
The volume and value of payments settled over CHIPS demonstrate the high
degree to which the U.S. banking system relies on CHIPS to facilitate significant
financial flows, particularly those involving transfers between U.S. money center
banks and foreign banks operating in the United States. As context for the value
of payments settling through CHIPS, every two weeks, CHIPS settles payments
equivalent to the gross domestic product of the United States.
Settlement volumes and values. CHIPS, settling $1.6 trillion on average a day, has
a substantial share by volume and value in the U.S. large-value payments market.
A significant percentage of CHIPS volume is sent or received by participants on
behalf of third parties that are not participants. At least 7,500 third parties are
listed in the database that CHIPS maintains to facilitate the routing of payments
straight through to their end beneficiaries.
Funding. The average and peak total participant funding for the CHIPS
account at the Federal Reserve Bank of New York (FRBNY) per day in 2011 was
substantial, with a significant portion being supplied by a small group of funding
agents acting on behalf of nonfunding participants. Total funding is low relative
to the value of payments settled over CHIPS because the bilateral and multilateral
netting feature of the system allows for a high leverage of liquidity compared to a
pure real-time gross settlement system, where payments are settled individually as
they are submitted.

(B) Aggregate exposure of CHIPS to its counterparties
Credit exposures. There are no credit exposures within CHIPS, and there is
no obligation to ensure the settlement of queued payments. Payment messages
are not settled until they are released from the CHIPS queue, and all payment
messages that are released are fully funded and settled with finality in real time.
Liquidity exposures. CHIPS does not bear liquidity exposures to its
counterparties because it does not guarantee settlement of any payment messages
that are not fully funded. While this feature, which is inherent to the design and
rules of CHIPS, eliminates liquidity risk to the system, participants bear liquidity
risk arising from unsettled payments in the queue. Participants are further
exposed to liquidity risk because the funds used to settle payment messages
over CHIPS are held in the CHIPS account at FRBNY as opposed to in the
participants’ own accounts.

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147

Liquidity exposures for CHIPS participants are high because payment messages
in the CHIPS queue are not guaranteed to settle. There is a possibility that
participants may not receive, either during the day or at the end of the day,
payments they are expecting to receive over CHIPS. This risk decreases over the
course of the day because of the intraday finality of settled payments, but there
is inherent liquidity risk in the end-of-day process, when participants must meet
their final funding requirements and CHIPS must successfully execute payouts.
Settlement of the payments remaining in the queue at the end of the day
is dependent on all participants successfully meeting their final funding
requirements, which, on average, is in the billions of dollars. If some participants
do not fulfill their final funding requirement, CHIPS will settle as many
remaining payments as possible and then delete the rest from the system
unsettled. There has been only one instance where a participant failed to meet
its final funding requirement, resulting in payment messages worth $7.3 billion
failing to settle over CHIPS.
Since that disruption, the typical value of the payments settled at the end of the
day has fallen to less than 1 percent of total daily value, yet that amount is still
sizeable. If a large proportion of those payments failed to settle because of a
disruption caused by the failure of one or more participants to make a final payin, it could put liquidity pressure on the intended recipients of those payments,
which would need to make up that liquidity outside of CHIPS. Following the
completion of final funding, a disruption impairing the ability of CHIPS to make
payouts could trigger more significant disruptions to the liquidity positions of
participants. In 2011, the daily average and peak of total CHIPS payouts at the
end of the day were significant.
Under either disruption scenario, participants might have to borrow funds in the
market late in the day to replace the payments or payouts not received in order
to meet their payment obligations outside of CHIPS or Federal Reserve account
balance requirements such as required reserves. This could be particularly
challenging for a participant with more limited access to U.S. dollar funding
markets, such as a bank in a weakened condition. For any participant, obtaining
replacement funding late in the day could prove difficult or costly, as the liquidity
of funding markets such as the Fed funds and repo markets declines toward the
end of the business day.

(C) Relationships, interdependencies, or other interactions of CHIPS with other FMUs
or payment, clearing, or settlement activities
The structure of participation in CHIPS indicates a tight, interdependent network
of institutional relationships and payment flows, such that a disruption could
reverberate throughout the financial system. Participants rely heavily on CHIPS
to settle significant U.S. dollar financial flows each day, including transactions
related to third-party activity for thousands of additional institutions. Activity
underlying CHIPS payments spans foreign exchange, trade finance, remittance,
correspondent banking, securities, and bank funding.

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Concentration of participants and degree of tiering. CHIPS activity is highly
concentrated with a small number of participants accounting for a relatively large
percentage of the value of the payment messages sent and received. Funding for
CHIPS is further concentrated with a small number of participants representing a
majority of the funding.
Although no FMUs depend on CHIPS directly, the participants that send and
receive the most value over CHIPS and contribute the most funding are also
some of the most active participants by value in CLS Bank, DTC, FICC, NSCC,
CME, ICE Clear Credit, and OCC. The liquidity problems caused by a disruption
to CHIPS might therefore adversely affect the payment activities of CHIPS
participants over those FMUs. Conversely, payment obligations arising within
those other FMUs that were expected to settle over CHIPS could be disrupted.
Interdependencies indirectly link CHIPS not only to other FMUs and payment,
clearing, and settlement activities, but also to the third-party customers that are
the originators or beneficiaries of payments settled over CHIPS. Participants
submit a majority of their CHIPS traffic by volume on behalf of one of
thousands of third-party customers. Examples of third-party customers include
affiliates and branches of CHIPS participants, other financial institutions, and
nonfinancial corporations. Because of the scope and nature of these customers,
a disruption to CHIPS could have a broader impact on both the financial system
and the real economy than might be assumed from consideration of only the
direct participants.

(D) Effect that the failure of or disruption to CHIPS would have on critical markets,
financial institutions, or the broader financial system
Market effects of a failure of or long-term disruption to the functioning of
CHIPS. There are two types of disruption to CHIPS that could have significant
effects on critical markets, financial institutions, and the broader financial
system. First, a disruption triggered by the failure of one or more participants to
make a required pay-in at the end of the day could cause several billion dollars
of payments not to settle over CHIPS, creating liquidity shortfalls for some
participants and their customers late in the day. Second, a disruption triggered
by an operational problem with CHIPS could cause significantly higher amounts
of payments not to settle over CHIPS. An operational disruption could also cut
off participants’ access to the funds in the CHIPS account, which could be a
significant amount by the end of the day.
The typical value of the payments settled at the end of the day is sizeable and
varies based on market conditions and the amount of supplemental funding
contributed by participants during the day. If one or more participants failed to
make a required pay-in at the end of the day, a portion of those payments would
not settle over CHIPS. As a result, the participants and their customers expecting
to receive those payments would need to make them up outside of CHIPS and
could, therefore, face liquidity shortfalls late in the day.
In the case of an operational disruption to CHIPS, participants could use the
Fedwire Funds Service to settle payments. Their ability to do so would depend
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on each participant’s access to Fedwire, internal system capabilities, and access
to sufficient intraday liquidity. In particular, the availability of liquidity varies
by institution, such that some participants might need access to additional
liquidity in order to reroute their CHIPS traffic. At a minimum, that increased
liquidity demand could create incentives for participants to delay sending
large outgoing payments over Fedwire until they first received large incoming
payments. Delayed settlement of those outgoing payments could in turn delay
the settlement of all downstream payments reliant on those funds, likely causing
liquidity problems to spread.
Effects of a short-term disruption to the FMU. Depending on its timing, an
operational disruption to CHIPS could leave participants without access to
the increasingly significant amounts of liquidity held in the CHIPS account.
As discussed under Consideration (B), the value of funds held in the CHIPS
account rises steadily throughout the day, with the funds returned to participants
as payouts at the end of day. A disruption that prevented CHIPS from making
payouts at the end of the day could cause significant liquidity shortages for
participants at a time of day when liquidity in funding markets may be least
available. This is particularly true for the subset of CHIPS participants that
do not have access to intraday credit from a Federal Reserve Bank. These
participants might need to seek funding in the Fed funds and repo markets,
where, as discussed previously, liquidity declines towards the end of the business
day. Further, liquidity in these markets would likely be especially tight under
the stressed market conditions surrounding a failure of or disruption to CHIPS.
Without this funding late in the day, participants might not be able to meet their
payment obligations outside of CHIPS or meet Federal Reserve account balance
requirements, such as reserve requirements.
Under either scenario, a disruption to CHIPS could reverberate throughout the
financial system, affecting the thousands of institutions worldwide that may be
reliant on payments settled over CHIPS. As discussed under Consideration (A),
CHIPS settles a sizeable overall share in the U.S. large-value payments market.
Furthermore, a significant portion of the volume of payment messages sent over
CHIPS is sent or received on behalf of one of thousands of third-party customers.
In addition to disrupting third-party customers, as discussed under Consideration
(C), a disruption to CHIPS might also indirectly disrupt other FMUs in the U.S.
financial sector through the channel of shared participants.

Conclusion
Large-value payment systems such as CHIPS play a key role in financial markets
by providing a means for banks to discharge payment obligations related to
important financial market activities. CHIPS is a particularly large system, settling
$1.6 trillion on average a day representing a significant percentage of the value
of the U.S. dollar large-value payment market. A disruption to CHIPS could
significantly increase the amount of unsettled payments in the CHIPS queue,
disrupt the ability of participants to manage their CHIPS traffic, and sufficiently
alter the payment and funding patterns over CHIPS so as to cause liquidity
disruptions affecting all participants, including 22 global systemically important
institutions, and potentially spread to their customers and to other FMUs and
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the broader financial system. The resulting widespread liquidity shortage could
prove difficult or costly to ameliorate, particularly if the disruption were to cut
off access to the funding in the CHIPS account and to occur at the end of the day
amid already stressed market conditions.
Taking into consideration the significant value and proportion of large-value
payments that settle over CHIPS, the increased liquidity required to reroute those
payments to settle outside of CHIPS, and the risk to other FMUs and downstream
financial institutions and nonfinancial companies that rely on those payments
to settle, it is the assessment of the Council that a failure of or disruption to
CHIPS could increase the risk of significant liquidity problems spreading among
financial institutions or markets and thereby threaten the stability of the financial
system of the United States. For the reasons set out here, the Council has
determined that PaymentsCo should be designated as a systemically important
FMU pursuant to Title VIII of the Act.

B. CLS Bank International
Description of CLS Bank International
CLS Bank, a legal person chartered by the Board of Governors of the Federal
Reserve System under the Edge Act, operates a multilateral system that settles
foreign exchange (FX) transactions among its financial institution members.5
Therefore, CLS Bank meets the definition of FMU set out in Title VIII of the Act.6
The FX market is one of the largest and most liquid global financial markets
with an average aggregate daily value settled of 8.0 trillion U.S. dollar equivalent
(USDE).7 The FX market plays a pivotal international role in determining the
relative value of a currency, providing liquidity to the international banking
system, and facilitating cross-border trade and investment. Because of its
importance, the FX market has long been a focus of attention by finance
ministries, central banks, and banking supervisors.
The FX market is an over-the-counter (OTC) market with globally dispersed
participants that connect local trading centers into a liquid, global market. The
three largest trading centers are located in the United Kingdom, the United
States, and Japan respectively, although a number of other countries also host
major centers. Due to the dispersion of market participants, the FX market is
also a 24-hour market with large volumes of cross-border transactions. The three
major instruments in the FX market are spot, forward, and FX swaps, which
collectively account for approximately 94 percent of FX market activity. These
instruments are typically considered part of the short-term international money
market, serving as critically important cross-currency funding tools for a wide
variety of participants. Settlement risk is the primary risk in the FX market and is
a key source of systemic risk.
CLS Bank is the sole multi-currency settlement system of its kind, offering both
liquidity savings and settlement risk mitigation across all major currencies, and
the only one that operates on a global basis across all the major currencies.8
CLS Bank settles an average daily value of 4.77 trillion USDE, representing 68
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percent of FX market activity in CLS Bank-eligible currencies and products. The
CLS Bank system links thousands of institutions, including many of the largest
banks, investment companies, and nonfinancial corporations, both domestic
and foreign. Through CLS Bank, these institutions are able to reduce their
settlement risk in the FX market through the use of payment-versus-payment
(PVP) settlement.9 CLS Bank is also used by and uses a number of other FMUs
to settle multi-currency payment flows. Among other potential effects, a failure
of or disruption to the functioning of CLS Bank could substantially increase
participants’ liquidity risk and reintroduce significant settlement risk among
institutions in the FX market.

Analysis of Systemic Importance
A) Aggregate monetary value of transactions processed by CLS Bank
CLS Bank settles a significant and increasing volume and value of activity in
the FX market. Through its services, CLS Bank significantly reduces settlement
risk and provides substantial liquidity savings through its use of multilateral net
funding. If the volumes and values settled by CLS Bank continue to grow, CLS
Bank’s role in the FX market, and market participants’ reliance on CLS Bank, will
become even more significant.
Settlement volumes and values. CLS Bank estimates that it settles, by value,
68 percent of FX market activity in eligible currencies and products. In 2011,
CLS Bank settled an average daily gross volume of 820,600 sides and an average
aggregate daily value of 4.77 trillion USDE. In addition, through PVP settlement,
CLS Bank mitigated a substantial amount of the settlement risk associated with
the average daily gross volume settled. In 2011, CLS Bank settled a peak daily
gross volume of 1,957,417 sides; on its peak settlement value day, March 19, 2008,
CLS Bank settled approximately 10.3 trillion USDE.
In 2011, U.S. dollar transactions settled at CLS Bank accounted for a substantial
amount of the average daily gross settlement volume and the average aggregate
daily settlement value. In addition, U.S.-based settlement members accounted for a
significant portion of the average aggregate daily value settled in 2011 at CLS Bank.
In 2011, the volume and value of transactions settled at CLS Bank increased by
4.7 percent and 15.5 percent, respectively, from 2010. Since 2007, the volume of
transactions processed by CLS Bank has grown at a compound annual rate of
22 percent, with U.S. dollar transaction volumes growing at a compound annual
rate of 23 percent. In addition, since 2007, the value of transactions processed by
CLS Bank has grown at a compound annual rate of 7.3 percent, with the value
of U.S. dollar transactions growing at a compound annual rate of 7.2 percent. In
comparison, from 2007 through 2010, the total value of the FX market grew at a
compound annual rate of 3.7 percent.
Funding. Members fund and defund their multi-currency accounts at CLS Bank
through 17 real-time gross settlement (RTGS) systems, including the Federal
Reserve’s Fedwire Funds Service for U.S. dollar payments. Funding occurs on a
multilateral net basis, which provides substantial netting efficiencies. In order to

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smooth out the liquidity needs of its members, CLS Bank permits its members
and their nostro agents to pay in over a five-hour funding window.

B) Aggregate exposure of CLS Bank to its counterparties
Although CLS Bank has a robust risk management framework, it is still exposed
to significant credit and liquidity risk.
Credit exposures. CLS Bank may extend credit to its members in the form of
haircut-adjusted short positions, which are collateralized by a member’s long
positions and capped at the aggregate short position limit (ASPL) for each
settlement member. ASPLs vary among members based on an assessment of each
member’s credit, liquidity, and operational capabilities.10
Based on the ASPL for each settlement member, CLS Bank’s maximum potential
credit exposure is in the billions of USDE.11 Though these exposures are
collateralized by haircut-adjusted long positions, as a result of extreme exchange
rate volatility, CLS Bank may have insufficient liquidity and incur financial losses,
which it would allocate to its surviving members.
Liquidity exposures. In the event that a settlement member fails to pay in the
currency required to cover a short position by the end of the funding window,
CLS Bank will attempt to swap the failing member’s remaining long positions
for the currency required to fulfill CLS Bank’s payout obligations. As a result,
CLS Bank has obtained committed lines of liquidity across the 17 currencies that
are eligible for settlement. U.S. dollar liquidity is provided by a group of U.S.
depository institutions, each of which is also a settlement member.
In the case of a single member pay-in failure, the peak liquidity that CLS
Bank would require from its committed liquidity providers is equivalent to the
maximum ASPL. Provided that its currency haircuts are sufficient to mitigate
market risk, CLS Bank’s committed lines of liquidity should be sufficient to
complete payouts in the appropriate currency, even if the failing member is a
liquidity provider in the required currency. However, if CLS Bank’s currency
haircuts are insufficient to absorb a significant depreciation in the value of the
members’ long positions relative to the value of their short positions, CLS Bank’s
liquidity needs may exceed its committed liquidity lines, and CLS Bank may incur
financial losses. Further, in the event that its liquidity providers are unwilling
or unable to provide the committed liquidity, CLS Bank will credit its affected
member(s) in an alternate currency, which its members may choose to receive
as a payout or hold overnight at CLS Bank, thereby shifting liquidity risk to its
member(s) and potentially resulting in liquidity disruptions to U.S. and foreign
financial markets.

C) Relationships, interdependencies, or other interactions of CLS Bank with other
FMUs or payment, clearing, or settlement activities
CLS Bank settlement activity is highly concentrated amongst its largest members.
In addition, CLS Bank is highly interconnected with a number of other FMUs
and trade repositories. These relationships and interdependencies increase the

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potential for a disruption at CLS Bank to spread to other participants, FMUs,
markets, and throughout the U.S. financial system.
Concentration of participants and degree of tiering. The value of instructions
settled by CLS Bank is highly concentrated among the largest of its 63 members.
Further, third-party settlement activity is highly concentrated among a group
of members. Since the value of instructions settled in CLS Bank is highly
concentrated, a disruption to one large member would have a significant impact
on the risks faced by CLS Bank (see factor (D) for the impact of a failure to pay
by one or more participants). However, the inclusion of the largest FX market
participants in CLS Bank ensures that a significant proportion of the FX market
is settled at CLS Bank using its PVP risk mitigating features.
In 2011, 27 of CLS Bank’s 63 members were active in submitting instructions on
behalf of third parties, though the majority of activity was concentrated among a
few institutions. In aggregate, third-party transactions represent approximately 11
percent of the aggregate value settled by CLS Bank. In addition, the three largest
U.S.-based third-party service providers account for more than 48 percent of total
third-party activity.
Dependencies of other FMUs and trade repositories on CLS Bank. CLS
Bank settles non-PVP instructions for The Warehouse Trust Company’s Trade
Information Warehouse (TIW), which is a subsidiary of DTCC, as well as the
CME, ICE Clear Europe, Eurex, and LCH.Clearnet. Specifically, CLS Bank settles
FX futures-related payments for the CME and ICE Clear Europe, and credit
derivative-related payments for TIW, Eurex, and LCH.Clearnet. Settlement at CLS
Bank provides operational and funding efficiencies for these FMUs and trade
repositories. The link with the TIW is particularly notable, as it allows payments
for OTC credit derivatives, which are calculated and bilaterally netted across
participants, to be directly submitted for settlement at CLS Bank.

