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FIN A NCIA L STA BILIT Y
O V E R S I G H T C O U N C I L

2013

ANNUAL

REPORT

Financial Stability Oversight Council
The Financial Stability Oversight Council (Council) was established by the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act) and is charged with three
primary purposes:
1.

2.

3.

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.
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.
To respond to emerging threats to the stability of the U.S. financial system.

Pursuant to the Dodd-Frank Act, the Council consists of ten voting members and five
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:
•	
•	
•	
•	
•	
•	
•	
•	
•	
•	

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:
•	
•	
•	
•	
•	

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 April 25, 2013. Except as otherwise indicated, data cited in this report
is as of March 25, 2013.

Abbreviations for Federal Member Agencies of the Council
•	

•	
•	
•	
•	
•	
•	
•	
•	

ii

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)

2 0 1 3 F S O C / / Annual Report

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.......................15
3.3.Progress on Financial Reform................................................................18

4	 Macroeconomic Environment..................................... 21
4.1. U.S. Economic Activity...........................................................................21
4.2.Nonfinancial Balance Sheets..................................................................24
4.3.Government Finance..............................................................................30
BOX A:  Macroeconomic and Financial Market Impacts
of the Fiscal Cliff and Debt Ceiling...........................................................32

4.4.External Environment.............................................................................36

5	 Financial Developments.............................................. 43
5.1. Asset Valuations................................................................................... 43
BOX B:  Global Monetary Policy Actions................................................................48

5.2.Wholesale Funding Markets.................................................................. 64
5.3.Bank Holding Companies and Depository Institutions.............................69
5.4.Nonbank Financial Companies...............................................................81
BOX C:  Convexity Event Risk................................................................................88

5.5.Investment Funds................................................................................. 90
5.6.Financial Market Infrastructure............................................................. 99
BOX D:  Collateral Availability.............................................................................. 108

6	 Regulatory Developments; Council Activities...........111
6.1. Safety and Soundness......................................................................... 111
6.2.Financial Infrastructure, Markets, and Oversight.................................. 117
BOX E:. International Coordination on Derivatives Reform,
Including Global Margining.................................................................... 121
C o n te n t s

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6.3.Consumer and Investor Protection.......................................................123
6.4.Data Standards...................................................................................126
6.5.Council Activities.................................................................................128

7	 Potential Emerging Threats...................................... 133
7.1. Fire Sales and Run Risk Vunerabilities..................................................133
7.2. Operational Risk..................................................................................135
7.3. Reliance Upon Reference Rates as a Vulnerability................................137
BOX F:  Lessons Learned From Superstorm Sandy............................................. 138

7.4. Financial System Vulnerability to Sudden Spikes
in Fixed Income Yields.........................................................................142
7.5. Foreign Economic and Financial Developments....................................144
7.6. Risk-Taking Incentives of Large, Complex,
Interconnected Financial Institutions....................................................146
BOX G:  Bank Consolidation and Financial Stability Policy................................... 148

References......................................................................151
Abbreviations................................................................. 155
Glossary......................................................................... 165
List of Charts................................................................. 181
Endnotes........................................................................ 187

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1

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 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 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.

Jacob J. Lew
Secretary of the Treasury
Chairperson, Financial Stability Oversight Council

Ben S. Bernanke
Chairman
Board of Governors of the Federal Reserve System

Thomas J. Curry
Comptroller of the Currency
Office of the Comptroller of the Currency

Richard Cordray
Director
Bureau of Consumer Financial Protection

Mary Jo White
Chair
Securities and Exchange Commission

Martin J. Gruenberg
Chairman
Federal Deposit Insurance Corporation

Gary Gensler
Chairman
Commodity Futures Trading Commission

Edward J. DeMarco
Acting Director
Federal Housing Finance Agency

Debbie Matz
Chairman
National Credit Union Administration

S. Roy Woodall, Jr.
Independent Member with Insurance Expertise
Financial Stability Oversight Council
M e m b e r S t a te m e n t

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2

Executive Summary

Since the Council’s last annual report, the U.S. financial system has continued to strengthen, with
increased capital and liquidity levels for core financial institutions and further improvements in financial
market infrastructure. Market discipline has provided a tailwind for regulatory efforts to promote the
conduct of financial transactions in a transparent and standardized fashion, particularly when compared
to the opaque securitization techniques used in the run-up to the financial crisis. Investor confidence has
also risen, as seen in further improvements of equity, fixed income, and housing markets. In addition,
implementation of the Dodd-Frank Act and international coordination on G-20 reform priorities have
brought significant progress towards establishing a more resilient and stable financial system, both
domestically and globally. Despite these positive developments, significant risks to the financial stability
of the United States remain. This year’s annual report is organized around seven themes, which recur
throughout the sections of the report.
The first theme concerns vulnerability to runs in wholesale funding markets that can lead to destabilizing
fire sales. In the past year, the Council took concrete steps in supporting the implementation of structural
reforms to reduce the likelihood of run risks of money market mutual funds (MMFs) by issuing proposed
recommendations for reform under Section 120 of the Dodd-Frank Act. There has been some progress
in reforming the tri-party repo market, though vulnerabilities to fire sales remain. Secondly, the housing
finance system continues to rely heavily on government and agency guarantees, while private mortgage
activity remains muted. The third theme concerns operational risks, which can cause major disruptions
to the financial system. Such risks include technological and operational failures, natural disasters,
and cyberattacks, and can arise from external or internal sources. The fourth theme consists of the
reliance on reference interest rates, which recent investigations have demonstrated were manipulated,
particularly in the case of the London Interbank Offered Rate (LIBOR). The international regulatory
community is moving forcefully to reform the governance and integrity of LIBOR and to consider
transitions towards alternative benchmarks. The fifth theme concerns the need for financial institutions
and market participants to be resilient to interest rate risk. Yields and volatilities in fixed income markets
are very low by historical standards, providing incentives for market participants to “reach for yield” by
increasing leverage, by engaging in maturity transformation, or by investing in less creditworthy assets,
thus potentially increasing exposure to risks of sudden spikes in yields. The sixth theme concerns longterm fiscal imbalances, as the absence of bipartisan agreement on U.S. fiscal adjustment has raised
questions about whether long-term fiscal problems may be resolved smoothly. The seventh theme is about
the United States’ sensitivity to possible adverse developments in foreign economies. Throughout the
remainder of this executive summary, these seven themes are discussed in more detail.

Fire Sale and Run Vulnerabilities
Although many of the least stable funding structures that failed in the crisis have disappeared,
important run risks in the financial system persist. The risks have been reduced in recent years due to
regulatory action and the still relatively recent memories of the crisis: wholesale funding market activity
is generally reduced, securities broker-dealers have markedly reduced leverage, and regulations have
diminished sponsorship of off-balance sheet vehicles by large financial institutions. In other instances,
severe investor losses during the crisis extinguished demand for some products and structures. However,
run risks in sectors such as MMFs and broker-dealers continue to persist. As witnessed in the financial

E xe c u t i v e S u m m a r y

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crisis, susceptibility to runs and reliance on confidence-sensitive funding by these entities can induce fire
sales in times of market stress.
MMFs’ susceptibility to runs could trigger fire sales of assets, impair the flow of short-term financing, and
propagate strains throughout the financial system. In the past year, the Council took concrete steps in
supporting the implementation of reforms to mitigate structural vulnerabilities of MMFs. In November 2012,
the Council proposed recommendations for public consideration regarding MMF reform, under Section
120 of the Dodd-Frank Act, with three alternatives: (1) a floating net asset value (NAV) for MMFs; or (2) the
introduction of a NAV buffer and a minimum balance at risk (MBR) for investors; or (3) a risk-based NAV
buffer of 3 percent in addition to other measures. The public comments on this proposal are currently under
review by the Council and the SEC, which is also examining the characteristics of MMFs’ susceptibility to runs.
The tri-party repo market remains vulnerable to runs by lenders in the event that concerns emerge regarding
the financial condition of borrowers such as securities broker-dealers, who depend heavily on this channel
for short-term funding. Additional risks stem from the continued heavy reliance on discretionary intraday
credit in the settlement process, and the limited capacity of lenders to manage the ramifications of a default
by a major borrower. Some progress has been made in increasing the resiliency of the tri-party market. The
reliance on intraday credit extended by the clearing banks has begun to decline and, as additional changes
are made to the settlement process, should be largely eliminated by the end of 2014. Nonetheless, a default
of a large broker-dealer or other large borrower would leave lenders with large volumes of collateral that they
would likely seek to liquidate quickly.