D) Effect that the failure of or disruption to CLS Bank would have on critical markets,
financial institutions, or the broader financial system
A failure of or long-term disruption to CLS Bank may significantly increase
settlement risk and liquidity demands in the FX market. In turn, these
developments may reduce FX market activity and the flow of funds in U.S. and
foreign financial markets and to the broader economy.
Market effects of a failure of or long-term disruption to the functioning of
CLS Bank. In addition to potentially transmitting credit risk to its members via
loss allocation, a failure of or long-term disruption to CLS Bank may result in a
reversion to non-PVP settlement and therefore reintroduce significant credit risk
to the FX market. Because CLS Bank is the sole global multi-currency settlement
system that eliminates FX settlement risk across all major currencies, a failure
of or long-term disruption to CLS Bank would require members to settle FX
transactions through non-PVP settlement arrangements, including bilateral
gross settlement, bilateral net settlement, and “on-us” settlement. A reversion
to non-PVP settlement arrangements could reintroduce a substantial amount
of settlement risk to the FX market daily. As a result, members would initially
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experience a sudden increase in settlement risk that may significantly exceed
counterparty settlement limits set by their internal credit risk management
function and may have to suddenly and drastically reduce their trading activity
to stay under prudent counterparty settlement limits. Alternatively, members
would need to collect large amounts of collateral from counterparties or accept
significantly higher levels of counterparty credit risk that may exceed their capital.
A reduction in trading activity would reduce the flow of funds between CLS
Bank participants, including domestic and foreign banks, investment companies,
and nonfinancial corporations, and would impair FX market liquidity. As FX
instruments are typically considered part of the short-term international money
market, a reduction of FX market liquidity would seriously disrupt cross-border
funding markets. As a result, the impact of a failure of or long-term disruption
to CLS Bank would be felt in U.S. and foreign financial markets, as well as in
the broader economy. Further, in the absence of PVP settlement, a failure of
an FX market participant would expose counterparties to significant credit risk
that could lead to additional failures of, or an erosion of confidence in, other
FX market participants. In addition, because CLS Bank settles transactions
both directly and indirectly for thousands of institutions, including banks,
investment companies, and nonfinancial corporations, the failure of CLS
Bank or a disruption of its settlement services could have a crippling impact on
international trade with adverse second-order effects on the real economy and
U.S. financial stability.
In the absence of CLS Bank and multilateral net funding in the FX market,
members would be required to provide additional liquidity to complete
settlement, thereby increasing liquidity demands on market participants. As such
funding may occur in stressed market conditions and require access to large and
alternative sources of liquidity at short notice, there could be significant liquidity
disruptions to financial markets. In particular, since the U.S. dollar accounts for
a substantial percentage of settlement value at CLS Bank, demands for additional
U.S. dollar liquidity may be substantial and could have a significant impact on
major U.S.-based banks and the U.S. financial system. Assuming that members
revert to bilateral gross settlement in the absence of CLS Bank, liquidity needs
would increase substantially, therefore providing another incentive for members
of CLS Bank to significantly reduce their trading activity and the flow of funds
between CLS Bank participants.
In addition to a reduction in FX market activity and an increase in liquidity
demands, the absence of CLS Bank would require that non-PVP settlement
arrangements absorb an additional average daily volume of 795,000 sides. A
sudden increase in the volume of non-PVP transactions, however, may result
in immediate operational challenges due to capacity constraints, potentially
preventing a significant volume of FX transactions from settling in a timely
fashion and thereby spreading liquidity risk among participants and their
counterparties. Further, to the extent that a failure of or disruption to the
functioning of CLS Bank results in non-PVP settlement, the relevant RTGS
systems would experience sudden increases in the volume and value of
instructions settled. In the United States, for example, the Fedwire Funds Service
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and CHIPS may be required to absorb a significant amount in additional U.S.
dollar payment activity daily.
CLS Bank also provides settlement of payments related to credit derivatives and FX
futures for multiple FMUs, both domestic and foreign. These FMUs benefit from
funding efficiencies and straight-through processing by settling at CLS Bank and,
in the short term, the absence of CLS Bank would be disruptive to these FMUs,
as they would have to reroute payments over the relevant RTGS systems. Based on
data compiled by the Federal Reserve Board, the U.S.-based members of CLS Bank
are also members in several other FMUs. In the event that CLS Bank is unable to
complete settlement and these members are unable to obtain timely settlement of
their payment instructions through alternative settlement arrangements, liquidity
disruptions may be transmitted to other key FMUs and markets.
Effects of a short-term disruption to the FMU. In the event that an operational,
market, or funding-related event results in a short-term disruption to CLS Bank,
CLS Bank would be required to defer settlement, but may be able to complete
settlement before the end of the settlement day. Settlement, however, is heavily
dependent on the closing times of the RTGS systems used to transfer funds to
and from members’ multi-currency accounts at CLS Bank and may require an
extension of the operating hours of certain RTGS systems on which CLS Bank
is dependent. Further, CLS Bank currently estimates that the largest single
settlement member pay-in failure (in terms of its aggregate impact on the
settlement of transaction at CLS Bank) would result in a significant percentage
of transactions not settling. As a result, members would need to settle these
transactions on a non-PVP basis outside of CLS Bank, thereby increasing the
amount of settlement risk in the FX market significantly. In a pay-in failure
situation, however, surviving members would receive additional pay-in calls, which,
if met, would significantly reduce the value of unsettled transactions at CLS Bank.
In the event of a large single member default, CLS Bank could issue additional
pay-in calls across the surviving members to fund additional liquidity.12 As such
funding may occur in stressed market conditions and require access to large and
alternative sources of liquidity at short notice, there could be significant liquidity
disruptions to financial markets. Further, as most additional funding will occur
in U.S. dollars when U.S. markets are closed (between 3 a.m. and 6 a.m. ET), the
impact on the financial system of the United States could be more severe.
The peak liquidity that CLS Bank could require from its committed liquidity
providers is equivalent to the maximum ASPL. Provided that its currency
haircuts are sufficient to mitigate market risk, CLS Bank’s committed lines of
liquidity should be sufficient for CLS Bank to satisfy its payout obligations in
the appropriate currency, even if the failing member is a liquidity provider in
the required currency. However, if additional members fail to fully satisfy the
additional pay-in calls that result from the original pay-in failure, then CLS Bank’s
liquidity needs may exceed its committed liquidity lines. As a result, CLS Bank may
be unable to meet its payout obligations, in which case it would pay an equivalent
amount in an alternate currency and transfer its liquidity risk to its members.

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Conclusion
CLS Bank is the sole global multi-currency settlement system of its kind, offering
both liquidity savings and settlement risk mitigation across all major currencies.
A failure of or long-term disruption to CLS Bank would have negative effects on
both its members and the FX market, resulting in significant credit, liquidity,
and operational disruptions. These effects would likely spill over into U.S. and
global financial markets, as the FX market is critical to meeting cross-currency
funding needs of global financial institutions. Further, PVP settlement in the FX
market continues to be encouraged by central banks, market regulators, and other
authorities in order to reduce settlement risk. Should the growth in the values
and volumes settled by CLS Bank persist, perhaps due to the continued growth of
the FX market and the inclusion of additional participants, settlement currencies,
and settlement sessions, CLS Bank will assume an even more dominant role in the
FX market. In the absence of alternative settlement arrangements offering both
settlement risk mitigation and liquidity savings across a similar set of FX products
and currencies, CLS Bank’s expansion will reduce overall risk but also concentrate
the risk associated with a potential disruption to or failure of CLS Bank.
Based on the significant values and volumes of FX market activity settled at CLS
Bank, the extensive network of financial and nonfinancial institutions that depend
on CLS Bank, the dependence of other critical FMUs on CLS Bank to effect
settlement, and the lack of substitutes offering both settlement risk mitigation and
liquidity savings, the Council has determined that CLS Bank should be designated
as a systemically important FMU pursuant to Title VIII of the Act.

C. Chicago Mercantile Exchange, Inc.
Description of Chicago Mercantile Exchange, Inc.
CME is a subsidiary of CME Group, Inc. (CME Group), a public company. CME,
through its U.S. clearing division (CME Clearing), provides clearing services
among futures commission merchants (which are included in the definition of
financial institution in Section 803 of the Act) and between futures commission
merchants (FCMs) and customers. Therefore, CME meets the definition of FMU
set out in Title VIII.13
CME is one of the largest central counterparty clearing services providers in
the world, clearing 96 percent of the entire market for U.S. futures, options
on futures, and commodity options.14 CME clears all contracts traded on the
designated contract markets (DCMs)15 owned by CME Group, namely the Chicago
Mercantile Exchange (CME DCM), Board of Trade of the City of Chicago, Inc.
(CBOT), the New York Mercantile Exchange (NYMEX), and the Commodity
Exchange, Inc. (COMEX). In addition, CME offers clearing services for the global
OTC market through, inter alia, CME ClearPort.
CME provides central counterparty clearing services for futures, options, and
swaps that can be used by market participants for a variety of purposes. Products
cleared by CME range from commodity futures, which are essential to price
discovery and liquidity for the underlying commodities, to interest rate swaps
(IRS) and equity index contracts, which can be used as hedges or as investments
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themselves. CME clears the largest and most liquid futures contracts based on
the Standard & Poor’s (S&P) 500 Index, Eurodollar, U.S. Treasury securities,
and energy products, as well as IRS. CME functions as the central counterparty
to market participants and clears a large number of transactions supported by
significant collateral. As a central counterparty, CME stands between its members
for every transaction cleared, serving as the seller to every buyer and the buyer to
every seller. In effect, members substitute CME’s credit for each other’s credit.
While the purpose of the contracts cleared by CME can vary, all such contracts
initially expose the participants on both sides of the contract to credit risk.
By guaranteeing to each counterparty that the other side of the contract will
be fulfilled, CME acts as a central counterparty to mitigate such risks. CME
collects margin from each of its clearing members to offset the risks of a clearing
member’s contracts and nets margin calls across all of each member’s contracts.
On average, CME clears contracts with a notional value in the trillions of U.S.
dollars and maintains collateral deposits averaging in the billions of U.S. dollars.

Analysis of Systemic Importance
A) Aggregate monetary value of transactions processed by CME
Number of transactions processed, cleared or settled. In 2011, CME cleared an
average daily gross volume in the millions of futures and options contracts and
average daily notional amounts in the millions of U.S. dollars for OTC CDS and
OTC USD IRS; in the millions of euros for OTC euro IRS; and in the millions
of pound sterling for OTC GBP IRS. CME cleared a peak daily gross volume in
the millions of contracts and peak daily notional amounts in the billions of U.S.
dollars of OTC CDS and OTC USD IRS, in the billions of euros of OTC euro IRS,
and in the billions of pound sterling of OTC GBP IRS.
Value of transactions processed, cleared or settled. In 2011, CME cleared
contracts with an average daily gross notional value in the trillions of U.S. dollars
and average daily gross notional values in the millions of U.S. dollars of OTC
CDS; millions of U.S. dollars of OTC USD IRS; millions of euros of OTC euro
IRS; and millions of pounds sterling of OTC GBP IRS. The peak daily gross value
of the contracts CME cleared was in the trillions of U.S. dollars for futures and
options, billions of U.S. dollars for OTC CDS, billions of U.S. dollars for OTC
USD IRS, billions of euros for OTC euro IRS, and billions of pound sterling for
OTC GBP IRS.
Value of other financial flows. For all listed derivatives, except cleared OTC IRS
and cleared OTC CDS, the average daily flow of funds (average daily variation
margin plus change in average daily initial margin) in 2011 was in the billions
of U.S. dollars, with a peak in the billions of U.S. dollars on August 8, 2011. The
peak daily open interest was in the millions of U.S. dollars on August 25, 2011.

B) Aggregate exposure of CME to its counterparties
Credit exposures. The period-end aggregate value of all collateral posted as of
December 30, 2011, was in the billions of U.S. dollars. On December 30, 2011,
the member guaranty fund requirement across all three guaranty funds was $4.5
billion, CME designated capital across the guaranty funds was $300.0 million,
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and the consolidated initial margin requirement was billions of U.S. dollars. For
2011, CME’s guaranty fund held average deposits of $3.8 billion, with a peak value
of $4.5 billion.
CME maintains minimum coverage of 99 percent for a liquidation period of one
day for futures, 99 percent for a liquidation period of five days for OTC IRS, and
99 percent for a liquidation period of five days for OTC CDS.
The average aggregate daily value of collateral (after haircuts) posted to CME was
in the billions of U.S. dollars. The peak aggregate dollar value of collateral (after
haircuts) posted to CME was in the billions of U.S. dollars on June 2, 2011. For
the 12 months ended December 30, 2011, the average intraday variation margin
at CME was in the billions of U.S. dollars. The peak intraday variation margin at
CME for all listed derivatives, excluding cleared OTC IRS and cleared OTC CDS,
was in the billions of U.S. dollars on September 22, 2011.
For the 12 months ended December 30, 2011, the average daily value of initial
margin at CME was in the billions of U.S. dollars. The peak daily value of initial
margin at CME was in the billions of U.S. dollars on June 1, 2011.
It is anticipated that with the introduction of mandatory clearing for swaps,
clearing volume and open interest will significantly increase, and margin on
deposit and exposure will increase proportionally.
Liquidity resources. On December 30, 2011, the amount of liquidity resources
(including only cash and U.S. Treasury and agency notes) at CME was in the
billions of U.S. dollars, with billions of U.S. dollars of liquidity resources on June
2, 2011. As of December 30, 2011, the total value of lines of credit from banks or
others was several billion U.S. dollars.
Liquidity exposures. For the 12 months ended December 30, 2011, the average
daily variation margin CME paid to clearing members was in the billions of U.S.
dollars. The peak daily variation margin CME paid to clearing members was
in the billions of U.S. dollars on August 8, 2011. The largest intraday variation
margin collect was in the billions of U.S. dollars on October 27, 2011.

C) Relationships, interdependencies, or other interactions of CME with other FMUs or
payment, clearing, or settlement activities
Participants. CME has a total of 64 clearing members, including futures
commission merchants (some of which are also broker-dealers), bank affiliates,
and proprietary trading firms. Twenty-nine of CME’s clearing members are foreign
clearing members (including U.S. operations of non-U.S. entities). CME’s clearing
members include some of the largest banking and brokerage firms in the world.
Other FMUs. CME has a cross-margining agreement with OCC, which is dually
registered as a Derivatives Clearing Organization (DCO) and as a securities
clearing agency. The average amount of margin subject to the cross-margining
agreement is in the millions of U.S. dollars. CME also has a cross-margining
arrangement with FICC, which generated a savings of millions of U.S. dollars
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on December 30, 2011 for clearing firms. In addition, CME has a mutual offset
arrangement with Singapore Exchange Ltd. The mutual offset arrangement with
Singapore Exchange Ltd. enables market participants to open a futures position
in one of the following five contracts on one exchange and liquidate it on the
other: Eurodollars, Euroyen TIBOR, Yen- and Dollar-Denominated Nikkei 225
futures, and E-micro S&P CNX Nifty (Nifty 50) futures.
Trading platforms. CME provides clearing services for the CME, CBOT,
NYMEX, and COMEX exchanges that are all part of CME Group. CME also
provides clearing services for the Green Exchange, a DCM that offers trading
in environmental futures and options, and for Eris Exchange, LLC, a DCM that
offers trading in IRS futures. The Dubai Mercantile Exchange, an energy-focused
commodities exchange regulated by the Dubai Financial Services Authority,
clears all of its trades through NYMEX, which outsources its clearing operations
to CME Clearing.
Other external service providers. CME uses the following platforms: Bloomberg,
Javelin, Tradeweb, Marketwire, Icelink, CME Globex, CME Clearport, and the
CME’s physical trading floor. In addition, CME uses the services of the following
companies: ION, Sungard, WTD, FFastFill, ATEO, and Whentech. CME also
maintains settlement bank relationships.
Average daily value of flows and other transactions with key financial
institutions. For the 12-month period ended December 30, 2011, the average daily
value of flows with key financial institutions was in the billions of U.S. dollars.
Average daily value of trades and other transactions on key trading platforms.
CME’s average daily value of trades was in the millions of U.S. dollars.

D) Effect that the failure of or disruption to CME would have on critical markets,
financial institutions, or the broader financial system
Role of CME in the market served. In 2011, CME cleared 96 percent of the total
U.S. futures and CFTC-regulated options market volume.16
Availability of substitutes. While several other clearinghouses clear products
that may be viewed as serving as substitutes for some of the products cleared by
CME, it would be impractical, in the short term, for another clearinghouse to
substitute for CME.
Concentration by product type. As mentioned, CME clears 96 percent of all U.S.
futures, options on futures, and commodity options volume.
Financial Data/Metrics. On December 30, 2011, CME had in the billions of U.S.
dollars in cash and cash equivalents, in the billions of U.S. dollars in government
securities, in the millions of U.S. dollars in valued securities, in the billions
of U.S. dollars in letters of credit, and in the millions of U.S. dollars in escrow
deposits of contracts.

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Clearinghouses reduce the costs and operational risks of clearing and settlement
among multiple market participants by mitigating counterparty risk, settling
or netting participants’ obligations, or providing other clearing services or
arrangements that mutualize or transfer credit risk among participants. CME
houses one of the largest clearinghouses worldwide.
The primary trigger of a default by CME would be a default by one or more
clearing members with extraordinary losses in excess of CME’s default resources.
While such a default could conceivably result from circumstances local to
those members, a default scenario would more likely be associated with a
disruption to the markets more generally, including scenarios such as historically
extraordinary volatility, extreme changes to normal price correlations, and acute
reductions in liquidity.
An alternative trigger of a default by CME would be a failure by one of its
settlement banks, in particular its concentration bank, because a substantial
portion of CME’s financial resources, as well as those of its members, are on
deposit with these banks. Thus, if those financial resources were to suddenly
become unavailable, CME’s operations would be adversely affected to a
considerable extent.
In addition, a CME default could result from a failure to maintain a generally
sound financial condition, such as a failure to maintain sufficient capital or other
financial resources against its general business risk or against the risk of one or
more clearing member defaults.
As discussed previously, it would be impractical, in the short term, for another
clearinghouse to substitute for CME. Moreover, even if swap transactions were
replaced on a bilateral basis, if the market had moved since the trades were
submitted to CME, it is unclear how the original counterparties would reinstate
the original bilateral transaction. In addition, it could be difficult or impossible
to reinstate the original transactions bilaterally if they were made on a trading
platform. Because multilateral netting reduces the exposure of a clearinghouse’s
members to each other, the de-netting of positions resulting from a CME
default would immediately increase counterparty risk, which could have serious
consequences for market participants, including exposure to credit risk and
demand for collateral.
Furthermore, netting provides a market benefit in that the margin required to
collateralize the exposure of a portfolio is generally smaller than collateralizing
its individual components, because the prices of the portfolio’s components
are often correlated. Central counterparty netting is more powerful, as each
member’s obligations to every other member can be netted and offset.17
Moreover, in the bilateral market, if A wishes to neutralize, e.g., a long exposure
to B, A would typically enter into a transaction with a short exposure to another
counterparty, e.g., C. This would offset A’s market risk, but would leave A with
credit risk to each of B and C. In a cleared market, if A has cleared a transaction
with a long exposure and enters into a cleared transaction with an offsetting
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short exposure, those exposures would be offset, leaving A with neither market
nor credit risk.
Thus, the amount of collateral posted in a set of bilateral transactions to obtain
the same level of protection that could be obtained through clearing would likely
increase exponentially, thereby leading to some combination of a substantial
increase in required collateral (with a consequent drain in liquidity), an increase
in the number and exposure of uncollateralized transactions (creating greater
exposures from further failures), and a decrease in the total number of transactions
that are entered into (based on a reduction of credit, which would likely have a
deleterious impact on the financial activity that those transactions hedge).
In addition, any disruption in the clearing or trading of these products would
likely severely impede price discovery, which would result in both a decrease in
market efficiency and a loss of liquidity for these products.
Moreover, there would likely be a negative impact on any economic activity that
presupposes the protection of hedging activity.18 For example, livestock producers
that do not want to take on the risk of changing prices in the cash markets may
abandon production entirely if they cannot use the futures market to lock in
a price ahead of actual merchandising, and those that do choose to continue
production may face an uneven playing field against other competitors, thereby
effectively making them not competitive in the global markets.
Similarly, a natural gas producer might use a futures contract to set a price now
for gas that it will sell in the future to avoid being exposed to the possibility of
lower prices. Without the protection of hedging, natural gas producers may
reduce production activities to lower their price exposures. As hedging activities
decrease, products become difficult to price and, without clear and competitive
prices, the markets for those products become less liquid. As liquidity decreases
in a market, market participants will likely demand additional collateral and, as
the amount of available capital decreases, there will be an increased demand for
credit, which, in an unstable market environment, will be difficult to obtain.
As positions move to the uncleared, bilateral market and are de-netted, settled
and replaced, operational risks and costs would likely increase, thereby decreasing
the number of reliable and readily available hedging opportunities. As a result,
financial institutions and other market participants may reduce their investment
activities, which could further stress the U.S. financial markets.
Finally, the contagion effect of a CME default if it were to lack sufficient resources
to make timely payments obligations on variation margin could severely disrupt
operations at other clearinghouses because of a crisis of confidence that
interrupts the orderly functioning of the market and/or because of the impact
that the loss of funds would have on an entity’s ability (or willingness) to pay (1)
losses owed to other DCOs, (2) increased collateral requirements for offsetting
losing positions, (3) deposits in pension fund cash accounts or (4) bank financing
charges. Essentially, the failure of CME would create enormous uncertainty about
the status of initiated transactions as well as the financial positions of its clearing
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members and their customers and could jeopardize the orderly functioning of
other DCOs and the U.S. financial markets as a whole.

Conclusion
The data reviewed by the Council indicate that CME processes a significant
volume of high-dollar-value transactions on a daily basis for critical U.S.
markets.19 Moreover, it is questionable whether finding a substitute for CME’s
products is a viable short-term solution. Accordingly, even the shortest disruption
of CME could disrupt clearing for a variety of futures and options transactions
and could effectively freeze the futures and options markets, thereby creating
liquidity and credit problems in the U.S. futures markets. The loss of central
counterparty clearing in the products CME clears would increase collateral
demands exponentially, resulting in a corresponding drain of liquidity.
A CME failure could also have an adverse impact on price discovery, which
could, in turn, lead to inefficient markets and a correlated increase in liquidity
problems. Finally, the contagion effect of a CME failure could impose material
financial losses on CME’s clearing members and other market participants (such
as customers) and could lead to increased liquidity demands and credit problems
across financial institutions, especially those that are active in the futures and
options markets. Where these financial institutions are active in multiple U.S.
markets, this contagion effect would have a broader impact and, as the markets
experience growing stress, would likely lead to increased demand for credit,
which would, in turn, likely lead to less liquidity. Thus, the Council believes that
a significant disruption or failure of CME could have a major adverse impact
on the U.S. financial markets, the impact of which would be exacerbated by
the limited number of clearing alternatives currently available for the products
cleared by CME. Accordingly, a failure or disruption of CME would likely have a
significant detrimental effect on the liquidity of the futures and options markets,
clearing members, which include large financial institutions, and other market
participants, which would, in turn, likely threaten the stability of the broader U.S.
financial system.
For the reasons set out here, the Council has determined that CME should be
designated as a systemically important FMU pursuant to Title VIII of the Act.

D. The Depository Trust Company
Description of The Depository Trust Company
DTC is an FMU as defined in Title VIII of the Act because it manages or operates a
multilateral system for the purpose of clearing and settling securities transactions
among financial institutions and between financial institutions and DTC.20
DTC serves as the central securities depository (CSD) for substantially all
corporate and municipal debt and equity securities available for trading in
the United States. DTC is a wholly owned subsidiary of DTCC and is generally
administered as an industry-owned utility on an at-cost basis.

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DTC provides depository services and asset servicing for a wide range of security
types such as money market instruments (MMIs), equities, warrants, rights,
corporate debt and notes, municipal bonds, government securities, asset-backed
securities (ABS), and collateralized mortgage obligations. DTC’s custodial
services include the safekeeping, record keeping, book entry transfer, and pledge
of securities among its participants. DTC substantially eliminates the physical
movement of securities by providing book-entry deliveries of securities, which
transfer the ownership of securities electronically among broker-dealers on
behalf of the beneficial owners of the securities. In addition to processing bookentry transfers, including those trades cleared through the NSCC, DTC provides
services to securities issuers, such as maintaining current ownership records and
distributing payments to shareholders. In 2011, DTC maintained custody and
ownership records for approximately $39.5 trillion in securities.
DTC has 298 full service members and 72 limited service members. DTC
members include U.S. broker-dealers, U.S. and non-U.S. banks or trust companies
(including a trust company having limited powers), non-U.S. CSDs, U.S.
government-sponsored enterprises (GSEs), and FRBNY. DTC direct participants
include some of the largest banks in the world by asset size, and include affiliates
of 25 of the 29 financial institutions considered to be globally systemically
important.21 Trades that DTC settles for NSCC are executed on more than 50
trading venues (including all U.S. securities exchanges and alternative trading
systems) and with other domestic and foreign clearing agencies.

Analysis of Systemic Importance
A) Aggregate monetary value of transactions processed through DTC
In 2011, DTC processed millions of book-entry securities deliveries and settled
transactions with a substantial value. Average daily gross volume was 804,502
deliver orders, payment orders, and pledges, with an average daily gross
transaction value of approximately $573 billion. The peak daily gross number of
transactions processed by DTC in 2011 was 1.24 million on June 29, 2011. In 2011,
the average daily gross value of transactions processed by DTC was $573 billion,
$339 billion of the total being MMIs and $234 billion of the total being other
securities. The peak daily gross value of transactions processed by DTC in 2011
was equal to $728.8 billion on August 12, 2011.
The average aggregate credit balance paid to participants as a result of the day’s
settlement activity in the end-of-day cross-endorsed DTC-NSCC settlement was
equal to $32.8 billion in 2011, with a peak aggregate credit balance payment of
$78.3 billion on August 1, 2011. The average daily value of scheduled payments
of dividend and principal and interest (P&I) payments due on DTC-eligible
securities in 2011 was $10.1 billion. The peak daily value of these P&I payments in
2011 was $41.0 billion.

B) Aggregate exposure of DTC to its counterparties
DTC is the central securities depository for the United States and is responsible
for the safekeeping, custody, and certain ownership records of $39.5 trillion of
securities as of December 31, 2011. As of December 31, 2011, total contributions
to DTC’s participants fund equaled approximately $1.76 billion. The participants
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fund is available to secure participants’ obligations and certain liabilities of DTC,
should they occur, such as when a participant fails to perform required payment
or securities delivery obligations. DTC’s participants fund supports the clearance
and settlement of a substantial portion of all corporate and municipal debt,
equity securities, ABS, exchange-traded funds (ETFs), and MMIs available for
trading in the United States.
DTC extends intraday credit to its participants by allowing them to have net
funds debit balances, which helps to facilitate the settlement process. These net
debits are capped at a maximum of $1.8 billion per legal entity and $3 billion per
affiliated family of participants. Through the various processes described here,
DTC requires all transactions to be fully collateralized by its participants and
therefore considers Value at Risk (VaR) not to apply to its operations.
DTC’s liquidity resources are limited to a committed, secured line of credit and
the value of assets held in the participants fund—including certain assets of the
defaulting participant held in anticipation of settlement. DTC’s line of credit,
established with a syndicate of 31 banks, totaled $1.9 billion as of December 31,
2011. DTC also maintained uncommitted credit lines totaling Can$150 million
with a participant to support Canadian settlement during 2011. Further, a $50
million shared uncommitted credit line with NSCC and DTCC is maintained with
a participant to support potential short-term operating cash requirements. In 2011,
the peak liquidity exposure to a single affiliated family of counterparties was $3
billion, which is the maximum net debit limit permitted for any participant family.
DTC rules require such exposures to be fully collateralized in each instance.

C) Relationships, interdependencies, or other interactions of DTC with other FMUs or
payment, clearing, or settlement activities
DTC’s operations and the current market structure for securities trading
and clearing involve significant interdependence between DTC and other
FMUs, settlement banks, clearing members, credit facility lenders, custodians,
exchanges, cross-margining entities, and pricing vendors. For example, NSCC—
which provides clearance, settlement, and central counterparty services for nearly
all broker-to-broker equity and corporate and municipal debt trades executed
on major U.S. exchanges and other equity trading venues—relies on an interface
with DTC to settle obligations via the book-entry movement of securities.
Throughout the day, the debits and credits in a DTC participant’s settlement
account are netted to calculate, at any time, the net debit balance or net credit
balance for the account. At end-of-day settlement, DTC and NSCC net the
settlement balances of each DTC participant that is also a member of NSCC.
DTC maintains relationships with a number of other internationally important
FMUs as well. In particular, DTC has established the Canadian-Link service
with CDS Clearing and Depository Services, Inc. (CDS, Inc.), which enables
DTC participants to clear and settle two categories of securities transactions: (1)
cross-border Canadian dollar securities transactions with participants of CDS,
Inc. and (2) intra-DTC Canadian dollar securities transactions with other DTC
participants. DTC also has established accounts at two non-U.S. CSDs, namely
Clearstream Bank AG in Germany and SIS SegaInterSettle AG in Switzerland.
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Non-U.S. CSDs with DTC accounts include: (1) CREST Nominees Ltd. (an
affiliate of Euroclear) in the U.K. and Ireland; (2) Caja de Valores, S.A. in
Argentina; (3) Tel Aviv Stock Exchange Clearing House (TASECH) in Israel;
(4) Monte Titoli, S.p.A. in Italy; (5) Japan Securities Depository Center, Inc.;
(6) Central Depository (Pte.) Ltd. in Singapore; and (7) Hong Kong Securities
Clearing Company Limited. In addition, BM&F BOVESPA in Brazil and CDS,
Inc. have pledgee accounts at DTC in order to receive U.S. securities collateral
at DTC. Notably, however, the level of activity by CSD participants at DTC is
insignificant in comparison to total DTC activity.
DTC has also formed a relationship with Omgeo, which provides global trade
confirmation and trade matching systems for institutional trades. Trades by
institutional investors are affirmed in Omgeo’s trade confirmation and tradematching systems, and the compared trade details are then passed on directly
to DTC’s settlement system for settlement on a delivery-versus-payment/receiptversus-payment (DVP/RVP) basis.

D) Effect that the failure of or disruption to DTC would have on critical markets,
financial institutions, or the broader financial system
The immediate effects of a failure of or a disruption to the functioning of DTC
would include a major disruption to the markets for which DTC is the central
securities depository as well as financial losses for many of DTC’s participants. A
disruption to DTC’s services would first lead to complete or partial disruption of
a significant amount in gross transaction value settled by DTC and to dividend,
interest, and certain principal payments made on a daily basis. Such a disruption
similarly would completely or partially disrupt the additional $23.8 billion
average daily net settlement obligations that NSCC’s Continuous Net Settlement
system instructs at DTC on behalf of NSCC and its members. The markets would
be impacted further by an inability to access or trade some or all of the $39.5
trillion in securities for which DTC acts as custodian. The absence of DTC’s
services could also delay or prevent payment of dividends, principal, and interest
to investors that own securities serviced by DTC. If a failure or disruption was
triggered by losses to DTC, those losses might be shared by and cause stress to
other FMUs, such as NSCC, with which it has a cross-guarantee agreement.
In addition, a failure or a disruption to the functioning of DTC would likely
result in significant spillover effects on the rest of the U.S. economy, reducing the
amount of credit available generally, reducing the value of household savings and
corporate reserves, affecting the financing activities of corporations, destabilizing
U.S. money market funds, and reducing the availability of secured credit.

Conclusion
DTC plays an important role in financial markets in particular because it holds in
its custody substantially all corporate debt and equity securities available for trading

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in the United States. Accordingly, a failure or disruption to the functioning of
DTC could:
•	

•	
•	

•	

Directly and negatively affect an enormous dollar value of financial assets
held in custody and a substantial dollar value and volume of financial
transactions in equity and debt markets;
Impose material direct losses on participants and their customers for
whom DTC acts as custodian;
Cause liquidity or credit problems resulting from its failure or disruption
to spread quickly and broadly among financial institutions and other
markets; and
Have cumulative negative effects on U.S. domestic equity and debt
markets, financial institutions, and the broader financial system that
are substantial in their own right and so severe as to create a risk that
liquidity and credit problems experienced could spread among financial
institutions and other markets and, therefore, threaten the stability of the
financial system.

Accordingly, it is the assessment of the Council that a failure of or a disruption
to DTC could increase the risk of significant liquidity problems spreading
among financial institutions or markets and thereby threaten the stability of the
financial system of the United States. For the reasons set out here, the Council
has determined that DTC should be designated as a systemically important FMU
pursuant to Title VIII of the Act.

E. Fixed Income Clearing Corporation
Description of Fixed Income Clearing Corporation
FICC is an FMU as defined in Section 803(6)(A) of the Act because it manages
or operates a multilateral system for the purpose of clearing and settling
securities transactions among financial institutions and between financial
institutions and FICC.22
FICC plays a prominent role in the fixed income market as the sole clearing
agency in the United States acting as a central counterparty (CCP) and provider
of significant clearance and settlement services for cash settled U.S. Treasury
and agency securities and the non-private label mortgage-backed securities
(MBS) markets. FICC is a wholly owned subsidiary of DTCC and is generally
administered as an industry-owned utility on an at-cost basis.
FICC is made up of two divisions, the Government Securities Division (FICC/
GSD) and Mortgage Backed Securities Division (FICC/MBSD), each providing
clearing services in a different portion of the fixed income market. FICC/
GSD provides clearing, settlement, risk management, central counterparty
services, and a guarantee of trade completion for (1) U.S. Treasury bills, notes,
bonds, Treasury inflation-protected securities (TIPS), and Separate Trading of
Registered Interest and Principal Securities (STRIPS); and (2) Federal agency
notes, bonds, and zero-coupon securities that are book-entry, Fedwire eligible,
and non-mortgage backed (collectively, U.S. government and agency securities).
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167

FICC/GSD accepts buy-sell transactions, repurchase and reverse repos, and
Treasury auction purchases in several types of U.S. government securities. In
2011, the two divisions cleared transactions valued at $1.1 quadrillion on a gross
basis and $64.8 trillion on a gross basis, respectively.
FICC/MBSD is the only centralized clearing facility in the non-private label MBS
market. FICC/MBSD provides clearing, netting, settlement, risk management,
and pool notification services to major market participants trading in passthrough MBS issued by the Ginnie Mae (GNMA), Freddie Mac, and Fannie Mae.
FICC/MBSD also processes options trades for “to-be-announced” transactions.
On April 2, 2012, FICC/MBSD began providing central counterparty services and
a guarantee of trade completion for MBS.
Both FICC/GSD and FICC/MBSD have relationships with more than 100
participants. FICC/GSD’s members include the nation’s major brokers and
dealers, as well as a wide range of entities that trade U.S. government securities.
FICC/GSD’s direct members include some of the largest banks in the world by
asset size and include affiliates of 23 of the 29 financial institutions considered to
be globally systemically important.23 FICC/MBSD’s participants generally include
the following: (a) banks and trust companies, (b) dealers, (c) inter-dealer brokers,
(d) government securities issuers, (e) registered investment companies, and (f)
unregistered investment pools.
A distinguishing characteristic of FICC is the wide range of risks it faces and
its ability to manage those risks. As a CCP, FICC faces credit risk, liquidity risk,
custody and investment risks, and operational risk. FICC uses a combination of
risk management tools to some of these risks to ensure it can meet its obligations.
These tools include (1) membership standards with regard to financial resources
and operational capacity, (2) collection of collateral deposits to meet clearing
fund requirements and mark-to-market payments in the form of margin, and
(3) close out and loss allocation procedures designed to facilitate an orderly
liquidation in the event of a member default.
Another important feature of FICC is that it uses multilateral netting through
which FICC/GSD and FICC/MBSD are able to reduce significantly the value of
securities and payments that must be exchanged each day. A disruption to FICC
could therefore have a multiplier effect on the liquidity needs of participants.

Analysis of Systemic Importance
A) Aggregate monetary value of transactions processed through FICC
In 2011, FICC/GSD processed 40.5 million transactions in U.S. government and
agency securities worth $1.1 quadrillion on a gross basis. Through multilateral
netting, FICC/GSD reduced the value of financial obligations requiring
settlement in 2011 from $1.1 quadrillion to $230 trillion. In 2011, FICC/MBSD
processed MBS transactions worth approximately $64.8 trillion, which through
multilateral netting was reduced in value to $3 trillion.
On an average day in 2011, FICC/GSD cleared 120,780 purchases and sales
of U.S. government securities, 39,156 repo transactions, and 1,122 GCF repo
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transactions, which in aggregate were reduced to 24,515 net obligations daily.
The peak daily gross number of trades for these three categories was 255,241
purchase and sales, 44,238 repo transactions, and 1,636 GCF repo transactions,
respectively. Peak aggregate netted obligations were 28,464 on July 29, 2011.
Daily trading volume at FICC/MBSD averaged 10,556 compared sides in 2011.
The daily gross number of compared sides at FICC/MBSD peaked at 30,237 on
October 6, 2011.
In 2011, the average daily gross value of trades compared by FICC/GSD was
$893.7 billion for sales and purchases of U.S. government securities, $1.7 trillion
for repos, and $796 billion for GCF repo transactions. The average daily net value
settlement in all three categories was $921 billion for FICC/GSD, and the average
daily funds only settlement (FOS) was $1.0 billion. The daily gross value of sales
and purchases of U.S. government securities in 2011 peaked at $1.6 trillion on
August 9, 2011. For repos and GCF repo transactions, the daily gross value of
trades peaked at $1.9 trillion and $1.2 trillion, respectively. These peaks occurred
on August 3, 2011, and September 8, 2011, respectively. The peak total of netted
transactions in 2011 for FICC/GSD was $999.4 billion on July 29, 2011, and FOS
peaked at $2.6 billion on August 10, 2011. FICC/MBSD compared, on average,
$284.7 billion worth of transactions each day in 2011. FICC/MBSD’s comparisons
of trade par value peaked at $988.2 billion on October 6, 2011.
FICC/GSD’s peak increase in daily total clearing fund deposits in 2011 equaled
$0.5 billion on August 10, 2011. The average daily total of funds only settlement
debit was $0.3 billion, and funds only settlement debits peaked at $1.8 billion on
August 10, 2011. FICC/MBSD’s average daily gross mark-to-market change for
2011, including changes in average daily initial margin, was $3.4 billion, and its
daily variation margin (mark to market) peaked at $10.4 billion on January 6, 2011.