Housing Finance Reform
Housing market developments in 2012 were generally positive, with indicators showing a fragile but steady
recovery. For example, housing prices have continued to rise since early 2012, while the percentage of
properties with negative equity has declined. Mortgage delinquencies have also declined, as has the rate
of new delinquencies and the inventory of properties in foreclosure, suggesting a slow return to a firmer
market. However, the housing market remains vulnerable to macroeconomic trends, and a fair number
of potential borrowers remain unable to obtain mortgage credit because of conservative underwriting
standards with respect to low or negative equity or relatively low credit scores. Finally, though the
inventory of bank-owned properties is generally declining, foreclosure timelines in some states remain
extraordinarily long, resulting in a continued overhang of distressed properties.
The housing finance system continues to draw on significant federal government support. Increasing the
presence of private capital in assuming credit risk in housing finance remains a priority. In spite of the
apparent stabilization in U.S. housing markets, both new loan origination volumes (loans used to purchase
homes, as opposed to refinancing existing loans) and the appetite to assume credit risk in mortgage
markets remain quite subdued post-crisis. There is very limited new private mortgage securitization activity
other than small-scale issuance of very-high-quality jumbo prime loans. Reduced purchase loan origination
volumes in the wake of the crisis may be due, in part, to constraints on origination capacity, continued
uncertainty over mortgage put-backs to lenders as litigation over legacy originations has increased the risk
and cost to both originators and issuers, and some market participants’ unwillingness to provide capital
except for agency- and government-guaranteed entities until certain regulations take effect.
In 2012, steps were taken towards establishing a new framework for housing finance and providing more
clarity to market participants, though much remains to be done. The Treasury and FHFA announced new
steps to expedite the wind-down of Fannie Mae and Freddie Mac, two government-sponsored enterprises
(GSEs). The GSEs continued to increase their guarantee fees, or the price of insurance that they provide to
protect bondholders from credit risk, in an effort to encourage private capital participation in the market.
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Keeping with this trend, the Federal Housing Administration (FHA) increased its mortgage insurance
premia in 2012. The FHFA and the GSEs also announced a new representations and warranties framework
to clarify originators’ purchase exposure and liabilities on new loans sold to the GSEs. The CFPB finalized
the following significant rules: the loan originator compensation rule, the mortgage servicing rules,
and the ability-to-repay rule, including the definition of a qualified mortgage (QM). These rulemakings
represent first steps towards removing uncertainty surrounding underwriting and servicing practices and
representations and warranties, which are critical to improving mortgage origination and securitization
issuance volumes.

Operational Risks
Major disruptions to the financial system can also arise from operational risks. Technological failures,
natural disasters, and cyberattacks can emanate from anywhere, at any time. Preparation and planning to
address these potential situations are essential to maintain the strength and resilience of our financial system.
One area of particular concern is the potential for systems failures in an environment where trading activity
is more dispersed and automated. The extremely high speeds at which markets operate today can compound
the overall impact of even small operational failures by propagating errors quickly and widely. In 2012,
equity markets experienced a number of control problems, highlighting the fragile relationship between
technological infrastructure and market stability. While bringing many advantages, technological advances
are not without risks. Recent significant systems issues include malfunctions in connection with the initial
public offerings of BATS Global Markets, Inc. (BATS) and Facebook, Inc., as well as losses suffered by
Knight Capital Group Inc. (Knight Capital) caused by errors in its systems related to routing orders. These
events have occurred notwithstanding current regulatory requirements and oversight programs relating to
technology standards and safeguards. The SEC is moving to help ensure robust system controls and, in March
2013, proposed Regulation Systems Compliance and Integrity (Regulation SCI) to strengthen the automated
systems of important market participants in the securities markets.
Financial infrastructure was also tested in 2012 by the impact of Superstorm Sandy. While the storm caused
severe damage to energy, telecommunications, and transportation infrastructures upon which markets
depend, critical post-trade financial utilities, including core settlement and clearing functions, operated
normally from their primary or contingency sites. Certain trading venues, such as the New York Stock
Exchange (NYSE) and NASDAQ, as well as over-the-counter (OTC) money and fixed income markets, were
closed for various periods on October 29 and 30, 2012. On the retail services side, currency inventories were
adequate, and ATMs generally were available outside the hardest hit areas. At the individual firm level, the
majority of institutions successfully employed their contingency plans and disaster recovery vendors, and most
contingency sites worked well. Effective governmental assistance through federal interagency coordination,
federal-state coordination, public-private partnerships, and targeted financial regulatory relief helped to
resolve issues and ensure adequate communication among affected parties. Despite the limited impact on
the financial sector, post-Sandy assessments still identified a number of potential improvements in the areas
of contingency planning and testing, incident management around market closures, and positioning of key
management and staff, and improvements to further mitigate dependencies on power, transportation, and
communications infrastructures.
During 2012, more than a dozen financial institutions were subject to sustained and persistent cyberattacks.
These attacks disrupted online access to consumer websites, causing inconvenience and annoyance to
customers, increased costs, and significantly elevated demand for mitigation service providers. To date, we
have not seen disruptions to market functioning or the health of the financial system from these attacks;
ongoing vigilance is required, though. In addition, improved cooperation across firms and industries is
necessary as the volume and sophistication of attacks increase. Public-private partnerships could further
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improve the analysis and dissemination of robust information to facilitate real-time responses to cyberattacks.
Furthermore, enhanced cybersecurity education directed to employees and consumers could improve
protection, mitigation, and responses.

Reforms of Reference Rates
Investigations by regulators across the globe concerning manipulations of LIBOR have exposed the structural
vulnerabilities of a voluntary and self-regulated regime for self-reported rates, particularly where underlying
transactions are limited or nonexistent. These benchmark interest rates in various currencies are the basis
for hundreds of trillions of dollars of swap transactions in notional amount, commercial and consumer loans,
futures contracts, and other financial derivatives products traded in OTC markets and exchanges around
the world. Approximately $350 trillion notional amount of interest rate swaps and $10 trillion of loans are
indexed to LIBOR alone. Given the number of transactions that rely on LIBOR and similar rates, problems
with these rates can more broadly threaten public confidence in the integrity of markets.
Recent investigations uncovered systematic manipulations of reference rate submissions, designed to increase
potential profit and signal relative financial health by submitting firms. These schemes affected LIBOR
submissions as well as similar rates such as the Euro Interbank Offered Rate (EURIBOR) and the Tokyo
Interbank Offered Rate (TIBOR). In the United States, the CFTC issued orders against Barclays, UBS AG,
and the Royal Bank of Scotland. The orders charged the banks with manipulating, attempting manipulation,
and false reporting, resulting in penalties of more than $1.2 billion in the United States, and over $2.5
billion globally. These manipulations were made possible in part by a decline in eligible transactions used to
support rate submissions in recent years, most notably as short-term funding markets have moved away from
unsecured lending between banking institutions.
The international regulatory community is moving forcefully to reform the governance and integrity of
LIBOR and to consider transitions towards alternative benchmarks. The CFTC and Department of Justice
(DOJ) settlement included requirements for banks to take specified steps to ensure the integrity and
reliability of their LIBOR and other benchmark interest rate submissions. In the United Kingdom, the
Financial Services Authority (FSA) has implemented reforms of LIBOR based on the recommendations of
the Wheatley Review, which include a number of major revisions to the system of governance, calculation, and
oversight. Committees across multiple international regulatory agencies are further engaged in developing
improved governance and reporting frameworks for reference rates and considering alternative benchmarks.
These international groups include organizations spanning central banks and regulators, such as the Bank
for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO).