B) Aggregate exposure of FICC to its counterparties
In 2011, FICC/GSD maintained a clearing fund that averaged $11.1 billion, while
FICC/MBSD maintained a participants fund that averaged $7.7 billion. The sizes
of these funds peaked at $25.0 billion for FICC/GSD on March 22, 2011 and $15.2
billion for FICC/MBSD on March 22, 2011. The average daily VaR estimates at a
99 percent confidence level for FICC/GSD in 2011 was $6.2 billion. The average
VaR for FICC/MBSD in 2011 was $5.0 billion. All of the collateral in the two
funds was held in cash and in U.S. government and agency securities.
FICC/GSD has liquidity needs for day-to-day securities settlement, daily funds
settlement obligations, and in the event of member default. FICC/MBSD, by
contrast, in 2011, had liquidity needs only for daily funds settlement obligations,
as it did not begin acting as central counterparty until April 2012. FICC/GSD’s
liquidity resources include the following: (1) the cash portion of the clearing
fund; (2) the cash that would be obtained by entering into repo transactions
using the eligible securities portion of the clearing fund (Treasury securities,
agency securities guaranteed by the U.S. government, and certain U.S. agency/
GSE pass-through securities); and (3) the cash that would be obtained by entering
into repos using the securities underlying transactions that would have been
delivered to the defaulting member had it not defaulted. In addition, FICC/GSD
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169

could receive funds from its cross-margining and cross-guaranty arrangements
if its resources proved insufficient to cover losses stemming from a member’s
default. FICC/GSD does not maintain any committed lines of credit.
In 2011, FICC/GSD’s peak liquidity exposure to a single counterparty totaled $111
billion. In 2011, FICC/MBSD’s peak liquidity exposure to a single counterparty
totaled $25 billion. This exposure was required to be covered by the settlement
obligations of other FICC/MBSD participants or through use of the FICC/MBSD
participants fund. For the year ended December 31, 2011, FICC/GSD had an
average of $10.6 billion in liquidity resources, which was comprised of $3.7 billion
in cash and $6.9 billion in U.S. Treasury and agency securities. FICC/MBSD had
an average of $7.1 billion in liquidity resources in 2011, of which $3.5 billion was
in cash and $3.6 billion was in U.S. Treasury and agency securities.

C) Relationships, interdependencies, or other interactions of FICC with other FMUs or
payment, clearing, or settlement activities
FICC/GSD has formed relationships with other market participants to mitigate
the risks attending the potential default of a mutual participant. FICC/GSD has
established a cross-margining arrangement with CME, and FICC has established
a multilateral cross-guaranty agreement with both the OCC and FICC’s affiliates,
NSCC and DTC, to cover certain obligations of a common defaulting member
to the extent of available resources of the member. FICC/GSD has also formed
a relationship with NYPC, a U.S. futures clearing corporation, to allow joint
clearing members to cross-margin certain positions cleared at FICC/GSD with
certain positions cleared at NYPC in a “one pot” margin portfolio.
FICC/GSD has only two clearing banks, JPMorgan Chase and Bank of New York
Mellon. These two entities are critically important to FICC for GCF repos and
security settlement processing. FICC/GSD also relies on FRBNY, both to issue
U.S. Treasury securities and to collect and pay margin deposits. Payments to and
from FICC/MBSD are made via DTC’s sub-account at FRBNY.
In addition, FICC’s parent company, DTCC, provides significant services to
FICC pursuant to a service agreement, including internal audit, corporate
communications, corporate and regulatory compliance, executive services,
finance, administration services, and legal services.

D) Effect that the failure of or disruption to FICC would have on critical markets,
financial institutions, or the broader financial system
A failure of or a disruption to the functioning of FICC/GSD would be broad and
severe. First, it could cause a complete or partial disruption of the substantial
number and value of transactions typically pending to be cleared and settled
through FICC/GSD in a two-day settlement cycle. Additionally, FICC/GSD
members could face financial losses equal to the average net value of transactions
guaranteed by FICC/GSD over the two-day settlement cycle, due to the full or
partial absence of the FICC/GSD trade guarantee. These potential losses would
be compounded by liquidity pressures due to at least a temporary limitation on
a member’s ability to access collateral in the clearing and participant funds. As

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of December 31, 2011, the approximate values of such contributions were $11.1
billion for FICC/GSD and $6.5 billion for FICC/MBSD.
There would also be a disruption to new trading activity in U.S. government
securities and MBS markets. Because there are no other clearing agencies
providing services similar to those of FICC, trades would need to be settled on a
bilateral basis.
In addition, a failure of or a disruption to the functioning of FICC would likely
result in significant spillover effects on the rest of the U.S. economy, reducing
the amount of credit available generally, drawing assets away from other
productive uses, reducing the value of corporate reserves and household savings,
destabilizing U.S. money market funds, and negatively affecting financing
activities of the U.S. government and GSEs.

Conclusion
FICC plays an important role in financial markets due to the high gross notional
value of the trades FICC/GSD and FICC/MBSD clear and the efficiencies
they provide through multilateral netting of trades and payments among their
members. In particular, because FICC/GSD is the sole clearing agency in the
United States acting as a central counterparty for cash-settled U.S. government
and agency securities, and FICC/MBSD is the predominant provider of clearance
and settlement services for U.S. MBS markets, a failure or disruption to the
functioning of FICC could:
•	
•	

•	

•	

Directly and negatively affect an enormous dollar value and volume of
financial transactions in the U.S. government securities and MBS markets;
Impose material direct losses on FICC counterparties and create
new demands for liquidity and new credit problems among financial
institutions and others that rely on such markets for credit or liquidity;
Cause liquidity or credit problems resulting from its failure or disruption
to spread quickly and broadly among financial institutions and other
markets; and
Have cumulative negative effects on U.S. government and MBS markets,
financial institutions, and the broader financial system that are substantial
in their own right and so severe as to create a risk that liquidity and credit
problems experienced could spread among financial institutions and
other markets and, therefore, threaten the stability of the financial system.

Accordingly, it is the assessment of the Council that a failure of or a disruption
to FICC could increase the risk of significant liquidity problems spreading
among financial institutions or markets and thereby threaten the stability of the
financial system of the United States. For the reasons set out here, the Council
has determined that FICC should be designated as a systemically important FMU
pursuant to Title VIII of the Act.

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F. ICE Clear Credit LLC
Description of ICE Clear Credit LLC
ICE Clear Credit is a Delaware limited liability company and an indirect
subsidiary of Intercontinental Exchange, Inc., a Delaware corporation. ICE Clear
Credit provides central counterparty clearing services to direct participants that
are financial institutions, as well as to indirect market participants (customers).
Therefore, ICE Clear Credit is an FMU as set out in Title VIII of the Act.24
ICE Clear Credit clears a majority of the CDS products in the United States that
are eligible for clearing by a central counterparty. ICE Clear Credit currently
clears 46 North American CDS contracts (Index Contracts), 132 single-name
components of North American CDS contracts (Single-Name Contracts), and
four foreign sovereign CDS contracts (Sovereign Contracts).25 Specifically, ICE
Clear Credit clears all of the active North American CDS indices for the 5-year
and 10-year tenors, and—save for certain financials—the most liquid U.S. single
names in the CDS market. Of the products that are accepted for clearing by ICE
Clear Credit, as of December 31, 2011, ICE Clear Credit cleared approximately 66
percent of all bilateral trades where both the buyer and the seller are ICE Clear
Credit clearing participants. In addition, ICE Clear Credit is currently the only
clearinghouse worldwide that clears foreign sovereign CDS. Since 2009, ICE Clear
Credit has cleared over 300,000 CDS transactions whose notional value is in the
trillions of U.S. dollars.26
ICE Clear Credit has a total of 27 clearing members, 14 of which are financial
or banking groups and 9 of which are non-U.S. domiciled. ICE Clear Credit’s
clearing members include some of the largest financial institutions designated as
G-SIFIs by the Financial Stability Board.
Irrespective of whether a CDS is being used to hedge risk or take on exposure to
certain credit markets, as a bilateral contract between two market participants,
a CDS creates credit and liquidity risk exposure between the counterparties to
the CDS contract. For centrally cleared CDS contracts, ICE Clear Credit reduces
these risks by serving as a central counterparty, interposing itself between the
two original bilateral counterparties. Additionally, ICE Clear Credit improves
market transparency and functioning by establishing robust daily settlement
prices for the CDS trades that it clears, which periodically its members are
required to stand behind, as well as monitoring and reporting open positions
among clearing members.

Analysis of Systemic Importance
A) Aggregate monetary value of transactions processed by ICE Clear Credit
Number of transactions processed, cleared or settled. In 2011, ICE Clear Credit
cleared an average daily gross volume of 821 Index Contracts, 1,145 Single-Name
Contracts, and 397 Sovereign Contracts. ICE Clear Credit cleared a peak daily
gross volume of 7,222 Index Contracts, 14,708 Single-Name Contracts, and 5,680
Sovereign Contracts.

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Value of transactions processed, cleared or settled. In 2011, ICE Clear Credit
cleared contracts with an average daily gross notional value in the billions of
dollars in each of Index Contracts, Single-Name Contracts, and Sovereign
Contracts. The peak daily gross notional values of the contracts ICE Clear Credit
cleared were in the hundred billion dollar range for each of Index Contracts,
Single-Name Contracts, and Sovereign Contracts.
Value of other financial flows. For all listed derivatives, the average daily flow of
funds (average daily mark-to-market valuation plus change in average daily initial
margin) was in the millions of dollars for initial margin and in the hundred million
dollar range for adjusted mark-to-market, and for all intraday fees (adjusted markto-market, upfront fee, coupon plus credit event). The peak daily flow of funds was
over a billion dollars for initial margin and in the hundreds of millions of dollars
for adjusted mark-to-market and for all intraday fees (adjusted mark-to-market,
upfront fee, coupon plus credit event). The peak daily open interest was in the
hundreds of billions for each of Index Contracts and Single-Name Contracts, and
in the tens of billions of dollars range for Sovereign Contracts.

B) Aggregate exposure of ICE Clear Credit to its counterparties
Credit exposures. During 2011, the average size of ICE Clear Credit’s guaranty
fund was in the billions of U.S. dollars, with a peak size of billions of U.S. dollars.
It is anticipated that following the implementation of a clearing requirement for
swaps, clearing volume and open interest will significantly increase, and margin
on deposit and exposure will increase proportionally.
Liquidity resources. The average amount of liquidity resources (including only
cash and U.S. Treasury and agency notes) at ICE Clear Credit was billions of U.S.
dollars, with a peak amount in the billions of U.S. dollars. As of December 31,
2011, the total value of lines of credit from banks or others was millions of dollars.
Liquidity exposures. The average aggregate daily dollar value of payouts by ICE
Clear Credit to clearing members was in the millions of U.S. dollars, with a peak
in the millions of U.S. dollars. The peak liquidity need with a single counterparty
was in the millions of U.S. dollars.

C) Relationships, interdependencies, or other interactions of ICE Clear Credit with
other FMUs or payment, clearing, or settlement activities
Participants. ICE Clear Credit has a total of 27 clearing members, 27 14 of which
are financial or banking groups and 9 of which are non-U.S. domiciled. ICE Clear
Credit’s clearing members include some of the largest banking and brokerage
firms in the world.
Other FMUs. ICE Clear Credit does not have any relationships with other FMUs,
other than its affiliate relationships.
Trading platforms. ICE Clear Credit clears OTC swaps (all cleared CDS
transactions are executed bilaterally) and therefore does not have a relationship
with any trading platforms. However, it is expected that ICE Clear Credit will
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begin clearing transactions executed on DCMs or swap execution facilities with
the commencement of CDS trading through such venues.
Other external service providers. ICE Clear Credit uses The Clearing
Corporation for license fee and management services and ICE for technology and
management services.
Average daily value of flows and other transactions with key financial institutions.
ICE Clear Credit does not have any flows with unaffiliated key financial institutions
other than its clearing members, settlement banks, and repo counterparties.
Average daily value of trades and other transactions on key trading platforms.
ICE Clear Credit clears OTC swaps and therefore does not have a relationship
with any trading platforms.
Average daily value of services provided and other transactions with other
external service providers not captured. ICE Clear Europe uses ICE Clear Credit
for technology and management services.

D) Effect that the failure of or disruption to ICE Clear Credit would have on critical
markets, financial institutions, or the broader financial system
Role of ICE Clear Credit in the market served. In 2011, of the North American
Index and Single-Name CDS market CDS products that ICE Clear Credit accepts
for clearing, ICE Clear Credit cleared approximately 66 percent of all bilateral
trades where both the buyer and the seller are ICE Clear Credit Clearing
participants. It is also the only clearinghouse worldwide that clears foreign
sovereign CDS.
Availability of substitutes. Currently, no other DCOs clear the breadth of
products cleared by ICE Clear Credit. Accordingly, it is impracticable to expect
that one could continue clearing ICE Clear Credit’s CDS products immediately or
in the short term following a disruption of ICE Clear Credit’s operations.
Concentration by product type. ICE Clear Credit is currently the only
clearinghouse worldwide that clears foreign sovereign CDS. In addition, ICE
Clear Credit clears all of the active North American CDS indexes for the 5-year
and 10-year tenors, and—save for certain financials—the most liquid U.S. single
names in the CDS market.
Financial Data/Metrics. On December 30, 2011, ICE Clear Credit had in the
billions of U.S. dollars in cash and cash equivalents and in the billions of U.S.
dollars in government securities.
ICE Clear Credit reduces systemic risk in the CDS market in a number of ways.
First, ICE Clear Credit lowers counterparty risk exposures among market
participants through the novation of CDS contracts. Second, ICE Clear Credit
lowers the likelihood of a default leading to a financial contagion of defaults
across major CDS counterparties by maintaining substantial financial resources
to manage the default of its two largest clearing members. Third, ICE Clear
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Credit reduces credit, liquidity, and operational risk by facilitating the timely
settlement of trade-related payment obligations. ICE Clear Credit is one of the
largest clearers of CDS transactions worldwide.
The primary trigger of a default by ICE Clear Credit would be a default by one
or more clearing members with extraordinary losses in excess of ICE Clear
Credit’s default resources. While such a default could conceivably result from
circumstances local to those members, a default scenario would more likely be
associated with a disruption to the markets more generally, including scenarios
such as extreme volatility, extreme changes to normal price correlations, and
acute reductions in liquidity. ICE Clear Credit may be more exposed to such
circumstances than other central counterparties, because it has significant
exposure to credit default swaps, which have jump-to-default risk.
An alternative trigger of a default by ICE Clear Credit would be a failure
of its settlement bank or one of ICE Clear Credit’s overnight reverse repo
counterparties, because a substantial portion of ICE Clear Credit’s financial
resources are on deposit with such entities. Thus, if those financial resources were
to suddenly become unavailable, ICE Clear Credit’s operations would be adversely
affected to a considerable extent. In addition, an ICE Clear Credit default could
result from a failure to maintain a generally sound financial condition, such as
a failure to maintain sufficient capital or other financial resources against its
general business risk or against the risk of one or more clearing member defaults.
An ICE Clear Credit failure, or a disruption in the functioning of its clearing
services, would effectively mean the immediate loss of the dominant clearing
platform for the credit default products it clears. This disruption would likely
expose ICE Clear Credit’s clearing members and other market participants
to credit and liquidity risks. The significant margin deposits held by ICE
Clear Credit could lead to a period wherein affected entities may be unable to
access, or in a worst case scenario would lose, the collateral they posted with
the clearinghouse. Furthermore, if ICE Clear Credit does not have sufficient
financial resources to satisfy its obligations to surviving market participants,
the ability of those participants to meet other financial obligations could be
adversely impacted. An ICE Clear Credit failure or disruption of its services could
directly pose credit and liquidity risk to other financial market infrastructures,
which include depositories, other clearinghouses, custodians, DCMs, trade
repositories, and swap execution facilities. Since many of ICE Clear Credit’s
clearing members are G-SIFIs, a disruption or failure could indirectly pose credit
and liquidity issues to every major market in the United States, every significant
market participant in the United States, and all significant financial market
infrastructures in the United States.
In the event of an ICE Clear Credit failure, it is unlikely in the short term that
a substitute could take over ICE Clear Credit’s clearing operations. Moreover,
market participants would have to post substantially more collateral to enter
into transactions in a bilateral space and obtain the same level of protection
or exposure than they would through ICE Clear Credit. For example, in
the bilateral market, if A wishes to neutralize, e.g., a long exposure to B, A
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175

would typically enter into a transaction with a short exposure to another
counterparty, e.g., C. This would offset A’s market risk, but would leave A with
credit risk to each of B and C that A would need to collateralize. Furthermore,
the margin required to collateralize the exposure of a portfolio is generally
smaller than collateralizing its individual components because the prices of
the portfolio’s components are often correlated. Central counterparty netting
is more powerful, as each member’s obligations to every other member can
be treated as one portfolio that is netted and offset.28 There could also be an
increase in the number and exposure of uncollateralized transactions (creating
greater exposures from further failures) and a decrease in the total number of
transactions. This would likely have a deleterious impact on the financial activity
that relates to those transactions.
In addition, any disruption in the clearing of these products would likely impede
the price discovery benefit of central counterparty clearing, which would result in
a decrease or loss of liquidity for these products and lead to market opacity. Large
aggregate exposures to counterparties under CDS contracts could be hidden
in opaque markets until the bankruptcy of a major CDS market participant is
imminent. The circumstances of such an event, which figured prominently in
the recent U.S. financial crisis, could have additional consequences on the ability
of U.S. financial institutions to obtain credit. Bank lending could freeze until
such time as market participants’ CDS exposure can be adequately priced and
it becomes clear market participants are able to honor contract obligations in a
stressed financial environment.
Furthermore, not only would price discovery and liquidity be impacted by such an
event, but there also would likely be a negative impact on any economic activity
that presupposes the protection of hedging activity. Assume, for example, that a
large U.S. based financial institution (FI1) hedged its exposure to the corporation
A corporate bonds it purchased by buying CDS protection from another financial
institution, and the trade was then cleared at ICE Clear Credit. If any of ICE
Clear Credit’s members default and ICE Clear Credit does not have, and cannot
obtain, sufficient financial resources to maintain operations, this CDS protection
would no longer be active. If corporation A were then to suddenly default, FI1
could have a large loss on the corporation A bonds; a loss that, but for ICE Clear
Credit’s failure, should have been hedged by the CDS. As positions move to the
bilateral market and are de-netted, settled, and replaced, operational risks and
costs would likely increase, thereby decreasing the number of reliable and readily
available hedging opportunities. As a result, financial institutions and other
market participants may reduce their investment activities, which could further
stress the U.S. financial markets.
In addition, an ICE Clear Credit failure or disruption would pose a substantial
adverse impact to the CDS market for the products cleared by ICE Clear Credit.
Market participants would likely experience substantial uncertainty around,
and possibly outright loss of their CDS positions at ICE Clear Credit. Market
participants would no longer be able use CDS to manage credit risk without
increasing bilateral counterparty credit risk. This, in turn, is likely to cause
a loss of confidence in the CDS market in general. For holders of the debt of
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reference entities to CDS, those participants may be forced to sell large amounts
of securities at potentially fire-sale prices if their CDS protection ceases to exist.
Market participants that transact with any reference entity and use CDS to hedge
credit risk may be forced to reduce or cease financial and other transactions with
those entities. Banks or other users of index CDS as broad-based, macroeconomic
hedges to credit risk may need to quickly sell securities or reduce lending activity
in order to comply with capital requirements in the absence of CDS hedging
benefits. Market participants that use sovereign CDS to hedge direct exposures
to those countries, indirect exposures to entities domiciled in those countries or
overall country risk may be forced to quickly sell securities and reduce or cease
financial and other transactions with those entities. All of these effects represent
the substantial risk of contagion from a disruption in the CDS market.
Finally, the contagion effect of an ICE Clear Credit default, if it were to lack
sufficient resources to make timely payments for mark-to-market obligations,
could severely disrupt operations at other clearinghouses because of a crisis
of confidence that interrupts the orderly functioning of the market and/or
because of the impact that the loss of funds would have on an entity’s ability
(or willingness) to pay (1) losses owed to other DCOs, (2) increased collateral
requirements for offsetting out-of-the money positions, (3) deposits in pension
fund cash accounts, or (4) bank financing charges. Essentially, the failure of ICE
Clear Credit would create enormous uncertainty about the status of initiated
transactions, as well as the financial positions of its clearing members and their
customers, and could jeopardize the orderly functioning of clearing members,
other DCOs, and the U.S. financial markets as a whole.
Based on its review of the information set forth here, the Council recognizes
that ICE Clear Credit currently clears a specific range of the total credit
derivatives market.29 ICE Clear Credit also has a membership of 27 clearing
members, including 14 financial or banking groups. Accordingly, when viewed
narrowly the effects of a failure or disruption of ICE Clear Credit could be
considered to affect a finite number of the world’s largest financial institutions,
each of which has, theoretically, immediate access to the bilateral markets for
CDS products and various other sources of credit and liquidity in the event of
such a failure or disruption.
However, the immediate loss of a clearing platform for most of the products
cleared by ICE Clear Credit would effectively lead to at least a temporary
disruption of the CDS market for these products as the market infrastructure
through which positions are established, maintained, and closed out would be
gone. This, together with the increased risks and costs in the bilateral markets,
would create great uncertainty about the capacity of already strained markets to
accommodate any anticipated corresponding liquidity needs, which would likely
lead to increased credit and liquidity problems for market participants. As these
risks and costs increase, institutions may reduce their investment activities due to
a lack of reliable and readily available hedging opportunities, which could further
stress the U.S. financial markets.

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Moreover, under rules recently promulgated by the CFTC30 and equivalent rules
being considered by the SEC pursuant to the Act, ICE Clear Credit will likely be
required to expand its membership base to include smaller financial institutions
and permit the direct involvement of buy-side firms for the first time. These
new regulatory standards will also result in numerous financial institutions
being required to clear trades with other financial institutions when clearing is
offered by one or more FMUs and thereby increase their practical reliance on
ICE Clear Credit in a manner consistent with the policy direction established by
the Act. Thus, and especially upon these new standards taking effect, a failure
or disruption of ICE Clear Credit would necessarily involve a broader segment
of the financial community and have a wider impact on the financial system of
the United States than would have been true in the recent past. These more
widespread effects reinforce the Council’s conclusion that a failure or disruption
to the functioning of ICE Clear Credit could create or increase the risk of
liquidity and credit problems spreading among financial institutions or markets
and thereby threaten the stability of the financial system of the United States.

Conclusion
The data reviewed by the Council indicate that ICE Clear Credit processes highdollar-value transactions on a daily basis for critical U.S. financial markets31 and
holds large amounts of collateral on deposit. Coupled with the unique nature
of CDS and the attendant jump-to-default risk that has to be managed, as well
as the size and nature of ICE Clear Credit’s clearing members, a significant
disruption to or failure of ICE Clear Credit could create instability in the U.S.
CDS and securities markets. Moreover, there are currently no substitute DCOs for
many of ICE Clear Credit’s products. The loss of central counterparty clearing
in the products ICE Clear Credit clears would increase collateral demands
exponentially, resulting in a corresponding drain of liquidity.
An ICE Clear Credit failure could also have an adverse impact on price discovery,
which could, in turn, lead to inefficient markets and a correlated increase in
liquidity problems. Finally, the contagion effect of an ICE Clear Credit failure
could impose material financial losses on ICE Clear Credit’s clearing members
and other market participants (such as customers) that could lead to increased
liquidity demands and credit problems across financial institutions. Where these
financial institutions are active in multiple U.S. markets, this contagion effect
would have a broader impact and, as the markets experience growing stress,
would likely lead to increased demand for credit, which would, in turn, likely
lead to less liquidity. Thus, the Council believes that a significant disruption or
failure of ICE Clear Credit could have a major adverse impact on the stability of
the U.S. financial markets, the impact of which would be exacerbated by the lack
of clearing alternatives currently available for many of the products cleared by
ICE Clear Credit. Accordingly, a failure or disruption of ICE Clear Credit would
likely have a significant detrimental effect on the liquidity of the swaps markets
and impose significant financial losses on clearing members, which include large
financial institutions and other market participants, which would, in turn, likely
threaten the stability of the broader U.S. financial system.

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For the reasons set out here, the Council has determined that ICE Clear Credit
should be designated as a systemically important FMU pursuant to Title VIII of
the Act.

G. National Securities Clearing Corporation
Description of National Securities Clearing Corporation
NSCC is a FMU as set out in Title VIII of the Act because it manages or operates a
multilateral system for the purpose of clearing and settling securities transactions
among financial institutions and between financial institutions and NSCC.32
NSCC plays a prominent role in providing clearance, settlement, and CCP
services for nearly all broker-to-broker equity and corporate and municipal
debt trades executed on major U.S. exchanges and other equity trading venues.
NSCC is a wholly owned subsidiary of DTCC and is generally administered as an
industry-owned utility on an at-cost basis.
NSCC provides clearing, settlement, risk management, central counterparty
services and a guarantee of completion for virtually all broker-to-broker trades
involving equity securities, corporate and municipal debt securities, American
depository receipts (ADRs), ETFs, and unit investment trusts (UITs). Clearance
and settlement generally occurs through NSCC’s Continuous Net Settlement
(CNS) system, under which all eligible compared and recorded transactions for
a particular settlement date are netted by issue into one net long (buy) or net
short (sell) position. NSCC guarantees the settlement of matched trades and, as
a CCP, is the legal counterparty to all of its members’ net settlement obligations.
NSCC’s CCP services reduce its members’ costs and risks associated with securities
transfers. In 2011, NSCC, on a gross basis, cleared 20.9 billion equity, corporate and
municipal bond, ADR, ETF, and UIT trades worth $220.7 trillion on a gross basis.
NSCC has 187 full service members and 647 limited service members. NSCC
members consist of registered broker-dealers, or banks or trust companies
(including a trust company having limited powers) that are members of the
Federal Reserve System or are supervised and examined by state or federal
authorities having supervision over banks or registered clearing agencies. NSCC
direct members include some of the largest banks in the world by asset size and
include affiliates of 24 of the 29 financial institutions considered to be globally
systemically important.33 Trades that NSCC clears and settles for its members are
executed on more than 50 trading venues for which it provides services (including
all U.S. securities exchanges and alternative trading systems) and with other
domestic and foreign clearing agencies.
A distinguishing characteristic of NSCC is the wide range of risks it faces and
its ability to manage those risks. As a CCP, NSCC faces credit risk, liquidity risk,
custody and investment risks, and operational risk. NSCC uses a combination
of risk management tools to mitigate some of these risks to ensure it can meet
its obligations. These tools include (1) membership standards with regard to
financial resources and operational capacity, (2) collection of collateral deposits
to meet clearing fund requirements and mark-to-market payments in the form
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of margin, and (3) close out and loss allocation procedures designed to facilitate
an orderly liquidation in the event of a member default.
Another important feature of NSCC is that it uses multilateral netting through
which NSCC is able to reduce significantly the value of securities and payments
that must be exchanged each day. A disruption to NSCC could therefore have a
multiplier effect on the liquidity needs of members.

Analysis of Systemic Importance
A) Aggregate monetary value of transactions processed through NSCC
In 2011, NSCC cleared $220.7 trillion worth of trades on a gross basis, which
represented nearly all broker-to-broker equity and debt trades executed on the
major U.S. exchanges and most other equity trading venues.
On an average trading day in 2011, NSCC cleared 83 million securities trades.
The peak daily gross number of trades in 2011 was 199 million trades on August
8, 2011, with peak netted obligations equal to 204,000 trades. The historic peak
day for trades occurred on October 10, 2008, when NSCC cleared 209.4 million
transactions. In 2011, the average daily gross value of transactions settled by
NSCC was $883 billion, with average aggregate netted obligations of $23.8 billion.
The peak daily gross value of trades in 2011 was equal to $1.9 trillion on August 8,
2011, with the peak daily netted obligation equal to $78 billion.
The average daily value of mark-to-market contributions to and distributions
from NSCC’s clearing fund for 2011 was $408.5 million. The peak daily value of
contributions to and distributions from NSCC’s clearing fund was $4.4 billion on
August 9, 2011.

B) Aggregate exposure of NSCC to its counterparties
In 2011, the average daily size of the NSCC clearing fund requirement was $3.9
billion and the peak size of the NSCC clearing fund requirement was $10.2 billion
(on August 9, 2011). The average daily VaR estimate at a 99 percent confidence
level for NSCC in 2011 was $2.9 billion, and the peak VaR for NSCC was $6.3
billion on August 12, 2011. Using the scenario of a default of NSCC’s largest
participant family, NSCC’s peak daily liquidity exposure to a single counterparty
in 2011 was $13 billion. In 2011 the average daily value of all collateral posted
to NSCC, including excess deposits, was $5.1 billion, and the peak value of
all collateral posted to NSCC was $11.9 billion (on August 9, 2011). All of the
collateral in the clearing fund was held by NSCC in cash and U.S. government
and agency securities.
NSCC seeks to maintain sufficient liquidity to enable it to settle transactions
in the default of the member-family to which NSCC has the largest aggregate
settlement exposure over the three days between the time when its guarantee
is issued, generally one day following the trade date (T+1), and final settlement
(T+3). NSCC’s liquidity resources are limited to a line of credit, its retained
earnings, and the value of assets held as collateral, including certain securities of
the defaulting member delivered in anticipation of settlement. NSCC’s liquidity
facility is a $6.2 billion committed line of credit through a syndicated loan facility.
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The amount of funds available to NSCC under the committed credit facility
is limited not only by the overall size of the facility, but also by the amount of
assets available to NSCC to pledge as collateral to lenders supporting the facility.
NSCC is also required to contribute up to 25 percent of its retained earnings
in the event the clearing fund and other collateral is not sufficient to cover a
loss. NSCC’s retained earnings were $151 million as of December 31, 2011. For
2011, the average daily amount of NSCC’s liquidity resources held in cash and
U.S. Treasury and agency securities was $4.7 billion. The peak amount of such
liquidity resources was $7.9 billion.

C) Relationships, interdependencies, or other interactions of NSCC with other FMUs
or payment, clearing, or settlement activities
NSCC’s CNS system relies on an interface with its affiliate DTC for the bookentry movement of beneficial ownership of securities through securities accounts
established at DTC to settle obligations. CNS short positions (i.e., obligations
to deliver) are compared against members’ DTC accounts to determine issue
availability. If securities are available, they are transferred from the NSCC
member’s account at DTC to NSCC’s account at DTC. The allocation of CNS long
positions (i.e., obligations to receive) to receiving NSCC members is processed
in an order determined by an algorithm built into the system. Securities are
automatically allocated to NSCC members’ long positions as the securities are
received by NSCC.
Throughout the day, the debits and credits in a DTC participant’s settlement
account are netted to calculate, at any time, the net debit balance or net credit
balance for the account. At end-of-day settlement, DTC and NSCC net the
settlement balances of each DTC participant that is also a member of NSCC. After
end-of-day netting with NSCC (also known as cross-endorsement), DTC reports
final figures for each DTC participant. Because each DTC participant must settle
through a “Settling Bank,” there is a “roll-up” for each Settling Bank which is a
net-net balance payable from or to such Settling Bank. Payments are made to and
from DTC’s account at FRBNY through the Federal Reserve National Settlement
Service System. Payments are made to and from NSCC on the National
Settlement System through the FRBNY sub-account of DTC. DTC and NSCC are
also parties to a netting contract and limited cross-guaranty agreement.
CDS Clearing and Depository Services Inc. (CDS, Inc.), the Canadian central
securities depository and central counterparty, is a full service member of NSCC,
as well as a participant of DTC. This relationship enables CDS, Inc. participants
to clear and settle OTC trades with U.S. broker-dealers through sponsored
accounts maintained by CDS, Inc. with DTC and NSCC and entitles them to
the privileges of direct membership in both organizations. However, CDS, Inc.
participants are not members of DTC and NSCC and therefore must look only to
CDS, Inc. for satisfaction of clearance and settlement obligations. Thus, if a CDS,
Inc. participant defaults on its obligation to DTC or NSCC, CDS, Inc. is required
to meet that obligation. CDS, Inc. mitigates its exposure to potential losses by
requiring participants to commit collateral to CDS, Inc. in amounts equivalent to
those required as collateral by NSCC and DTC.

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181

NSCC receives transactions on exercises and assignments of options from OCC
that are cleared and settled through NSCC. NSCC and OCC rely on one another
for coverage of certain risks through a Third Amended and Restated Options
Exercise Settlement Agreement between them (the Accord). The arrangement is
designed to facilitate the settlement of the underlying securities upon the exercise
or assignment of such options by mitigating duplicative margin requirements.
The Accord provides for a two-way guaranty between OCC and NSCC of the
mark-to-market amounts for options transactions for which NSCC has guaranteed
completion in the event of a mutual participant’s failure. The failure of OCC
to meet its obligations under that agreement, and vice versa, could impair the
ability of the parties to ensure access to adequate margin with respect to a failing
participant that is a common member of both NSCC and OCC. Additionally,
there is an agreement with OCC providing for the settlement of exercises and
assignments of options on securities cleared and settled through NSCC in the
event of a mutual participant’s failure.
In addition, NSCC’s parent company, DTCC, provides significant services to
NSCC pursuant to a service agreement, including internal audit, corporate
communications, corporate and regulatory compliance, executive services,
finance, administration services, and legal services.

D) Effect that the failure of or disruption to NSCC would have on critical markets,
financial institutions, or the broader financial system
The primary effect of a failure of or a disruption to the functioning of NSCC
would be a disruption to the settlement of the $3.5 trillion in notional value of
transactions typically pending to be cleared and settled through NSCC on an
average day. Additionally, initiating new trades would be difficult at best due to
the lack of any clearing agencies offering similar services. Given the enormous
efficiencies of multilateral netting provided by NSCC, bilateral settlement of
transactions at current normal volumes would not be practical.
A failure of or a disruption to the functioning of NSCC would have several other
likely effects. Members of NSCC could experience financial losses or liquidity
shortages due to NSCC’s inability to honor its central counterparty obligations
and due to members’ inability to access clearing fund contributions. There
would also be financial and operational stresses placed on other FMUs such as
DTC and OCC, which have closely related operations. Additionally, if bilateral
gross settlement of NSCC-cleared trades were attempted, DTC’s capacity could
be overwhelmed as it experiences enormous increases in values and volumes
of transactions.
In addition, a failure or a disruption to the functioning of NSCC would likely
result in significant spillover effects on the rest of the U.S. economy, reducing the
amount of credit available generally, drawing assets away from other productive
uses, reducing the value of household savings, and affecting the financing
activities of corporations and municipalities.

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Conclusion
NSCC plays an important role in financial markets due to the high gross
notional value of the trades NSCC clears and the efficiencies it provides through
multilateral netting of trades and payments among its members. In particular,
because NSCC clears and settles virtually all broker-to-broker equity and
corporate and municipal debt securities transactions in the United States and
supports more than 50 trading venues for which it provides services (including all
U.S. securities exchanges and alternative trading systems), a failure or disruption
to the functioning of NSCC could:
•	
•	

•	

•	

Directly and negatively affect an enormous dollar value and volume of
financial transactions in equity and debt markets;
Impose material direct losses on NSCC counterparties and create
new demands for liquidity and new credit problems among financial
institutions and others that rely on such markets for credit or liquidity;
Cause liquidity or credit problems resulting from its failure or disruption
to spread quickly and broadly among financial institutions and other
markets; and
Have cumulative negative effects on U.S. domestic equity and debt
markets, financial institutions, and the broader financial system that
are substantial in their own right and so severe as to create a risk that
liquidity and credit problems experienced could spread among financial
institutions and other markets and, therefore, threaten the stability of the
financial system.

Accordingly, it is the assessment of the Council that a failure of or a disruption to
NSCC could increase the risk of significant liquidity problems spreading among
financial institutions or markets and thereby threaten the stability of the financial
system of the United States. For the reasons set out here, the Council determined
that NSCC should be designated as a systemically important FMU pursuant to
Title VIII of the Act.

H. The Options Clearing Corporation
Description of The Options Clearing Corporation
The Options Clearing Corporation (OCC) is an FMU as defined in Title VIII
of the Act because it manages or operates a multilateral system for the purpose
of clearing and settling securities transactions among financial institutions and
between financial institutions and OCC.34
OCC is the predominant clearing organization for U.S. options markets. OCC
provides its clearing members with clearing and settlement services that eliminate
the need for individual counterparties to bilaterally exchange option premiums
and collect and maintain margin on a daily basis. These services increase
the speed and efficiency of trading and settlement while reducing members’
operational expenses. Additionally, OCC acts as a central counterparty for certain
options and other derivatives therefore reducing credit risk for its members.

Appendix A

183

OCC’s clearing members serve institutional investors, professional traders, and
retail customers. OCC currently has approximately 120 clearing members, which
comprise some of the largest domestic and foreign financial institutions including
banks, broker-dealers, futures commission merchants, investment advisers, and
investment funds. OCC’s members include some of the largest banks in the world
by asset size and include affiliates of 17 of the 29 financial institutions considered
to be globally systemically important.35
The primary services that OCC provides relate to the clearing and settlement
of options and futures. The types of options cleared include those on equities,
indices, currency, and commodities though equity options accounted for
approximately 93 percent of total clearing volume. OCC is the sole issuer and
settling agent for all stock options, equity index options, and single-stock futures
listed on U.S. exchanges.
When OCC accepts a trade for clearing, it becomes a central counterparty for the
transaction and therefore is subject to credit risk resulting from the transactions
it clears. OCC mitigates the risk from these transactions by collecting margin
collateral from its members and by maintaining a clearing fund. However, it is
still exposed to market risk should it be necessary to liquidate collateral as well as
model risk that exists relating to the methodology used to calculate margin calls.