Fixed Income Valuations and Low Interest Rate Environment
Fixed income markets are currently characterized by low yields across the maturity and credit spectrum. In
addition, realized and implied volatilities in fixed income and equity markets are subdued and have reached
levels not seen since early 2007. The current low level of yields reflects three underlying factors. The first
factor is the market expectation of future short-term interest rates, which is driven by expected monetary
policy. Globally, central banks have been easing monetary policy in order to aid recovery from the global
financial crisis, and the Federal Reserve has provided explicit short-term rate guidance tied to economic
conditions. The second factor keeping yields low is related to the pricing of interest rate risk. The pricing
of risk can be gauged by term premia for Treasury securities, which are estimated to be at their lowest since
the early 1960s. The pricing of risk reflects a gradual shift in the composition of buyers towards those who
are less risk-sensitive, particularly due to the large-scale asset purchase programs of the Federal Reserve and
other central banks. Finally, the third factor contributing to low yields is that investor appetite for credit risk
in fixed income markets has been increasing, albeit from a low level. Credit losses and provisions have been

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declining over many months. Credit yields are thus low due to the low Treasury yields and the improved
outlook for solvency risk.
The implications of changes in asset prices for financial stability depend on how these assets are funded, the
extent to which valuations are accompanied by leverage or maturity transformation, and whether investors
have sufficient information about the risk-return tradeoffs in their decisions. Recent changes in asset prices
have not been accompanied by the broad-based increases in leverage and maturity transformation that took
place prior to 2007. Nevertheless, yield-seeking behavior, which is supported by low levels of market volatility,
is apparent in several markets. In credit markets, the issuance of high-yield bonds reached a historical high
in the fourth quarter of 2012, and leveraged loan issuance was also elevated. While underwriting standards
remain conservative in many markets, there are some examples of loosening standards. For example,
there are signs of weakening underwriting standards in the types of covenants employed in certain newly
issued bonds and loans. The issuance of collateralized loan obligations (CLOs) is similarly close to peak
levels, coinciding with the rise in high-yield loan and bond issuance. CLOs provide investors with leveraged
exposure to non-investment grade corporate credit. In addition, assets under management for corporate
bond mutual funds and exchange-traded funds have grown rapidly. Other investors, such as pension funds
and hedge funds, have also absorbed much of the new supply in credit markets.
Adding duration risk by investing in longer-maturity assets is another form of yield-seeking behavior. In
the commercial banking sector, publicly available data indicate that the mismatch between the average
maturity of assets and average maturity of liabilities has increased recently at smaller banks, though not at
large institutions. Insurance companies and pension funds are also exposed to interest rate risk. Certain real
estate investment trusts (REITs), known as agency REITs, are REITs that invest in agency mortgage-backed
securities (MBS) and are primarily funded through repo markets. Agency REITs are actively engaged in
leveraged maturity transformation. While the sector has reduced leverage somewhat since the crisis and,
at present its holdings are not very large compared to the overall MBS market, it has grown considerably in
recent years. A shock to agency REITs could induce repo lenders to raise margins or pull back funding, which
in turn could compel agency REITs to sell into a declining market, potentially impacting MBS valuations
significantly.
Yields and volatilities are expected to return to more normal levels over the long term. A gradual
normalization in the context of a strengthening recovery does not pose a significant threat to financial
stability. By contrast, a sudden spike in yields and volatilities could trigger a disorderly adjustment, and
potentially create outsized risks. The threats to financial stability posed by reaching for yield are mitigated by
the same improvements in the resiliency of the financial system that reduce vulnerability to other potential
dangers. Greater resilience is the result of strong reform efforts in recent years, as well as still subdued risk
taking by some market participants in the aftermath of the events of 2008. The capital and liquidity buffers of
the banking system have continued to grow over the past year, and nonbank credit intermediation activity has
declined since 2008. Overall, both the willingness and the ability of investors to take on leverage have been
reduced for a variety of reasons.

Market and Economic Impact of Fiscal Policy
Notwithstanding the overall improvement in the U.S. financial system, concerns persist about economic and
financial market impacts of long-term fiscal imbalances. In particular, the process of U.S. fiscal adjustment
has raised questions about the manner in which long-term fiscal issues will be resolved. In 2012, financial
markets continued to respond to fiscal and political uncertainty, though market volatility was impacted less
than was the case during the debt ceiling crisis in 2011.

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A series of automatic tax increases and spending cuts, the so-called fiscal cliff, were set to take effect at
the start of 2013. In addition, the statutory debt ceiling was reached on December 31, 2012 (although
extraordinary measures authorized by law were available to postpone the date that the United States would
otherwise default on its obligations by about two months). The passage of the American Taxpayer Relief
Act of 2012 (ATRA) on January 1, 2013 reduced uncertainty for market participants by cancelling the tax
increases for most U.S. households and deferring the budget cuts for several months. Furthermore, a number
of business and personal tax measures were put in place, including a permanent resolution for Alternative
Minimum Tax provisions. In February, the debt ceiling was suspended until mid-May. After the initial
response to the legislation, the financial market impact of these fiscal developments has been minimal so far.
In financial markets, the consequences of failing to increase the debt ceiling were generally seen as distinct
from and more immediately serious than the effects of the fiscal cliff. In particular, the effects of the
fiscal cliff would accrue over time as households, businesses, and governments adjusted their spending
and investment decisions. However, the inability of the Treasury to borrow might cause an interruption
of principal and interest payments on U.S. sovereign debt, which financial markets regard as one of the
safest assets. With these “flight to quality” characteristics in mind, the approach of the fiscal cliff had mixed
effects on financial markets. Downside concerns increased the volatility of certain Treasury bills considered
at risk for extension or missed payments. However, the prices of safe haven assets rose, including longerdated Treasury securities, though to a lesser extent than in August 2011, when Standard & Poor’s (S&P)
downgraded its rating of U.S. debt.