Analysis of Systemic Importance
(A) Aggregate monetary value of transactions processed through OCC
OCC also cleared stock lending transactions covering a total of 7.3 billion shares
in 2011. The dollar value and volume of options transactions handled by OCC
includes substantially all of the equity options traded on U.S. options exchanges.
In 2011, OCC cleared an average daily gross volume of 18.1 million option
contracts, 152,000 futures contracts and 29 million stock loan shares. The peak
daily gross volume for OCC in 2011 was approximately 41.5 million option
contracts, 383,000 futures contracts and 89.3 million stock loan shares. OCC’s
average month-end open interest for 2011 was 305 million option contracts and
960,000 futures contracts. Daily open interest peaked at approximately 386
million option contracts on August 19, 2011 and 1.2 million futures contracts on
December 16, 2011.
In 2011, the average daily gross value of premium exchanged by OCC was $5.95
billion for option contracts and $1.2 billion for stock loan transactions. The peak
daily gross value of premium exchanged during 2011 was $20.3 billion for options
contracts and $3.1 billion for stock loan transactions, respectively. The average
notional value of open interest for contracts cleared by OCC in 2011 was $3.3
trillion based on month-end data.
OCC processed an average of $1.2 billion in daily changes in initial and variation
margin payments in 2011, and the peak daily initial and variation margin
payments processed by OCC was $22.1 billion on August 8, 2011.

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(B) Aggregate exposure of OCC to its counterparties
As of December 31, 2011, OCC held $76.3 billion in margin deposits on behalf
of its clearing members, $57.3 billion of which consisted of cash and other
underlying securities accepted as margin by OCC and approximately $19 billion
of which consisted of equity and index option escrow deposits accepted in lieu
of margin. As of December 31, 2011, OCC also maintained a clearing fund for
options and futures clearing activity totaling $2.9 billion. All of the collateral in
the clearing fund was held in the form of cash and U.S. Treasury securities.
In 2011, the average aggregate daily value of collateral (after haircut) posted to
OCC was $89.8 billion. OCC’s VaR estimate at a 99 percent confidence level was
on average $15 billion in 2011, and the average collateral required to be deposited
with OCC to cover that exposure was $33.6 billion. The daily average size of the
OCC clearing fund in 2011 was $2.8 billion, and the remaining $53.4 billion in
collateral deposits consisted of mark-to-market charges to cover changes in the
value of option positions and stock and index option contracts held in escrow
in lieu of margin. The average collateral coverage ratio for OCC during 2011
was 135 percent based on the ratio of valued collateral (not including option
collateral held in escrow) over estimated margin requirements, using monthend data over a 12-month period. The aggregate dollar value of collateral (after
haircut) posted to OCC peaked at $123.7 billion on August 9, 2011. In 2011, the
peak VaR was $35.7 billion, the peak collateral requirement was $63.5 billion, and
the peak clearing fund requirement was $3.4 billion.
OCC’s liquidity resources include the defaulting member’s collateral, the assets
in the clearing fund, and a $2 billion secured line of credit.36 The amount of
funds available to OCC under the committed secured credit facility is constrained
not only by the overall size of the facility, but also by the amount of assets that
OCC can pledge as collateral to lenders supporting the facility, which is limited
to the securities in OCC’s clearing fund. OCC’s bylaws give it the authority to
use a defaulting clearing member’s margin and clearing fund deposits to obtain
temporary liquidity for purposes of meeting obligations arising out of (1) the
default or suspension of a clearing member or any action taken by OCC in
connection therewith or (2) the failure of any bank or any clearing organization
to perform any obligation owed to OCC. In addition, OCC may use such assets
to borrow or otherwise obtain funds through any means determined to be
reasonable by its Chairman, Management Vice Chairman, or President of the
Corporation in his or her discretion (including, without limitation, pledging such
assets as security for loans and/or using such assets to effect repurchase, securities
lending, or other transactions). OCC rules provide, among other things, that
upon the suspension of a clearing member, OCC shall promptly liquidate, in the
most orderly manner practicable, all of the clearing member’s margin.
For 2011, the average amount of OCC’s liquidity resources held in cash and
U.S. Treasury and agency notes was $12 billion, and the peak amount of liquid
resources was $25.8 billion. The peak liquidity exposure OCC experienced
with a single counterparty occurred on September 19, 2011, when the exposure
totaled $3 billion. OCC did not provide information regarding the average peak
exposure to individual members during the course of 2011.
Appendix A

185

(C) Relationships, interdependencies, or other interactions of OCC with other FMUs
or payment, clearing, or settlement activities
OCC’s operations and the current market structure for listed options trading
and clearing involve significant interdependence between OCC, other FMUs,
settlement banks, clearing members, credit facility lenders, custodians,
exchanges, cross-margining entities, and pricing vendors.
OCC maintains two active cross-margin relationships with the CME and ICE
Clear U.S. OCC clearing members use these cross-margin relationships to realize
the benefits of net settlement across the securities and futures markets, as well
as billions of dollars of savings on clearinghouse margin requirements. OCC’s
average margin amount in 2011 subject to these cross-margining arrangements
was approximately $2.3 billion.
OCC is party to a multilateral cross-guaranty agreement with DTC, FICC, and
NSCC, which provides for the sharing of residual close-out proceeds from
a defaulting member between these clearing agencies in the event that one
clearinghouse is in an excess position and another is in a shortfall position.
In addition, OCC maintains an agreement with NSCC that governs the loss or
profit sharing resulting from the settlement of exercised or assigned options of
a common defaulting member. That arrangement is designed to facilitate the
settlement of the underlying securities upon the exercise or assignment of such
options by mitigating duplicative margin requirements.
DTC, in its role as a securities depository, provides services to OCC clearing
members, including the ability to pledge collateral held in DTC accounts to
OCC for collateral purposes. The most prevalent form of collateral—valued
securities—is pledged to OCC in this manner. DTC also provides the operational
support for securities lending transactions to be executed in both the bilateral
stock loan program and the AQS Market Loan platform.

(D) Effect that the failure of or disruption to OCC would have on critical markets,
financial institutions, or the broader financial system
Should there be a failure of or disruption to the functioning of OCC, the
immediate effects could be manifested in two primary forms. The first is direct
financial stress placed on clearing members who would be at least temporarily
unable to access margin collateral and clearing fund deposits. Additionally, there
could be a complete or partial disruption of the $3.3 trillion in average notional
value of open interest for which OCC is issuer and guarantor as well as a sudden
decrease in options trading activity in the markets for which OCC is the sole
clearing agent due to increased risk and decreased efficiency in OCC’s absence.
As of December 31, 2011, OCC held $57.3 billion in margin deposits on behalf
of its clearing members, $2.9 billion in clearing fund deposits, and $19 billion
in equity and index option escrow deposits accepted in lieu of margin. A failure
of or disruption to the functioning of OCC could temporarily limit participants’
access to these deposits in the short term and possibly result in losses of the $19
billion of escrow deposits.

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In addition, in the event OCC is no longer available as an issuer and guarantor,
options cleared and settled through OCC may have to be replaced, to the extent
practicable, including through entering into transactions in the underlying
instruments, with an average replacement value of approximately $3.3 trillion. In
the event such a disruption were to occur, settlement of many future transactions
in options contracts currently cleared by OCC could be required to occur on a
bilateral basis between the parties to the respective transactions in a daily average
amount of $5.95 billion. The same is true of stock loan transactions with an
average daily gross value of $1.2 billion.
In addition, a failure or disruption to the functioning of OCC would likely result
in significant spillover effects on the rest of the U.S. economy, reducing the
amount of credit available generally, drawing assets away from other productive
uses, disrupting the markets for securities and indexes underlying options cleared
by OCC, reducing the value of household savings, and reducing the ability of
corporations to use options to manage risks.

Conclusion
OCC is the sole clearing agency providing clearance and settlement services for
U.S.-listed options. A failure or disruption of OCC could:
•	
•	

•	

•	

Directly and negatively affect significant dollar value and volume of
financial transactions in options and futures markets;
Impose material direct losses on OCC counterparties and create
new demands for liquidity and new credit problems among financial
institutions and others that rely on options markets for risk management
and other purposes;
Cause liquidity or credit problems resulting from its failure or disruption
to spread quickly and broadly among financial institutions and other
markets; and
Have cumulative negative effects on U.S. domestic options and futures
markets, financial institutions, and the broader financial system that
are substantial in their own right and so severe as to create a risk that
liquidity and credit problems experienced could spread among financial
institutions and other markets.

Accordingly, it is the assessment of the Council that a failure of or a disruption to
OCC could increase the risk of significant liquidity or credit problems spreading
among financial institutions or markets and thereby threaten the stability of the
financial system of the United States. For the reasons set out here, the Council
has determined that OCC should be designated as a systemically important FMU
pursuant to Title VIII of the Act.

Appendix A

187

Glossary
Adjustable-Rate Mortgage

A mortgage that allows for the periodic adjustment of the interest
rate on the basis of changes in a specified index or rate.

Agency Mortgage-Backed

A mortgage-backed security issued or guaranteed by federal

Security

agencies or government-sponsored enterprises.

Asset-Backed Commercial

Short-term debt that has a fixed maturity of up to 270 days and

Paper (ABCP)

is backed by some financial asset, such as trade receivables,
consumer debt receivables, or auto and equipment loans
or leases.

Asset-Backed Security (ABS)

A term debt instrument that is collateralized by specific financial
assets, such as credit card receivables or auto loans, and that
makes payments based on the performance of these assets.

Auction Rate Security (ARS)

A debt security, often issued by municipalities, in which the yield
is reset regularly via a Dutch auction.

Bank for International

An international financial organization that serves central banks

Settlements (BIS)

in their pursuit of monetary and financial stability, helping foster
international cooperation in those areas and acting as a bank
for central banks.

Bank Holding Company (BHC)

Any company that has direct or indirect control of one or more
banks and is regulated and supervised by the Federal Reserve in
accordance with the Bank Holding Company Act of 1956.

Basel Committee on Banking

The Basel Committee on Banking Supervision (BCBS) develops

Supervision (BCBS)

and issues international standards on bank capital adequacy.
In 1988, the BCBS introduced a capital measurement system
commonly known as the Basel Capital Accord, or Basel I. In
2004, the BCBS issued a revised capital adequacy framework
titled “International Convergence of Capital Measurement and
Capital Standards: A Revised Framework,” which is commonly
referred to as the New Accord, or Basel II. Following the financial
crisis, the BCBS developed new global standards for the banking
system that are collectively referred to as Basel III.

Broad Dollar Index

A weighted average of the foreign exchange values of the U.S.
dollar against the currencies of a large group of major U.S. trading
partners. The index weights, which change over time, are derived
from U.S. export shares and from U.S. and foreign import shares.

Glossary

189

Broker-Dealer (BD)

An entity that is engaged in the business of buying and selling
securities for itself and others.

Central Counterparty

An entity that is interposed between the initial participants to
a bilateral transaction and becomes the buyer to every seller
and the seller to every buyer of a specified set of contracts or
financial instruments.

Clearing Bank

A commercial bank that facilitates payment and settlement of
financial transactions, such as check clearing or matching trades
between the sellers and buyers of securities and other financial
instruments and contracts.

Clearinghouse (Derivatives

An entity through which financial institutions agree to

Clearing Organization or

exchange payment instructions or other financial obligations

Clearing Agency)

(e.g., securities). The institutions settle for items exchanged
at a designated time based on the rules and procedures of
the clearinghouse. In some cases, the clearinghouse may
assume significant counterparty, financial, or risk management
responsibilities for the clearing system.

Clearing House Interbank

An automated clearing system used primarily for international

Payments System (CHIPS)

payments. This system is owned and operated by The Clearing
House and engages Fedwire Funds Service for settlement.

Collateralized Mortgage

A type of mortgage-backed security. CMOs are bonds that

Obligation (CMO)

represent claims to specific cash flows from large pools of home
mortgages. The streams of principal and interest payments on
the mortgages are distributed to the different classes of CMO
interests, known as tranches, according to a complicated deal
structure. Each tranche may have different principal balances,
coupon rates, prepayment risks, and maturity dates (ranging from
a few months to 30 years).

Commercial Bank

A chartered and regulated financial institution authorized to take
deposits from the public, obtain deposit insurance from the FDIC,
and engage in certain lending activities.

Commercial Mortgage Backed

A security that is collateralized by a pool of commercial

Security (CMBS)

mortgage loans and that makes payments that are based on the
performance of those loans.

Commercial Paper (CP)

Short-term (maturity typically up to 270 days), unsecured
corporate debt.

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Committee on the Global

Monitors developments in global financial markets for central

Financial System

bank governors. The Committee on the Global Financial System
has a mandate to identify and assess potential sources of stress
in global financial markets, to further the understanding of the
structural underpinnings of financial markets, and to promote
improvements to the functioning and stability of these markets.
The Committee on the Global Financial System also oversees the
collection of the BIS international banking and financial statistics..

Committee on Payment and

A committee of central banks hosted by the BIS that sets

Settlement Systems (CPSS)

standards for payment and securities settlement systems.

Core Deposits

Deposits that are stable, lower cost, and reprice more slowly than
other deposits when interest rates change. Core deposits are
typically funds of local customers who also have a borrowing or
other relationship with the bank.

Credit Default Swap (CDS)

A bilateral over-the-counter contract in which one party agrees
to make a payment to the other party in the event of a specified
credit event, in exchange for one or more fixed payments.

Credit Rating Agency

A private company that evaluates the credit quality of debt
issuers, as well as their issued securities, and provides ratings
on the issuers and those securities. Many credit rating agencies
are nationally recognized statistical rating organizations, the
largest of which are Fitch Ratings, Moody’s Investors Service, and
Standard & Poor’s.

Credit Union

A member-owned, not-for-profit cooperative financial institution
formed to permit members to save, borrow, and obtain related
financial services. All federally chartered credit unions and most
state-chartered credit unions provide federally insured deposits
and are regulated by the NCUA.

Dark Pool

A trading network that matches the orders of multiple buyers and
sellers for a financial instrument without displaying quotations to
the public.

Debt Valuation Adjustment (DVA)

A decrease in the mark-to-market value of a bank holding
company’s liability that is booked as a profit.

Defined Benefit Plan

A retirement plan that uses a predetermined formula to calculate
the amount of a participant’s future benefit.

Defined Contribution Plan

A retirement plan in which the amount of the employer’s annual
contribution is specified.

Glossary

191

Depository Institution

A financial institution that is legally permitted to accept deposits
from individuals. Depository institutions include savings banks,
commercial banks, savings and loan associations, and
credit unions.

Discount Window

The Federal Reserve facility for extending credit directly to
eligible institutions.

Farm Credit System

A government-sponsored enterprise created by Congress and
composed of a network of borrower-owned financial institutions
that provide credit to farmers, ranchers, residents of rural
communities, agricultural and rural utility cooperatives, and
other eligible borrowers. The Farm Credit System is the largest
agricultural lender in the United States and is regulated by the
Farm Credit Administration.

Federal Financial Institutions

An interagency body that prescribes uniform principles,

Examination Council (FFIEC)

standards, and report forms for the federal examination of
financial institutions by the Federal Reserve, the FDIC, the NCUA,
the OCC, and the CFPB. The FFIEC makes recommendations to
promote uniformity in the supervision of financial institutions. The
State Liaison Committee (SLC) serves as a voting member. The
SLC includes representatives from the Conference of State Bank
Supervisors, the American Council of State Savings Supervisors,
and the National Association of State Credit Union Supervisors.

Fedwire Funds Service

A real-time gross settlement system owned and operated by the
Federal Reserve Banks that offers participants the ability to send
and receive time-critical payments for their own account or on
behalf of their clients.

Fedwire Securities Service

A book-entry securities transfer system operated by the Federal
Reserve Banks that provides participants safekeeping, transfer,
and delivery-versus-payment settlement services.

FICO Score

A measure of a borrower’s creditworthiness based on the
borrower’s credit data; developed by the Fair Isaac Corporation.

Financial Market Infrastructure

A multilateral system among participating financial institutions,
including the operator of the system, used for the purposes of
recording, clearing, or settling payments, securities, derivatives,
or other financial transactions. Financial market infrastructures
exist in many financial markets to support and facilitate the
transferring, clearing, or settlement of financial transactions.

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Financial Market Utility (FMU)

Subject to certain exclusions, the Dodd-Frank Act defines an FMU
as “any person that manages or operates a multilateral system
for the purpose of transferring, clearing, or settling payments,
securities, or other financial transactions among financial
institutions or between financial institutions and the person.”

Fiscal Consolidation

Government policy aimed at reducing government deficits and the
pace of debt accumulation.

Fiscal Year

Any 12-month accounting period. The fiscal year for the federal
government begins on October 1 and ends on September 30 of
the following year; it is named after the calendar year in which
it ends.

Futures Commission Merchants

Individuals, associations, partnerships, corporations, and trusts

(FCM)

that solicit or accept orders for the purchase or sale of any
commodity for future delivery on or subject to the rules of any
exchange and that accept payment from or extend credit to those
whose orders are accepted.

General Obligation Bond

A type of municipal bond backed by the full faith and credit of the
governmental unit that issues the bond.

Government-Sponsored

A corporate entity that has a federal charter authorized by law but

Enterprise (GSE)

that is a privately owned financial institution.

Gross Domestic Product (GDP)

The broadest measure of aggregate economic activity, measuring
the total value of all final goods and services produced within a
country’s borders during a specific period.

The Group of Twenty Finance

An international forum established in 1999 to bring together

Ministers and Central Bank

officials of systemically important industrialized and developing

Governors (G-20)

economies to discuss key issues in the global economy.

Household Debt Service Ratio

An estimate of the ratio of debt payments to disposable personal
income. Debt payments consist of the estimated required
payments on outstanding mortgage and consumer debt.

Interest Rate Risk Management

Management of the exposure of an individual’s or an institution’s
financial condition to movements in interest rates.

International Association of

International organization that represents insurance regulators

Insurance Supervisors (IAIS)

and supervisors in 190 jurisdictions worldwide. The IAIS issues
global insurance principles, standards and guidance papers to
promote effective insurance supervision.

Glossary

193

International Organization of

An international organization of securities market regulatory

Securities Commissions (IOSCO)

agencies that sets standards for securities markets.

International Swaps and

A trade association of over-the-counter derivatives participants.

Derivatives Association (ISDA)

The ISDA Master Agreements standardized derivative terms to
simplify netting and reduce legal risks for market participants.

Investment-Grade Bond

A bond whose rating is among the highest in creditworthiness as
measured by credit rating agencies.

Large Bank Holding Company

Any bank holding company (BHC) that files the FR Y-9C. All
BHCs with total consolidated assets of $500 million or more are
required to file. Before March 2006, the threshold was $150
million. BHCs meeting certain additional criteria determined by
the Federal Reserve may be required to file regardless of size.

Leveraged Buyout

An acquisition of a company in which the buyer uses borrowed
funds for a significant portion of the purchase price.

Loan-to-Value Ratio (LTV)

The ratio of the amount of a loan to the value of an asset,
typically expressed as a percentage. This is a key metric when
considering the financing of a mortgage.

Marketable Debt

Obligations that can be bought and sold on public
secondary markets.

Mark-to-Market

The process by which the reported value of an asset is adjusted
to reflect its market value.

Maturity Transformation

A condition in which a financial intermediary issues shorter-term
liabilities to fund longer-term assets.

Model Risk

Risk related to using an incorrect model specification. For
example, misspecification can result from programming errors,
technical errors, data issues, or calibration errors.

Money Market Fund (MMF)

A type of mutual fund that is required by law to invest in low-risk
securities and pays dividends that generally reflect short-term
interest rates. MMFs typically invest in government securities,
certificates of deposit, commercial paper, or other highly liquid
and low-risk securities.

Mortgage-Backed Security (MBS) An asset-backed security backed by a pool of mortgages.
Investors in the security receive payments derived from the
interest and principal payments on the underlying mortgages.

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Mortgage Servicer

A company that acts as an agent for mortgage holders by
collecting and distributing mortgage cash flows. Servicers
also handle defaults, modifications, settlements, and
foreclosure proceedings.

Municipal Bond

A bond issued by states, cities, counties, local governmental
agencies, or certain instrumentalities of the state.

Mutual Fund

A type of investment company that issues redeemable securities,
which the fund generally stands ready to buy back from investors
at their current net asset value. Also called an open-end
investment company or open-end fund.

Nationally Recognized Statistical

A credit rating agency that is registered with the SEC as a

Rating Organization

nationally recognized statistical rating organization.

Over-the-Counter (OTC)

A method of trading that does not involve an organized exchange.
In over-the-counter markets, participants trade directly with each
other, typically through voice or computer communication.

Payday Lenders

Lenders that make small, short-term loans to households, with
the loan repayment due in full on the borrower’s pay day.

Personal Consumption

A measurement of the goods and services purchased

Expenditures (PCE)

by households.

Personal Savings Rate

Personal savings as a percentage of disposable personal income.

Prudential Regulation

Regulation aimed at ensuring the safe and sound operation of
financial institutions, set by both state and federal authorities.

Public Company Accounting

A nonprofit corporation established by Congress that oversees the

Oversight Board (PCAOB)

audits of public companies to protect the interests of investors
and further the public interest in the preparation of informative,
accurate, and independent audit reports. PCAOB also oversees
the audits of broker-dealers.

Public Debt

Cumulative amounts borrowed by the Treasury Department or the
Federal Financing Bank from the public or from another fund or
account. The public debt does not include agency debt (amounts
borrowed by other agencies of the federal government).

Q4/Q4

Fourth quarter over fourth quarter. A way of computing the rate
of growth of a statistic over a calendar year by comparing the
statistic’s value in the fourth quarter of the year with its value in
the fourth quarter of the previous year.

Glossary

195

Ratings Uplift

The difference between the stand-alone credit rating assigned by
a credit rating agency to an issuer, based on that issuer’s intrinsic
financial strength, and the higher credit rating that considers the
possibility of implicit external (e.g., government) support.

Receiver

A custodian appointed to maximize the value of the assets of a
failed institution or company and to settle the liabilities.

Repurchase Agreement (Repo)

A transaction in which one party sells a security to another party
while agreeing to repurchase it from the counterparty at some
date in the future at an agreed price.

Reserves

Funds that a depository institution holds against specified
deposit liabilities.

Residential Mortgage-Backed

A security that is collateralized by a pool of noncommercial,

Security (RMBS)

residential mortgage loans and makes payments that are based
primarily on the performance of those loans.

Revenue Bond

A type of municipal bond backed by revenue from the project the
bond finances.

Revolving Credit

A lending arrangement whereby a lender commits to provide
a certain amount of funding to a borrower on demand. The
borrower may generally borrow and repay the committed funding
at any time over the term of the agreement.

Risk-Based Capital

An amount of capital, based on the risk-weighing of various asset
categories, that a financial institution should hold to protect
against adverse developments.

Securities Lending

The temporary transfer of securities from one party to another for
a specified fee and term in exchange for collateral in the form of
cash or securities.

Securitization

A financial transaction in which assets such as mortgage loans
are pooled, and securities representing interests in the pool
are issued.

Self-Regulatory Organization

An organization that has the authority to regulate its members

(SRO)

by establishing and enforcing rules and standards regarding its
members’ conduct.

Short-Term Wholesale Funding

Large-value, short-term funding instruments, exceeding
deposit insurance limits, that are typically issued to institutional
investors. Examples include large checkable and time deposits,
financial open market paper, and repurchase agreements.

196

2 0 1 2 F S O C / / Annual Report

Supervisory Capital Assessment

A stress test, conducted from February to May 2009, designed to

Program (SCAP)

estimate the capital needs of U.S. bank holding companies with
assets exceeding $100 billion under an adverse macroeconomic
scenario; it was administered by the Federal Reserve, OCC,
and FDIC.

Supervisory Information

Generally refers to reports of examination and inspection,
operating and condition reports, and any information derived
from, relating to, or contained in them, and information gathered
by agencies responsible for supervising financial institutions in
connection with any investigation or enforcement action.

Temporary Liquidity Guarantee

A program implemented in October 2008 by the FDIC through a

Program (TLGP)

systemic risk determination to provide liquidity to the banking
industry by restoring banks’ access to funding markets and by
stabilizing bank deposits. The program had two components: the
Debt Guarantee Program and the Transaction Account Guarantee
(TAG) Program.

Term Asset-Backed Securities

A Federal Reserve funding facility that issued loans with terms

Loan Facility (TALF)

of up to five years to holders of eligible asset-backed securities
(ABS). TALF was intended to assist the financial markets in
accommodating the credit needs of consumers and businesses
by facilitating the issuance of ABS collateralized by a variety of
consumer and business loans. TALF was also intended to improve
the market conditions for ABS more generally. The program
began operating in 2009.

Thrift

A financial institution that ordinarily possesses the same
depository, credit, financial intermediary, and account
transactional functions as a bank but that is chiefly organized
and primarily operates to promote savings and home mortgage
lending rather than commercial lending. Also known as a savings
bank, a savings association, or a savings and loan association.

Time Deposits

Deposits that the depositor, generally, does not have the right to
withdraw funds before a designated maturity date without paying
an early withdrawal penalty. A certificate of deposit is a
time deposit.

Tri-Party Repo

A repurchase agreement in which a third-party agent, such as a
clearing bank, acts as an intermediary to facilitate the exchange
of cash and collateral between the two counterparties. In addition
to providing operational services to participants, the tri-party
agents in the U.S. tri-party repo market extend large amounts of
intraday credit to facilitate the daily settlement of tri-party repos.

Glossary

197

Troubled Asset Relief Program

A government program to address the financial crisis, authorized

(TARP)

by the Emergency Economic Stabilization Act of 2008, allowing
the government to purchase or insure up to $700 billion in assets
and equity from financial institutions.

Underwriting Standards

Terms, conditions, and criteria used to determine the extension of
credit in the form of a loan or bond.

Yield Curve

A curve mapping the relationship between bond yields and their
respective maturities.

198

2 0 1 2 F S O C / / Annual Report

Abbreviations
ABCP

Asset-Backed Commercial Paper

ABS

Asset-Backed Security

ADR

American Depository Receipt

AIFP

Automotive Industry Financing Program

AIG

American International Group

ANPR

Advance Notice of Proposed Rulemaking

ARS

Auction Rate Security

ASPL

Aggregate Short Position Limit

AUM

Assets Under Management

BAC

Bank of America

BBA

British Bankers’ Association

BCBS

Basel Committee on Banking Supervision

BD

Broker-dealer

BEA

Bureau of Economic Analysis

BFI

Business Fixed Investment

BHC

Bank Holding Company

BIS

Bank for International Settlements

BLS

Bureau of Labor Statistics

C

Citigroup

C&I

Commercial and Industrial

CBO

Congressional Budget Office

CCAR

Comprehensive Capital Analysis and Review
Abbreviations

199

CCP
CD

Certificate of Deposit

CDS

Credit Default Swap

CFPB

Consumer Financial Protection Bureau

CFTC

Commodity Futures Trading Commission

CHIPS

Clearing House Interbank Payments System

CICI

CFTC Interim Compliant Identifier

CLS

CLS Bank International

CMBS

Commercial Mortgage-Backed Security

CME

Chicago Mercantile Exchange

CMO

Collateralized Mortgage Obligation

CNS

Continuous Net Settlement

CP

Commercial Paper

CPP

Capital Purchase Program

CPPI

Commercial Property Price Index

CPSS

Committee on Payment and Settlement Systems

CRE

Commercial Real Estate

CSD

Central Securities Depository

CU

Credit Union

DCM

Designated Contract Market

DCO

Derivatives Clearing Organization

DOJ

U.S. Department of Justice

DTC

Depository Trust Company

DTCC

200

Central Counterparty

Depository Trust and Clearing Corporation

2 0 1 2 F S O C / / Annual Report

DVA

Debt Valuation Adjustment

E&S

Equipment and Software

EBA

European Banking Authority

ECB

European Central Bank

EFSF

European Financial Stability Facility

EMBI+

Emerging Markets Bond Index Plus

EME

Emerging Market Economies

ESM

European Stability Mechanism

ETF

Exchange Traded Fund

EU

European Union

FAQ

Frequently Asked Questions

FASB

Financial Accounting Standards Board

FCM

Futures Commission Merchant

FDIC

Federal Deposit Insurance Corporation

FFIEC

Federal Financial Institutions Examination Council

FFS

Federal Funds Sold

FHA

Federal Housing Administration

FHFA

Federal Housing Finance Agency

FICC

Fixed Income Clearing Corporation

FICO

Fair Isaac Corporation

FINRA

Financial Industry Regulatory Authority

FIO

Federal Insurance Office

FMU

Financial Market Utility

FOS

Funds Only Settlement

Abbreviations

201

FRB
FRBNY

Federal Reserve Bank of New York

FSA

Financial Services Authority

FSB

Financial Stability Board

FSOC

Financial Stability Oversight Council

FX

Foreign Exchange

FXPB

Foreign Exchange Prime Brokers

G-20

The Group of Twenty Finance Ministers and Central Bank Governors

G-SIB

Globally Systemically Important Bank

GAO

Government Accountability Office

GBP

British Pound Sterling

GCF

General Collateral Finance

GDP

Gross Domestic Product

GM

General Motors

GNMA

Ginnie Mae

GS

Goldman Sachs

GSA

Green Street Advisors

GSD

Government Securities Division

GSE

Government-Sponsored Enterprise

G-SIFI

Globally Systemically Important Financial Institution

HAMP

Home Affordable Modification Program

HARP

Home Affordable Refinance Program

HFT

High-Frequency Trading

HUD

202

Federal Reserve Board

U.S. Department of Housing and Urban Development

2 0 1 2 F S O C / / Annual Report

IAIS

International Association of Insurance Supervisors

IASB

International Accounting Standards Board

ICE

IntercontinentalExchange

IFRS

International Financial Reporting Standards

IMF

International Monetary Fund

IOSCO

International Organization of Securities Commissions

IPO

Initial Public Offering

IRS

Interest Rate Swap

ISDA

International Swaps and Derivatives Association

JPM

JPMorgan Chase

LEI

Legal Entity Identifier

LIBOR

London Interbank Offered Rate

LSOC

Legal Segregation with Operational Commingling

LTRO

Longer-term Refinancing Operations

LTV

Loan-to-Value Ratio

MBS

Mortgage-Backed Security

MBSD

Mortgage-Backed Securities Division

MFG

MF Global

MHA

Making Home Affordable

ML LLC

Maiden Lane LLC

ML II

Maiden Lane II LLC

ML III

Maiden Lane III LLC

MMF

Money Market Fund

MMI

Money Market Instrument

Abbreviations

203

MOL
MS

Morgan Stanley

MVC

Model Validation Council

NAIC

National Association of Insurance Commissioners

NAV

Net Asset Value

NBER

National Bureau of Economic Research

NCUA

National Credit Union Administration

NDF

Non-deliverable Forward

NFIB

National Federation of Independent Business

NMS

National Market System

NPR

Notice of Proposed Rulemaking

NSCC

National Securities Clearing Corporation

NYPC

New York Portfolio Clearing

OCC

Office of the Comptroller of the Currency

OCC

The Options Clearing Corporation (only in Appendix A)

OFR

Office of Financial Research

OITP

Other Important Trading Partners

OLA

Orderly Liquidation Authority

ORSA

Own Risk and Solvency Assessment

OTC

Over-the-Counter

OTS

Office of Thrift Supervision

P&I

Principal and Interest

PCA

Prompt Corrective Action

PCAOB

204

Maximum Obligation Limitation

Public Company Accounting Oversight Board

2 0 1 2 F S O C / / Annual Report

PCE

Personal Consumption Expenditures

PFMI

Principles for Financial Market Infrastructures

PVP

Payment-versus-Payment

Q4/Q4

Fourth Quarter over Fourth Quarter

QRM

Qualified Residential Mortgages

REIT

Real Estate Investment Trust

Repo

Repurchase Agreement

RESPA

Real Estate Settlement Procedures Act

RMBS

Residential Mortgage-Backed Security

ROA

Return on Assets

RTGS

Real Time Gross Settlement

RWA

Risk-Weighted Assets

S&P

Standard & Poor’s

SCAP

Supervisory Capital Assessment Program

SEC

Securities and Exchange Commission

SEF

Swaps Execution Facility

SIFMA

Securities Industry and Financial Markets Association

SIPA

Securities Investor Protection Act

SIPC

Securities Investor Protection Corporation

SLHC

Savings and Loan Holding Company

SLOOS

Senior Loan Officer Opinion Survey

SMP

Securities Markets Programme

SRC

Systemic Risk Committee

SRO

Self-Regulatory Organization

Abbreviations

205

STIF
STRIPS

Separate Trading of Registered Interest and Principal Securities

TAG

Transaction Account Guarantee

TALF

Term Asset-Backed Securities Loan Facility

TARP

Troubled Asset Relief Program

TILA

Truth in Lending Act

TIPS

Treasury Inflation-Protected Securities

TIW

Trade Information Warehouse

TLGP

Temporary Liquidity Guarantee Program

TR

Trade Repositories

UIT

Unit Investment Trust

USD

U.S. Dollar

USDA

U.S. Department of Agriculture

USDE

U.S. Dollar Equivalent

VA

Department of Veterans Affairs

VaR

Value at Risk

VRDO

Variable Rate Demand Obligations

WAL

Weighted Average Life

WAM

Weighted Average Maturity

WFC

Wells Fargo Company

WFE

World Federation of Exchanges

YTD

206

Short Term Bank Common and Collective Investment Funds

Year to Date

2 0 1 2 F S O C / / Annual Report

Notes on the Data
Except as otherwise indicated, data cited in this report is as of July 6, 2012.

Glossary of Certain Government Data Sources
Bank Holding Company Performance Report (BHCPR): Report of financial information produced for select
top-tier bank holding companies and published by the Federal Reserve.
Flow of Funds: Data release compiled and published by the Federal Reserve.
FR 2004: Report of market activity for primary dealers in U.S. government securities published by the
Federal Reserve.
FR Y-9C: Consolidated financial statement for domestic bank holding companies published by the
Federal Reserve.
SLOOS: Survey of senior loan officers on bank lending practices published by the Federal Reserve Board.

Academic Papers Cited in This Report
Copeland, Adam M., Antoine Martin, and Michael Walker. “The Tri-Party Repo Market before the 2010
Reforms,” Federal Reserve Bank of New York Staff Reports, 2010, No. 477.
Bech, Morten L., Antoine Martin, and James McAndrews. “Settlement Liquidity and Monetary Policy
Implementation—Lessons from the Financial Crisis,” Federal Reserve Bank of New York Economic Policy Review 18,
March 2012, No. 1.

Other
Bloomberg data: © 2012 Bloomberg Finance L.P. All rights reserved. Used with permission.
Certain data was obtained through Haver Analytics.
iMoneyNet data made available for use by iMoneyNet subscribers and press, all others please contact
iMoneyNet for subscription information.
Inside Mortgage Finance, 2012 Mortgage Statistical Annual Copyright 2012. www.insidemortgagefinance.com.
® Markit makes no warranty, expressed or implied, as to accuracy, completeness or timeliness, or as to the
results to be obtained by recipients of the products and services described herein, and shall not in any way be
liable for any inaccuracies, errors or omissions herein.
© 2012, Markit Group Limited. All rights reserved. Any unauthorized use, disclosure, reproduction or
dissemination, in full or in part, in any media or by any means, without the prior written permission of Markit
Group Limited is strictly prohibited.
Moody’s data provided by Moody’s Investors Service.
The Risk Management Association’s Aggregate Data Survey (2000–2012).
N o te s o n t h e D a t a

207

List of Charts
Chart 4.1.1	

Change in Real Gross Domestic Product....................................................................23

Chart 4.1.2	

Change in Real Personal Consumption Expenditures...................................................24

Chart 4.1.3	

Personal Saving Rate..............................................................................................24

Chart 4.1.4	

Private Housing Starts.............................................................................................24

Chart 4.1.5	

Net Change in Payroll Employment............................................................................26

Chart 4.1.6	

Civilian Unemployment Rate.....................................................................................26

Chart 4.1.7	

Labor Force Participation Rate.................................................................................26

Chart 4.1.8	

Long-Term Unemployment.......................................................................................27

Chart 4.2.1	

Nonfinancial Corporate Credit Market Debt to Net Worth..............................................27

Chart 4.2.2	

Financial Ratios for Nonfinancial Corporations.............................................................27

Chart 4.2.3	

Bond Issuance by Nonfinancial Firms........................................................................28

Chart 4.2.4	

Corporate Bond Spreads.........................................................................................28

Chart 4.2.5	

Bank Business Lending Standards and Demand.........................................................28

Chart 4.2.6	

Nonfinancial Corporate Bond Default Rate..................................................................29

Chart 4.2.7	

Noncurrent Commercial & Industrial (C&I) Loans.........................................................29

Chart 4.2.8	

CMBS New Issuance...............................................................................................29

Chart 4.2.9	

Noncorporate Assets..............................................................................................30

Chart 4.2.10	 Noncorporate Credit Market Debt to Net Worth..........................................................30
Chart 4.2.11	 Net Borrowing by Nonfinancial Noncorporate Businesses.............................................30
Chart 4.2.12	 Bank Business Lending Standards and Demand.........................................................31
Chart 4.2.13	  mall Businesses’ Difficulty Obtaining Credit..............................................................31
S
Chart 4.2.14	 Household and Nonprofit Balance Sheets..................................................................31
Chart 4.2.15	 Share of Owners’ Equity in Household Real Estate......................................................32
Chart 4.2.16	 Household Debt Service Ratio..................................................................................32
Chart 4.2.17	 Household Financial Obligations Ratio.......................................................................32
Chart 4.2.18	 Nonmortgage Consumer Credit Flows.......................................................................33
Chart 4.2.19	 Average Amount of Revolving Credit Available............................................................33
Chart 4.2.20	 Credit Card Delinquency Rates by Credit Score...........................................................33
Chart 4.2.21	 Applications for Credit.............................................................................................34
Chart 4.3.1	