Foreign Financial Developments
While sentiment in U.S. financial markets has improved, United States financial stability remains sensitive to
possible adverse developments in global markets and among our major trading partners. Threats to financial
stability in the United States from developments related to the euro area decreased in the latter part of
2012, although recent developments in Cyprus indicate that significant downside risks remain. The markets’
perception of reduced tail risks relative to early 2012 is partially due to policy efforts in the euro area to
restore financial stability. These actions have, at least temporarily, been successful in preventing significant
dislocations in financial markets.
Notably, the European Central Bank (ECB) created the Outright Monetary Transactions (OMT) program,
allowing the ECB to purchase sovereign debt of member states that are in compliance with a reform program
at the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM). The OMT
helped to reverse the steep rise of peripheral sovereign debt yields, which have declined markedly since the
program’s announcement. The European Union (EU) reached a political agreement to place euro-area
banks, as well as banks in non-euro countries that opt in, under the overarching supervision of the ECB.
Together these efforts helped to improve bank access to market funding and reduced reliance on ECB
funding. Governments of vulnerable countries undertook important efforts to consolidate fiscal positions,
strengthen banking systems, and advance reforms to boost growth prospects, and received support from the
ESM and the International Monetary Fund (IMF). The Spanish government narrowed its fiscal deficit and
made progress toward recapitalizing its banking system, while European authorities took additional actions
to support Greece. However, Cyprus’ recent difficulties serve as a reminder that many countries within the
euro area remain in a vulnerable position, and underscore the importance of moving forward with efforts to
strengthen the foundations of a monetary union. Despite these aggressive policy actions and financial market
recovery, substantial challenges remain. While fiscal austerity has narrowed euro-area countries’ deficits,
this same fiscal austerity has contributed to a contraction in euro-area economies. Moreover, access to credit
remains highly constrained across many vulnerable countries, as financial markets across the euro area
remain fragmented. Many countries in Europe remain in the midst of deep and prolonged recessions. The

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European Commission forecasts reflect an anemic economic outlook, predicting a GDP contraction of 0.3
percent across the euro area in 2013, following a contraction of 0.6 percent in 2012.
Countries outside the euro area also face tough policy tradeoffs. Confronted with recession, many
governments face an uphill battle to reduce budget deficits and maintain the social consensus necessary to
advance fiscal reforms. Such fiscal tightening may leave advanced economies vulnerable to new financial
shocks and to slower economic growth. Just as in the euro area, real GDP also contracted in Japan and the
United Kingdom. In Japan, the central bank adopted a 2 percent inflation target in coordination with the
Ministry of Finance, as advocated for by the newly-elected Prime Minister, Shinzo Abe, who pledged to
enact stimulus to boost growth and end deflation. The yen depreciated by 8.7 percent against the dollar to
¥/$ 86.7 during the second half of 2012, and depreciated by an additional 12.5 percent to ¥/$ 97.6 in 2013
through early April. The U.S. has a strong financial stability interest in Japan finally escaping from deflation
and securing more robust growth. Japan’s fiscal outlook remains challenging. Japan’s fiscal deficit is likely to
remain at 10 percent of GDP in 2013, the same as 2012, as the fading of reconstruction spending is roughly
offset by the Abe Administration’s fiscal stimulus. Foreign developments require continuous monitoring of
the U.S. financial sectors’ vulnerabilities, capital and liquidity reserves and risk management practices.

Outline
The remainder of the report is organized in five sections. Section 3 presents the recommendations of the
Council. Section 4 reviews recent macroeconomic developments. Section 5 provides an update of financial
developments, including asset valuations, wholesale funding, bank holding companies and depository
institutions, nonbank financial companies, investment funds, and financial market infrastructures. Section
6 reviews regulatory developments and summarizes Council activity since the 2012 annual report. Section 7
discusses potential emerging threats, including threats from fire sale and run risk vulnerabilities, operational
risks, reliance upon reference rates as a vulnerability, financial system vulnerability to sudden spikes in fixed
income yields, foreign economic and financial developments, and risk-taking incentives of large, complex,
interconnected financial institutions.

E xe c u t i v e S u m m a r y

9

3

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

3.1.1

Reforms of Wholesale Funding Markets

Money Market Funds
The Council took concrete steps to support the implementation of structural reforms to mitigate the
vulnerability of money market mutual funds (MMFs) to runs, a recommendation made by the Council
in its 2011 and 2012 annual reports. In November 2012, the Council issued Proposed Recommendations
Regarding Money Market Mutual Fund Reform, under Section 120 of the Dodd-Frank Act.1 This action
followed the decision by SEC Commissioners not to move forward with the MMF reforms as proposed by
their staff in August 2012.
The Council’s proposed recommendations included three alternatives for public consideration:
•	

•	

•	

Alternative One: Floating Net Asset Value. Require MMFs to have a floating net asset value
(NAV) per share by removing the special exemption that currently allows MMFs to utilize
amortized cost valuation and/or penny rounding to maintain a stable $1.00 NAV.
Alternative Two: Stable NAV with NAV Buffer and Minimum Balance at Risk. Require MMFs
to have a NAV buffer with a tailored amount of assets of up to 1 percent to absorb day-to-day
fluctuations in the value of the funds’ portfolio securities and allow the funds to maintain a
stable NAV. The NAV buffer would be paired with a requirement that 3 percent of a shareholder’s
highest account value in excess of $100,000 during the previous 30 days—a minimum balance
at risk (MBR)—be made available for redemption on a delayed basis. In the event that an
MMF suffers losses that exceed its NAV buffer, the losses would be borne first by the MBRs of
shareholders who have recently redeemed, providing protection for shareholders who remain in
the fund.
Alternative Three: Stable NAV with NAV Buffer and Other Recommended Measures. Require
MMFs to have a risk-based buffer of 3 percent of NAV to provide explicit loss-absorption
capacity that could be combined with other measures to enhance the effectiveness of the buffer
and potentially increase the resiliency of MMFs. The other measures include more stringent
investment diversification requirements, increased minimum liquidity levels, and more robust
disclosure requirements.

The public comment period on the Council’s proposed recommendations closed on February 15, 2013.
The Council received approximately 150 comment letters on its proposed recommendations and is in
the process of reviewing those comments. The SEC, by virtue of its institutional expertise and statutory
authority, is best positioned to implement reforms to address the risk that MMFs present to the economy.

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11

If the SEC moves forward with meaningful structural reforms of MMFs before the Council completes its
Section 120 process, the Council expects that it would not issue a final Section 120 recommendation to the
SEC. The Council understands the SEC is currently in the process of considering further regulatory action.
To inform this examination, SEC staff produced a report, requested by certain SEC Commissioners, on
the causes of investor redemptions in prime MMFs during the 2008 financial crisis, on changes in certain
characteristics of MMFs before and after the SEC’s 2010 modifications to MMF regulation, and on the
potential effect of further reform of MMFs on investor demand for MMFs and alternative investments.2
The Council also recommends that the SEC consider the views expressed by commenters on the Council’s
proposed recommendations and by the Council as the SEC considers any regulatory action to improve
loss-absorption capacity and mitigate MMFs’ susceptibility to runs. The Council further recommends that
its members examine the nature and impact of any structural reform of MMFs that the SEC implements to
determine whether the same or similar reforms are warranted for other cash-management vehicles, including
non-Rule 2a-7 MMFs. Such an examination would provide for consistency of regulation while also decreasing
the possibility of the movement of assets to vehicles that are susceptible to large-scale runs or otherwise pose
a threat to financial stability.

Tri-Party Repo
In its 2012 annual report, the Council highlighted the tri-party repo market’s vulnerabilities and noted a lack
of progress in addressing them. The vulnerabilities are as follows:
•	
•	
•	

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.
Lack of a mechanism to ensure that tri-party repo investors do not conduct disorderly, uncoordinated
sales of their collateral immediately following a broker-dealer’s default.

Reliance on intraday credit is beginning to decline. Two government securities clearing banks, JPMorgan
Chase (JPM) and Bank of New York Mellon (BNYM), have made operational and technological changes
that reduce the intraday credit they extend. As a result of these efforts, market participants have begun to
adjust their behavior in ways that reduce market demand for intraday credit. Consequently, intraday credit
has declined to approximately 80 percent of market volume, down from 100 percent as of the Council’s 2012
annual report.
JPM and BNYM plan to implement further technology and operational changes through 2013 and 2014.
These changes will improve the resiliency of tri-party settlement by making clearing bank intraday credit
available only on a pre-committed basis, and by reducing the intraday credit supplied by the clearing banks to
no more than 10 percent of volume by late 2014.
Some signs of improvement in broker-dealer liquidity risk management practices. With the active
encouragement of relevant supervisors and regulators, broker-dealers have made progress in reducing
their reliance on short-term secured funding. The proportion of overnight funding fell from 64 percent
in December 2011 to 59 percent in December 2012 (non-government assets shifted from 41 percent to
33 percent).
The risk of fire sales in the event that a major broker-dealer faces default remains a financial stability
concern. Reforms made since the financial crisis, such as higher capital and liquidity requirements, have
reduced the risk of a dealer default. However, the Council recognizes that a major broker-dealer’s default
could threaten financial stability as the broker-dealers’ creditors liquidate the collateral pledged against their

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tri-party repo lending. The fire sales of this collateral could destabilize financial markets and amplify the
negative consequences of such a default.
The Council acknowledges the work that has been done in the past year to reduce reliance on discretionary
intraday credit extended by the clearing banks. The Council emphasizes the importance of the commitment
on the part of all market participants toward achieving the longer-term goals in this area in accordance with
the published timelines. However, the Council urges continued coordinated efforts by market participants
and financial regulatory agencies with relevant authority to address the remaining risks associated with the
tri-party repo market, notably by better preparing investors and other market participants to deal with the
consequences of a dealer’s or other large borrower’s distress or default.

3.1.2

Housing Finance Reform

Last year saw signs of improvement in the residential housing market. Home prices increased, delinquency
rates declined, and home sales reached 3-year highs. Despite these improvements, the housing finance system
remains highly reliant on federal government support, with nearly 90 percent of newly originated mortgages
carrying some form of government backing in 2012. Given this, the development and implementation of
a broad reform plan for the housing finance system that supports the central objectives of bringing more
private capital back to the housing finance market is critical. The Council recommends that the Treasury,
HUD, and FHFA continue to work with Congress and other stakeholders to develop and implement a broad
plan to reform the housing finance system. With this work ongoing, member agencies have advanced reform
by taking initial measures to expedite the wind-down of the government-sponsored enterprises (GSEs),
encourage private capital to take mortgage credit risk, improve borrower and investor protections, and help
develop a new housing finance infrastructure.

Review of 2012 Recommendations and 2013 Goals
In the 2012 annual report, the Council recommended that member agencies continue to work on the
development of a long-term housing finance reform framework that supports the central role of private
capital while improving borrower and investor protections. Progress has been made and is highlighted by the
following key actions:
•	
•	
•	

•	

Modification of the Treasury’s Preferred Stock Purchase Agreements (PSPAs) with the GSEs to

expedite the wind-down of the retained portfolios of Fannie Mae and Freddie Mac.

Development and implementation of FHFA’s Strategic Plan for the operation of the GSE

conservatorships.

Publication by the CFPB of final regulations under the Real Estate Settlement Procedures Act

(Regulation X) and the Truth in Lending Act (Regulation Z), which set forth standards for servicing

mortgage loan accounts and additional protections for borrowers who are delinquent.

Finalization of the CFPB’s ability-to-repay/qualified mortgage rule.

Notwithstanding the above, further progress needs to be made in 2013. Outlined below are steps Council
member agencies plan to take in 2013 in order to help meet the Council’s housing finance goals.

Reducing the GSEs’ Footprint
Under its Strategic Plan, the FHFA announced priorities for 2013 of contracting GSE operations by setting
objective targets. In particular, each GSE will provide an opportunity for private capital to re-enter the
market through risk-sharing transactions and through further reductions in its mortgage investment
portfolios. These efforts, combined with higher guarantee fees, are expected to help facilitate increased
participation by the private sector in the mortgage markets. The Council recommends that the FHFA
continue these efforts in order to help bring more private capital back into mortgage finance.
Annual Repor t Recommendations

13

participation by the private sector in the mortgage markets. The Council recommends that the FHFA
continue these efforts in order to help bring more private capital back into mortgage finance.

Facilitating Increased Private Mortgage Market Activity
A significant amount of work remains to foster increased levels of private activity in the mortgage finance
market. To help facilitate this, the Council recommends that the relevant agencies continue their work to
resolve the risk-retention rule, including the qualified residential mortgage (QRM) definition, to further
encourage private capital to re-enter the mortgage finance market. More broadly, the FHFA, Treasury, HUD,
CFPB, and Congress must continue to address the weaknesses that became evident in the recent housing
crisis by promoting the development of standards and best practices in the mortgage market.

Building a New Housing Finance Infrastructure
The FHFA announced in March 2013 that a business entity would be established jointly by the GSEs to build
a new secondary mortgage market infrastructure, including the development of a common securitization
platform designed to function as an independent market utility. The Council recommends that the FHFA
continue to explore changes to the country’s housing finance infrastructure that would lead to a more
efficient and sustainable mortgage market. In addition to the work on the common securitization platform,
this should include model legal agreements, improvements to the mortgage transfer system, and an improved
compensation system for mortgage servicers. These processes should be coordinated with the measured
wind-down of the GSEs and the implementation of a more sustainable structure for the government’s role in
the housing finance system.

3.1.3

Reforms Relating to Reference Rates

The Council recommends international cooperation for the development of high-level principles for
financial benchmark governance, controls, data sufficiency, and oversight. Current efforts include the
U.K. authorities’ work on the London Interbank Offered Rate (LIBOR), the International Organization of
Securities Commissions’ (IOSCO) work on principles for financial benchmarks and transition to alternative
benchmarks, and the Bank for International Settlements’ (BIS) Economic Consultative Committee’s work on
the need for a reliable and robust framework for producing reference rates. Relevant member agencies should
also cooperate with the Financial Stability Board (FSB) in any related work it may undertake.
The small number of transactions in the unsecured, interbank lending market underpinning reference
rates like LIBOR and weak governance structures undermine market integrity and raise financial stability
concerns. While ongoing international efforts are necessary to remediate deficiencies in governance, they
cannot address the insufficient number of transactions, particularly in longer tenors, in the unsecured,
interbank lending market. Investigations by regulators and law enforcement agencies across the globe
concerning manipulations and false reporting of LIBOR and similar rates have exposed the structural
vulnerabilities of these benchmarks. The shift away from banks funding each other in an unsecured market
has led to a scarcity or outright absence in longer tenors of real transactions underpinning these benchmark
rates and has exacerbated vulnerabilities of these benchmarks. Yet currently, hundreds of trillions of dollars
in derivatives, loans, and other financial instruments reference these benchmarks. This situation leaves the
financial system with benchmarks that are prone to and provide significant incentives for misconduct.
Given these vulnerabilities and the real risk that they will remain, in order to ensure market integrity and
support financial stability, the Council recommends that U.S. regulators cooperate with foreign regulators,
international bodies, and market participants to promptly identify alternative interest rate benchmarks that
are anchored in observable transactions and are supported by appropriate governance structures, and to
develop a plan to accomplish a transition to new benchmarks while such alternative benchmarks are being
identified. The Council further recommends that steps be taken to promote a smooth and orderly transition
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to alternative benchmarks, with consideration given to issues of stability and to mitigation of short-term
market disruptions.

3.2

Heightened Risk Management and Supervisory Attention

3.2.1

Operational Risk

Internal Controls
Strong internal control systems and processes for financial institutions and market utilities are essential
safeguards against business disruptions and system failures that could adversely affect the flow of financial
transactions among financial institutions, markets, consumers, and businesses. Failed operational processes
were the root of many recent, high-profile problems within the financial system. The Council has previously
highlighted the importance of improved risk management and controls in the context of high-speed and
automated trading activities. The SEC has responded to these concerns in securities markets with a proposed
rule to strengthen the automated systems of important market participants. The Council recommends
continued engagement by regulators, market exchanges, and participants to explore durable solutions to the
challenges of managing complex technology in trading environments and the vulnerabilities exposed by
the operational malfunctions in 2012. In addition, the Council recommends that regulators continue to
monitor the adequacy of internal control and corporate governance processes of financial institutions and
market utilities.