Net Debt Outstanding as a Percent of GDP................................................................34

Chart 4.3.2	

Federal Unified Budget Surplus.................................................................................34

Chart 4.3.3	

Federal Debt Held by the Public................................................................................35

Chart 4.3.4	

Interest Outlays and Average Maturity of U.S. Public Debt............................................35

Chart 4.3.5	

Change in State and Local Government Debt.............................................................35

Chart 4.3.6	

Change in State Tax Revenue...................................................................................36

Chart 4.3.7	

Change in Local Tax Revenue..................................................................................36
List of Char ts

209

Chart 4.3.8	

Municipal Bond Issuance by Type.............................................................................36

Chart 4.3.9	

Municipal Tax-Exempt Bond Yield Ratios....................................................................37

Chart 4.3.10	 ARS and VRDO Funding of Long-Term Muni Bonds.....................................................37
Chart 4.4.1	

Real GDP Growth...................................................................................................38

Chart 4.4.2	

Developed Market Economies GDP Growth................................................................38

Chart 4.4.3	

Euro Area GDP Growth............................................................................................38

Chart 4.4.4	

ECB Liquidity Providing Operations...........................................................................40

Chart 4.4.5	

Euro-Dollar Implied FX Swap Basis...........................................................................41

Chart 4.4.6	

Total Swap Line Amount Outstanding........................................................................41

Chart 4.4.7	

Emerging Market Economies GDP Growth.................................................................42

Chart 4.4.8	

Net International Financial Flows to EMEs...................................................................42

Chart 4.4.9	

Change in Total Chinese Social Financing..................................................................43

Chart 5.1.1	

Federal Debt Outstanding Held by Public...................................................................45

Chart 5.1.2	

Yield Curve............................................................................................................45

Chart 5.1.3	

Foreign Holders of U.S. Federal Debt........................................................................45

Chart A.1	

S&P Downgrade of U.S. Debt: Flight to Quality...........................................................46

Chart A.2	

S&P Downgrade of U.S. Debt: Effect on Equities........................................................46

Chart 5.1.4	

Euro Area 10-Year Yield Spreads to German Debt.......................................................47

Chart B.1	

Greece: Average Bond Price and CDS.......................................................................48

Chart B.2	

Greece: Debt Exchange...........................................................................................48

Chart 5.1.5	

10-Year Sovereign Debt Yields.................................................................................51

Chart 5.1.6	

Emerging Market Bond Spreads...............................................................................51

Chart 5.1.7	

Price Changes in Selected Equities Indices................................................................52

Chart 5.1.8	

Global Equities.......................................................................................................52

Chart 5.1.9	

U.S. Corporate Bond Spreads—Investment Grade.....................................................52

Chart 5.1.10	 U.S. Dollar Exchange Rates......................................................................................53
Chart 5.1.11	 Commodities..........................................................................................................54
Chart 5.1.12	 Farm Land Prices and Value of Crop Yield.................................................................54
Chart 5.1.13	 Agricultural Real Estate Debt Outstanding..................................................................54
Chart 5.1.14	 Large Bank Holding Company Liability Structure.........................................................55
Chart 5.1.15	 Wholesale Cash Investors........................................................................................55
Chart 5.1.16	 Retail Deposits vs. Short-Term Wholesale Funding......................................................55
Chart 5.1.17	 Estimated Value of the Repo Market..........................................................................57
Chart 5.1.18	 Tri-Party Repo Collateral Distribution.........................................................................58
Chart 5.1.19	 Commercial Paper Outstanding................................................................................58
Chart 5.1.20	 Value of Securities on Loan......................................................................................59
Chart 5.1.21	 Securities Lending Cash Reinvestment......................................................................59
Chart 5.1.22	 National Repeat Sales Home Price Indices.................................................................60
Chart 5.1.23	 Mortgages with Negative Equity................................................................................60
Chart 5.1.24	 Mortgage Delinquency and Foreclosure.....................................................................60

210

2 0 1 2 F S O C / / Annual Report

Chart 5.1.25	 Foreclosure Pipeline................................................................................................61
Chart 5.1.26	 Median Credit Score at Mortgage Origination.............................................................61
Chart 5.1.27	 HARP Refinancings.................................................................................................62
Chart 5.1.28	 Mortgage Originations.............................................................................................63
Chart 5.1.29	 Issuance of RMBS..................................................................................................63
Chart 5.1.30	 GSE Net Income and Losses....................................................................................63
Chart 5.2.1	

Aggregate BHC Pre-Tax Income...............................................................................64

Chart 5.2.2	

Change in Tier 1 Common Ratios for Aggregate U.S. BHCs.........................................65

Chart 5.2.3	

Change in Tier 1 Common Ratios for 19 Largest BHCs...............................................65

Chart 5.2.4	

U.S. Unemployment Rate: Actual vs. Stress Scenarios................................................65

Chart 5.2.5	

Initial and Stressed Tier 1 Common Capital Ratios......................................................66

Chart 5.2.6	

Consolidated Liquidity Ratio for Top 50 BHCs............................................................66

Chart 5.2.7	

Short-Term Wholesale Funding at Largest BHCs................................................. 66, 131

Chart 5.2.8	

Change in Tier 1 Common Ratios for BHCs < $50B...................................................67

Chart 5.2.9	

BHC Dividends and Repurchases..............................................................................67

Chart 5.2.10	 Return on Average Assets........................................................................................68
Chart 5.2.11	 Price-to-Book Ratio of 6 Large Complex BHCs..........................................................69
Chart 5.2.12	 CDS Spreads of 6 Large Complex BHCs........................................................... 69, 128
Chart 5.2.13	 FDIC-Insured Failed Institutions.................................................................................69
Chart 5.2.14	 Commercial Bank and Thrift Pre-Tax Income..............................................................70
Chart 5.2.15	 Commercial Property Price Indices...........................................................................70
Chart 5.2.16	 Concentration of Credit Union Assets........................................................................70
Chart 5.2.17	 Federally Insured Credit Union Income.......................................................................71
Chart 5.2.18	 Credit Union Fixed Rate Real Estate and Long‑Term Assets..........................................71
Chart 5.2.19	 U.S. Branches and Agencies of Foreign Banks: Assets................................................72
Chart 5.2.20	 U.S. Branches and Agencies of Foreign Banks: Liabilities.............................................72
Chart 5.3.1	

Life and Other Insurance: Capital and Income.............................................................73

Chart 5.3.2	

Life Insurers: Impact of Low Rate Environment............................................................73

Chart 5.3.3	

Commercial Mortgage Origination by Lender Type......................................................74

Chart 5.3.4	

Property and Casualty Insurance: Capital and Income.................................................75

Chart 5.3.5	

Money Market Mutual Fund Assets by Fund Type.......................................................75

Chart 5.3.6	

Institutional vs. Retail Money Market Fund Assets.......................................................75

Chart 5.3.7	

Prime Funds Liquidity...................................................................................... 76, 134

Chart 5.3.8	

MMF WAL.............................................................................................................76

Chart 5.3.9	

Gross Yield of 5 Outlier MMF Families.......................................................................76

Chart 5.3.10	 Aggregate Broker-Dealer Assets and Leverage...........................................................77
Chart 5.3.11	 Broker-Dealer Revenues..........................................................................................77
Chart 5.3.12	 Consumer Loans Outstanding..................................................................................77
Chart 5.3.13	 Business Loans Outstanding....................................................................................80
Chart 5.3.14	 Real Estate Investment Trust (REIT) Assets.................................................................80

List of Char ts

211

Chart 5.3.15	 Mutual Fund Flows by Asset Class (2011 to 2012 Q1).................................................80
Chart 5.3.16	 Mutual Fund Taxable Bond Flows (2011 to 2012 Q1)..................................................81
Chart 5.3.17	 Retirement Funds by Type........................................................................................81
Chart 5.3.18	 Public and Private Pension Funding Level...................................................................81
Chart 5.3.19	 U.S. Private Equity AUM..........................................................................................82
Chart 5.3.20	 U.S. Private Equity AUM by Strategy.........................................................................82
Chart 5.3.21	 Change in Hedge Fund AUM....................................................................................82
Chart 5.3.22	 Hedge Fund Performance by Strategy.......................................................................83
Chart 5.3.23	 Growth in ETF Assets and Number of Funds..............................................................83
Chart E.1	

TARP Bank Support Program Status.........................................................................84

Chart E.2	

AIG Investments Committed and Returned.................................................................85

Chart 5.4.1	

Average Trade Size—U.S. Equities...........................................................................86

Chart 5.4.2	

Average Daily Volume Shares by Venue.....................................................................87

Chart 5.4.3	

U.S. Equities Share Volume......................................................................................87

Chart 5.4.4	

Regional Market Share of Trades..............................................................................87

Chart F.1	

HFT % Use in Various Asset Classes.........................................................................88

Chart 5.4.5	

Annual Payment Clearing Volumes............................................................................90

Chart 5.4.6	

Annual Payment Clearing Values...............................................................................90

Chart 5.4.7	

Fedwire Funds Daylight Overdrafts............................................................................90

Chart 5.4.8	

Deciles of Fedwire Value Time Distribution.................................................................91

Chart 5.4.9	

Reserve Balances...................................................................................................91

Chart 5.4.10	 Global OTC and Exchange-Traded Derivatives Growth..................................................91
Chart 5.4.11	 Global Exchange-Traded Derivatives..........................................................................92
Chart 5.4.12	 Exchange-Traded Derivatives Globalization.................................................................92
Chart 5.4.13	 SwapClear Volume..................................................................................................92
Chart 5.4.14	 Outstanding SwapClear Volumes..............................................................................93
Chart 5.4.15	 ICE Clear Credit......................................................................................................93
Chart 5.4.16	 ICE Clear Europe....................................................................................................93
Chart 5.4.17	 Interest Rate Derivatives..........................................................................................94
Chart 5.4.18	 CDS and Other Credit Derivatives.............................................................................94
Chart 7.2.1	
Chart 7.2.2	

U.S. MMF Exposure to Europe...............................................................................125

Chart 7.2.3	

Large U.S. Banks’ Exposure to Europe....................................................................125

Chart 7.2.4	

Insurance Industry Exposure to Europe....................................................................125

Chart 7.2.5	

Real Private Residential Investment.........................................................................126

Chart 7.3.1	

Aggregate BHC Capital Ratios................................................................................127

Chart 7.3.2	

Core Deposits as a Percent of Total Liabilities...........................................................127

Chart 7.3.3	

Short-Term Wholesale Funding...............................................................................127

Chart 7.4.1	

Less-Stable Funding Sources at 6 Largest BHCs......................................................131

Chart H.1	

212

Sovereign Yields................................................................................................... 124

Prime Fund Bank Holdings.....................................................................................135

2 0 1 2 F S O C / / Annual Report

Chart H.2	

Prime Fund Portfolio Composition...........................................................................135

Chart 7.4.2	

Credit Quality of High-Yield New Issues....................................................................140

Chart 7.4.3	

Complex Financial Institutions in 2012..................................................................... 141

Chart 7.4.4	

Assets of the 10 Largest Depository Institutions........................................................142

Chart 7.4.5	

Moody’s BHC Systemic Support Uplift.....................................................................143

Chart 7.4.6	

S&P Current Actual Rating & Market Derived Signal..................................................143

List of Char ts

213

Endnotes
Section 6

Insured depository institutions, Farm Credit System institutions, Fannie Mae, Freddie Mac, and the
Federal Home Loan Banks are not subject to resolution under the OLA.
1

In the case of a failing insurance company, the company is resolved under the relevant state’s
liquidation or rehabilitation process rather than under the FDIC’s receivership process. Special procedures also apply to the resolution of failing financial companies that are broker-dealers.
2

The Council met on August 8, 2011; September 15, 2011; October 11, 2011; October 31, 2011;
November 11, 2011; December 5, 2011; December 21, 2011; February 1, 2012; April 3, 2012; May
22, 2012; June 11, 2012; and July 18, 2012.
3

4

The Freedom of Information Act regulation is available online at www.fsoc.gov.

5

The transparency policy is available online at www.fsoc.gov.

Appendix A
1

12 U.S.C. § 5463(a) (2).

2

12 CFR 1320.10.

3

See 12 U.S.C. § 5462(6).

The list of globally systemically important financial institutions, as determined by the Financial Stability Board, is available at www.financialstabilityboard.org/publications/r_111104bb.pdf
4

5

12 U.S.C. § 611 et seq. (section 25A of the Federal Reserve Act).

6

See 12 U.S.C. § 5462(6).

See Bank for International Settlements, Triennial Central Bank Survey, Report on global foreign
exchange market activity in 2010 (Triennial Survey) (December 2010). The Bank for International
Settlements reports average daily FX market turnover as 3.98 trillion USDE, which is the sum of one
side of each FX transaction in 2010. For the purpose of comparability with statistics provided by
CLS Bank, this value has been doubled and reported as the average aggregate daily value settled in
the FX market.
7

CLS Bank currently settles transactions in 17 currencies: the Australian dollar, British pound, Canadian dollar, Danish krone, euro, Hong Kong dollar, Israeli shekel, Japanese yen, Mexican peso, New
Zealand dollar, Norwegian krone, Singapore dollar, South African rand, South Korean won, Swedish
krona, Swiss franc, and U.S. dollar.
8

By settling the two sides of an FX transaction simultaneously, on a PVP basis, CLS Bank substantially reduces settlement risk to institutions using its services.
9

An ASPL of zero would require that settlement members prefund transactions before settlement
can take place.
10

The maximum potential credit exposure is calculated as the sum of each settlement member’s
ASPL and assumes that each member reaches its ASPL at the same time.
11

Members are not required to meet all additional pay-in calls, though non-compliance may result
in some of their trades not settling at CLS Bank on settlement date and would be considered a
multiple member pay-in failure.
12

See 12 U.S.C. § 5462(6). However, because DCMs are expressly excluded from the definition
of an FMU (the Act specifically states that “the term ‘financial market utility’ does not include – (i)
13

E n d n o te s

215

designated contract markets…”), the activities of CME’s designated contract markets fall outside of
this definition.
CFTC staff calculation based on volume (based on the number of contracts cleared). The underlying data for the calculation is taken from publicly available data compiled by the Futures Industry
Association (FIA). See note 16.
14

DCMs are CFTC-regulated markets for the trading of contracts for sale of a commodity for future
delivery or commodity options. Essentially, they are boards of trade (or exchanges) that operate
under the regulatory oversight of the CFTC, pursuant to Section 5 of the Commodity Exchange Act.
15

16

US Futures & Options Volume
Number of contracts traded and/or cleared
2011
CME Group
ICE Futures US
CBOE Futures Exchange
Chicago Climate Futures Exchange
NYSE Liffe US
US Total
CME Group % of total

3,386,986,678
107,287,467
12,040,074
84,580
20,898,174
3,527,296,973
96%

For example, a central counterparty will net member A’s long exposure in oil (formerly to B) and A’s
short exposure in natural gas (formerly to C), in determining A’s collateral requirements.
17

Generally speaking, hedging activities result in more efficient markets and, ultimately, lower costs
for consumers.
18

The futures and options markets play critical roles in the U.S. financial system because they provide
two important functions. First, market participants such as grain merchants, energy firms, and portfolio
managers use futures and options to reduce the risk to their business associated with volatile prices.
Second, the futures and options markets provide the economy with price discovery (meaning they
help determine the price level for commodities), and because futures prices are determined by supply
and demand, the prices discovered through these markets offer valuable economic information that
determines how (and how much of) these commodities are produced and consumed.
19

20

See 12 U.S.C. § 5462(6).

The list of globally systemically important financial institutions, as determined by the Financial
Stability Board, is available at www.financialstabilityboard.org/publications/r_111104bb.pdf.
21

22

See 12 U.S.C. § 5462(6).

The list of globally systemically important financial institutions, as determined by the Financial
Stability Board, is available at www.financialstabilityboard.org/publications/r_111104bb.pdf.
23

24

See 12 U.S.C. § 5462(6).

This data is as of May 2, 2012. For a complete list of all of ICE Clear Credit’s clearing eligible
products, see www.theice.com/publicdocs/clear_credit/ICE_Clear_Credit_Clearing_Eligible_Products.xls.
25

See ICE Surpasses $15 Trillion Milestone in Global CDS Clearing at http://ir.theice.com/releasedetail.cfm?ReleaseID=545362.
26

As of May 10, 2012, ICE Clear Credit’s clearing members were: Bank of America, N.A., Barclays
Bank PLC, Barclays Capital Inc., BNP Paribas, BNP Paribas Securities Corp., Citibank N.A., Citigroup Global Markets Inc., Credit Suisse International, Credit Suisse Securities (USA) LLC, Deutsche
Bank AG, London Branch, Deutsche Bank Securities Inc., Goldman, Sachs & Co., Goldman Sachs
International, HSBC Bank USA, N.A., HSBC Securities (USA) Inc., JPMorgan Chase Bank, National
Association, J.P. Morgan Securities LLC, Merrill Lynch International, Merrill Lynch, Pierce, Fenner
& Smith, Incorporated, Morgan Stanley Capital Services LLC, Morgan Stanley & Co. LLC, Nomura
27

216

2 0 1 2 F S O C / / Annual Report

International PLC, Nomura Securities International, Inc., Société Générale, The Royal Bank of Scotland plc, UBS AG, London Branch, and UBS Securities LLC.
For example, a central counterparty will net member A’s long exposure in one CDS index (formerly
to B) and A’s short exposure in a different, but risk-related CDS index (formerly to C), in determining
A’s collateral requirements.
28

According to the Bank for International Settlements, “Amounts outstanding with central counterparties…increased to about 17% of the total market at end-June 2011, after reaching 15% at endDecember 2010.” The BIS report is available at: www.bis.org/publ/otc_hy1111.pdf.
29

Derivatives Clearing Organization General Provisions and Core Principles, 76 FR 69334 (Nov. 8,
2011).
30

The CDS market plays a critical role in the U.S. financial system for financial market institutions
because it facilitates lending and corporate finance activity among such participants, which can be
crucial in a tight credit environment. In addition, just as equity investors use indexes (such as the
S&P 500) to hedge against broad market moves, credit indexes serve a similar purpose for credit
investors (protecting assets) and issuers (locking in advantageous issue levels).
31

32

See 12 U.S.C. § 5462(6).

The list of globally systemically important financial institutions, as determined by the Financial
Stability Board, is available at www.financialstabilityboard.org/publications/r_111104bb.pdf.
33

34

See 12 U.S.C. § 5462(6).

The list of globally systemically important financial institutions, as determined by the Financial
Stability Board, is available at www.financialstabilityboard.org/publications/r_111104bb.pdf.
35

A portion of the clearing fund assets must be used to collateralize the secured line of credit and
will not be available in addition to the credit itself if the line of credit is drawn upon.
36

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Financial Stability Oversight Council
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Washington, D.C. 20220
www.fsoc.gov


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102