Cybersecurity
Since the summer of 2012, financial services companies have experienced a series of coordinated distributed
denial-of-service (DDoS) attacks against their public-facing websites. Among other things, the Treasury and
financial regulators have facilitated the sharing of information between the government and the financial
services sector in response to these attacks. The Council has received reports on the nature of these
attacks and the threat posed to the financial system. The Council recommends that senior management at
financial institutions remain engaged on these issues and commit to improve the flow of information both
within individual firms and between firms, through appropriate channels. The Council recommends that
government agencies enhance information sharing between the public and private sectors and work with the
private sector to assess the effects of cyberattacks on business continuity and recovery. Financial regulators
should continue to review and update their examination policies and guidance for information security in
light of the evolving threat environment.

Infrastructure
Superstorm Sandy underscored the interdependencies between our nation’s financial system and other key
infrastructures. The Council recommends that regulators assess their policies and guidance in the areas of
contingency planning and testing, incident management around market closures, and positioning of key
management and staff, and improvements to further mitigate dependencies on power, transportation, and
communications infrastructures. Regulators should assess whether examinations are appropriately ensuring
conformance with these requirements.

3.2.2

Risk of Prolonged Period of Low Interest Rates

Depository Institutions, Broker-Dealers, and Bank Holding Companies
Sustained low levels of interest rates, combined with ample deposit and wholesale funding liquidity as well as
low loan demand, may have led some firms to reach for yield without sufficient attention to the risk-return
tradeoff. Supervisors and market participants should be particularly attuned to signs of heightened interest
rate and credit risk at depository institutions, credit unions, broker-dealers, and bank holding companies
Annual Repor t Recommendations

15

(BHCs). While duration extension and increased credit risk taking may boost near-term earnings, it could
significantly increase losses in the event of a sudden yield curve steepening, a large rise in rates, or a
significant widening of credit spreads. In addition, excessive risk posed by such strategies could be masked if
an institution does not have appropriate risk management controls in place. The Council recommends that
regulatory agencies and private sector risk managers continue their scrutiny of the ways in which potential
changes in interest rates could adversely affect the risk profiles of financial firms. This should be done with
regular assessments of interest rate and credit risk management strategies, including thorough assessments of
how institutions will perform in a stressed or rapidly changing market environment. Established supervisory
guidance by the prudential banking and credit union regulators directs that financial institutions have
interest rate and credit risk management and measurement systems commensurate with the level and
complexity of their risk profiles.

Insurance Companies
Insurance companies are generally subject to interest rate risk, given their investments in fixed income assets;
however, the life insurance sector is particularly sensitive to interest rate risk, as a result of its investment
in longer-duration fixed income assets, which are typically held to maturity in order to match their longtail liabilities. Particular insurance products are more sensitive to interest rate risk, such as whole life, fixed
annuities, and products with explicit guaranteed returns.
State insurance regulators require life insurance companies in their states to perform annual asset adequacy
testing to determine whether the assets backing liabilities provide sufficient cash flow to meet future
contractual payments to policyholders and other expenses. As part of asset adequacy testing, life insurance
companies are required to test the sensitivity of assets and liabilities to changes in interest rates and to
adverse economic scenarios.
The Council recommends that FIO and state insurance regulators continue to be vigilant in monitoring
the impact of the low interest rate environment (see Section 5.4.2) on insurance companies and that state
insurance regulators continue to ensure that the economic scenarios run by insurance companies
are sufficiently robust and appropriately capture interest rate and other economic risks.

Pension Funds
The current interest rate environment presents challenges for pension funds. Both public and private
defined benefit (DB) pension plans remain significantly underfunded relative to the present value of their
liabilities due to inadequate contributions, losses incurred in 2007 and 2008, and, in the case of corporate
plans, declines in liability discount rates. Low financial market returns have exacted a heavy toll on funding
levels, while at the same time benefit costs have continued to rise. The Council recommends that appropriate
authorities continue their scrutiny of the ways in which low interest rates could adversely affect the risk
profiles of pension funds and continue to address the funding status of pension funds. A recent notable
SEC enforcement case against the State of Illinois’s pension funds underscored the importance of greater
transparency and accuracy in disclosures about risks associated with funding levels of pension funds.

3.2.3

Capital, Liquidity, Resolution

Capital and Liquidity
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. Considerable
progress is being made on robust capital and liquidity planning at U.S. financial institutions. The Federal
Reserve has conducted its Dodd-Frank Act-mandated supervisory stress tests and the 2013 Comprehensive
Capital Analysis and Review (CCAR) exercise to ensure that the largest U.S. BHCs have sufficient capital and
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rigorous, forward-looking capital planning processes to allow these organizations to continue operations
throughout periods of severe stress. The Council recommends that the Federal Reserve continue its efforts
to promote forward-looking capital and liquidity planning. The Federal Reserve has proposed enhanced
prudential standards, including capital and liquidity planning requirements, for the largest domestic BHCs,
foreign banking organizations (FBOs) with a U.S. banking presence, and nonbank financial companies
designated by the Council. In June 2012, the federal banking agencies invited public comment on
proposed regulatory capital rules that, in part, would implement Basel III reforms that seek to improve the
quantity, quality, and risk sensitivity of regulatory capital. The Council recommends that agencies continue
coordinating their development of regulations to help ensure enhanced capital planning and robust capital
for financial institutions.
On liquidity planning, the Council recommends that supervisors and private sector risk managers closely
monitor the risks inherent in short-term funding of longer-term assets. While some forms of maturity
transformation are an integral part of the traditional banking model, such as using retail deposits to fund
commercial loans, firms should diversify their funding base and place prudent limits on the volume of creditsensitive, short-term liabilities in order to reduce funding vulnerabilities. In October 2012, the SEC proposed
a rule that would require the largest broker-dealers to perform a liquidity stress test at least monthly and,
based on the results of that test, maintain liquidity reserves to address potential funding needs during a stress
event. Furthermore, in July 2012, the NCUA issued a proposed rule on the need for federally insured credit
unions to have contingency funding plans that clearly set out strategies for addressing liquidity shortfalls in
emergency situations. Other agencies have also issued additional guidance regarding these issues. The Basel
III liquidity framework, which the federal banking agencies expect to implement domestically through the
rulemaking process, supplements the Federal Reserve’s recently proposed enhanced prudential standards
for liquidity with quantitative measures of an institution’s liquidity position under a short-term period of
liquidity stress.

Resolution Plans
Resolution plans and the orderly liquidation authority, in conjunction with enhanced prudential standards,
are critical elements of Dodd-Frank Act reform. Effective resolution planning for the largest financial
institutions is an important tool to address the operational and legal complexity of these firms on an ongoing
basis. All BHCs with total consolidated assets of $50 billion or more and nonbank financial companies
designated by the Council for supervision by the Federal Reserve are required to develop, maintain, and
periodically submit resolution plans, also known as living wills, that would facilitate these entities’ resolution
under the Bankruptcy Code. Additionally, the FDIC requires FDIC-insured depository institutions with assets
of $50 billion or more to file plans for their orderly resolution under the Federal Deposit Insurance Act.
The overarching goal of these resolution plans is to better prepare firms, supervisors, and resolution
authorities for a potential firm resolution and to foster sound resolution-related contingency planning. If the
Federal Reserve and the FDIC jointly determine that a resolution plan is not credible or would not facilitate
orderly resolution under the Bankruptcy Code, then the company must resubmit the plan with revisions,
including, if necessary, proposed changes in business operations or corporate structure. If the company fails
to resubmit a credible plan that would result in orderly resolution under the Bankruptcy Code, the Federal
Reserve and the FDIC may jointly impose more stringent capital, leverage, or liquidity requirements;
growth, activities, or operations restrictions; or, after two years and in consultation with the Council,
divestiture requirements.
In 2012, 11 financial institutions, including those with nonbank assets greater than $250 billion, submitted
their initial resolution plans. The Federal Reserve and FDIC are reviewing and analyzing those submissions.

Annual Repor t Recommendations

17

In 2013, over 100 additional firms are expected to submit their initial resolution plans. Additionally, the 11
financial firms that submitted initial plans in 2012 will be expected to refine and clarify their submissions in
2013. The Council recommends that the Federal Reserve and FDIC implement their authority in a manner
that fosters sound resolution planning and better prepares firms and authorities for a rapid and orderly
resolution under the Bankruptcy Code.

3.3

Progress on Financial Reform

International coordination of financial regulation and macroprudential surveillance is essential to mitigate
threats to financial stability by containing regulatory arbitrage and by formulating policies to preempt
emerging risks to financial stability. Directly, and through its members and member agencies, the Council
has pursued international financial regulatory coordination to promote regulatory consistency and financial
system stability, with the aim of supporting sustainable real economic growth. The Council, its members,
and its member agencies will continue to strengthen coordination of financial regulation both domestically
and internationally.
In recent years, the Group of 20 (G-20), a forum of 19 countries plus the European Union (EU), has led
international economic policy coordination. In 2009, in the midst of the global financial crisis, the G-20
outlined major pillars of a new international financial regulatory system. This agenda has been advanced by
the FSB, which has worked closely with international standard-setting bodies and national authorities. Three
Council member agencies represent the United States at the FSB: the Treasury, the Federal Reserve, and the
SEC. In developing and implementing the international financial regulatory reform agenda, the Council
supports the development of policies that promote a level playing field, mitigate regulatory arbitrage, and
address the treatment of regulatory gaps.
Assuring that banks are adequately capitalized, U.S. regulators are continuing to make significant progress
in implementing capital and liquidity standards for large, complex financial institutions through the DoddFrank Act and the Basel III reforms. The Basel III accords, which are currently expected to be fully phased
in by 2019, will set internationally agreed heightened capital and liquidity requirements. Basel III will also
ensure far more consistency in the manner by which countries define capital for the purposes of measuring
risk-weighted assets. The uniform application of these rules by supervisors is as important as the development
of consistent rules. In 2013, the Council is particularly interested in the Basel Committee on Banking
Supervision’s (BCBS) study on the consistency of measurement of risk-weighting practices in banking
and trading portfolios. The results of the study will help regulators to standardize the currently disparate
risk-weighting practices across jurisdictions. The BCBS’s broader goal of simplifying and improving the
comparability of regulatory capital requirements for banking firms should remain a top priority.

Strengthening the Regulation of Large, Complex Financial Institutions
The FSB, in consultation with international standard setters, is in various stages of developing methodologies
to identify financial institutions whose distress or disorderly failure, because of their size, complexity, and
systemic interconnectedness, would cause significant disruption to the wider financial system and economic
activity. The FSB, in consultation with IOSCO, plans to present a methodology to determine global
systemically important nonbank non-insurers by the end of 2013. The FSB has established a comprehensive
policy framework for global systemically important banks (G-SIBs) that includes: (1) a new international
standard for resolution regimes; (2) more intensive and effective supervision; (3) requirements for crossborder cooperation, recovery, and resolution planning; and (4) additional loss absorbency for those banks
determined to be G-SIBs. The FSB, in consultation with the BCBS, designates global systemically important
financial institutions (G-SIFIs) for heightened supervision, including capital surcharges. Accordingly,
the ability of G-SIBs to absorb losses will be increased, helping to reduce the probability of failure
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and internalizing the negative cross-border externalities not addressed by existing regulatory policies.
The Council supports the G-SIB policy framework and encourages its consistent implementation
across jurisdictions.
The Dodd-Frank Act provides for the application of enhanced prudential standards to BHCs with $50 billion
or more in total consolidated assets. In addition, the Council has authority to designate nonbank financial
companies for Federal Reserve supervision and enhanced prudential. The Council currently is in the final
stages of evaluating an initial set of nonbank financial companies for potential designation—an important
priority for the Council in 2013.

Developing a Framework for the Supervision of Large, Global Systemically Important Insurers
The FSB, in consultation with the International Association of Insurance Supervisors (IAIS), is continuing to
create a new framework for the identification and effective supervision of large, global systemically important
insurers. In addition, the IAIS is continuing to work on an integrated, multilateral, and multidisciplinary
framework for the group-wide supervision of internationally active insurance groups (IAIGs), called the
Common Framework for the Supervision of Internationally Active Insurance Groups, which is expected to
be adopted by 2018. The Council recommends that FIO, representing the United States, and state insurance
regulators, through the National Association of Insurance Commissioners (NAIC), continue to play their
respective roles in international insurance matters.

Developing an International Framework to Resolve Global Financial Institutions
The international benchmark for resolution regimes is the FSB’s 2011 Key Attributes of Effective Resolution
Regimes for Financial Institutions. The United States has been working diligently with international
counterparts to ensure that cross-border recovery and resolution plans are developed for major global
financial institutions, that international authorities develop criteria to improve the “resolvability” of G-SIFIs,
and that institution-specific, cross-border resolution cooperation arrangements are negotiated. The Council
acknowledges that international coordination is particularly important in this area, and the Council
welcomes the joint policy paper released by the FDIC and the Bank of England (BOE) in December 2012.
The Council also welcomes the establishment of a joint working group between the European Commission
and the FDIC to discuss issues related to deposit insurance and the resolution of large banks and systemically
important financial institutions (SIFIs). In addition, the Council looks forward to the results of the FSB’s first
peer review of existing resolution regimes led by the FDIC, evaluating FSB jurisdictions and their existing
resolution regimes using the Key Attributes as a benchmark.3 The report of this review has recently been
issued, and provides recommendations for future work by the FSB and its members in support of effective and
credible resolution regimes for SIFIs. Effective cross-border cooperation will be essential to implementing the
FDIC’s orderly liquidation authority under Title II of the Dodd-Frank Act.

Increasing the Transparency and Regulation of Over-the-Counter (OTC) Derivatives
The United States, along with Japan, has led the way on implementation of the G-20 leaders’ commitment
to centralized clearing and exchange trading of standardized derivatives contracts. The G-20 also called
for the reporting of all derivatives contracts to trade repositories, as well as the application of higher capital
requirements for non-centrally cleared contracts. While no jurisdiction met the end of 2012 deadline,
the CFTC has already begun implementing its OTC derivatives rules, including certain registration and
reporting requirements and limited clearing requirements. In parallel with continued coordination between
the CFTC and SEC on domestic implementation of derivatives rules, the United States continues to work with
other jurisdictions to build the internationally cohesive regulatory framework necessary to effectively reform
this cross-border market. The Council encourages continued development of these reforms, as they are
essential to increase transparency and to mitigate risk that could arise from the OTC derivatives market.

Annual Repor t Recommendations

19

Improving the Oversight and Regulation of Nonbank Intermediaries
There is a considerable amount of work in progress to address potential risks in the area of shadow banking,
a term that is often used to refer to the system of financial intermediaries and activities that conduct maturity,
credit, and liquidity transformation without access to the Federal Reserve’s and FDIC’s backstops. Given the
role nonbank financial intermediation played in amplifying the financial crisis, the FSB is developing an
integrated framework of recommendations to strengthen oversight and regulation of the shadow banking
system. In the United States, significant steps have already been taken to mitigate these potential risks. These
steps include reforms to improve the resilience of MMFs, the tri-party repo market, and securitization. The
Council, through its authority to designate nonbank financial companies for supervision by the Federal
Reserve and enhanced prudential standards, can expand the regulatory perimeter to certain activities and
entities in the shadow banking system.

Data Resources and Analytics
The Council continues to recommend 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 and forthcoming implementation of the Legal Entity Identifier
(LEI) is a valuable first step, one that will help to precisely identify 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 OFR
continue to work with the Council’s member agencies to promote the use of, and establish where necessary,
data standards for identification of legal entities, financial products, and transactions, and to improve the
quality of and facilitate the access to standardized, aggregate data by the regulators. Finally, the Council
recommends that cross-border exchange of supervisory data among supervisors, regulators, and financial
stability authorities be facilitated in a manner that safeguards the confidentiality and privilege of such
information. This will help provide comprehensive oversight of financial institutions and markets with a
global reach and improve coordination on financial stability.
Since the 2007 to 2008 financial crisis, the United States has worked effectively through the G-20 and FSB
to develop and implement a new global financial regulatory architecture designed to enable a more stable,
robust, and transparent financial system. Considerable progress has already been made, but much more
work remains to be done. The Council will continue to pursue a reform agenda, both domestically and
internationally, to support these goals.

20

2 0 1 3 F S O C / / Annual Report

4

Macroeconomic Environment

This section provides an overview of
macroeconomic developments since the start of
2012, by reviewing (1) U.S. economic activity;
(2) nonfinancial balance sheet developments;
(3) government finance; and (4) the external
economic environment. Furthermore, the
macroeconomic and financial market impacts
of the fiscal cliff and debt ceiling are discussed.

4.1

U.S. Economic Activity

4.1.1

Real Gross Domestic Product

Economic growth was moderate in 2012, with
real GDP expanding 1.7 percent (Chart 4.1.1).
Concern about the future pace of the economic
recovery and the sustainability of fiscal policy
likely restrained the demand of businesses
and households. Tighter underwriting
standards in some sectors, especially in home
mortgage lending, together with the overhang
of foreclosed and underwater mortgages,
weighed on the recovery of the housing
sector and consumer spending. Reductions
in government spending negatively affected
domestic demand, and the fiscal and financial
difficulties in Europe weighed on external
demand. Economic activity was held down in
the second half of the year by some temporary
factors including a severe drought in much
of the country and the disruptions caused by
Superstorm Sandy.

Consumption and Residential Investment
Real personal consumption expenditures
(PCE) increased at a moderate pace of about
2 percent in 2012 (Chart 4.1.2), supported
partly by growth in household net worth and
some improvement in labor market conditions
and consumer sentiment. However, consumer
sentiment remains below pre-crisis norms,
weighed down by concern about the economic
environment and limited access to credit for
many households. Growth in real disposable
income was modest over most of the year,

Chart 4.1.1		 Change in Real Gross Domestic Product
4.1.1 Change in Real Gross Domestic Product
Percent
4

Percent
4

As Of: 2012 Q4

2

2

0

0

-2

-2

-4

2006

2007

2008

2009

Source: BEA, Haver Analytics

2010

2011

2012

-4

Note: Annual changes are Q4/Q4.

Chart 4.1.2		
Change in Real Personal Consumption Expenditures
4.1.2 Change in Real Personal Consumption Expenditures

Percent
4

Percent
4

As Of: 2012 Q4

2

2

0

0

-2

-2

-4

2006

2007

2008

Source: BEA, Haver Analytics

2009

2010

2011

2012

-4

Note: Annual changes are Q4/Q4.

Macroeconomic Environment

21

Chart 4.1.3 		 Private Housing Starts
4.1.3 Private Housing Starts
Millions of Units
2.0

As Of: Feb-2013

Millions of Units
0.5
0.4

1.5
Multifamily
(right axis)

0.3

1.0

0.5

0.0
2002

0.2

Single-family
(left axis)

2004

2006

Source: Census Bureau,
Haver Analytics

0.1

2008

2010

2012

0.0

Note: Seasonally adjusted at an annualized
rate. Gray bar signifies NBER recession.

before jumping in the fourth quarter, when
a large number of firms issued special or
accelerated dividends and employee bonuses
in anticipation of higher marginal tax rates on
high-income households in 2013.
Housing activity continued to show signs of
gradual improvement last year, but remained
weak relative to longer-run norms. Housing
starts (Chart 4.1.3), sales of new and existing
homes, and home prices all increased, spurred
in part by historically low mortgage rates.
However, tighter underwriting standards on
mortgages, especially for individuals with lower
credit scores (see Section 4.2.3), low or negative
levels of home equity among many households,
and elevated unemployment continue to
restrain the demand for housing. Moreover, the
shadow inventory of homes held off the market
due to vacancy or reduced homeowner’s equity
remained elevated.

Business Fixed Investment
Real business fixed investment (BFI) rose at a
moderate pace in 2012, following rapid growth
in 2010 and 2011, while BFI as a share of GDP
remained below its pre-recession level. Business
investment in equipment and software (E&S)
decelerated in 2012 as the pent-up demand
for investment projects deferred during the
recession has diminished since the earlier stages
of the recovery. E&S investment is likely further
restrained by concerns about the pace of global
economic growth. Meanwhile, investment in
nonresidential structures remained subdued,
as high vacancy rates, low commercial real
estate prices, and tighter credit for builders
continued to hamper growth. However, there
were some gradual signs of improvement in
the commercial real estate (CRE) sector (see
Section 5.1.4).

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2 0 1 3 F S O C / / Annual Report

Government Purchases
On net, real government expenditures at
the federal, state, and local levels continued
to contract in 2012. Real state and local
government purchases fell at an annual rate
of about 1.5 percent in the first half of the
year and were about flat in the second half,
held down by ongoing budgetary pressures,
though those pressures appear to have lessened
since earlier in the recovery as state and local
tax revenues have increased. Real federal
government purchases fell almost 3 percent
during the year, reflecting large declines in
federal defense spending at the end of the
year and the wind down of the fiscal stimulus
provided during the recession.

Imports and Exports
Real exports of goods and services rose very
modestly last year, held down by a fall off in
demand from the euro area. Imports of goods
and services were about flat, consistent with the
pace of final aggregate demand and the rise
in the dollar. Altogether, net exports made a
very small but positive contribution to real GDP
growth last year.

4.1.2

Chart 4.1.4 		 Net Change in Nonfarm Payroll Employment
4.1.4 Net Change in Nonfarm Payroll Employment
Thousands of Jobs
600

As Of: Mar-2013

Thousands of Jobs
600

400

400

Monthly Change

200

200

0

0

-200

-200
3-Month Moving
Average

-400

-400

-600

-600

-800

-800

-1000
2006

2007

2008

2009

Source: BLS, Haver Analytics

2010

2011

2012

2013

-1000

Note: Gray bar signifies NBER recession.

Chart 4.1.5 		 Civilian Unemployment Rate
4.1.5 Civilian Unemployment Rate
Percent
12

As Of: Mar-2013

Percent
12

9

9

6

6

The Labor Market

The labor market improved slowly in 2012, but
remains weak. Nonfarm payroll employment
increased at an average monthly rate of about
159,000 jobs in the 12 months ending March
2013 (Chart 4.1.4). The private sector added
166,000 jobs per month, while government
payrolls dropped at an average rate of about
6,000 per month.
These job gains helped reduce the
unemployment rate from 8.5 percent at the
end of 2011 to 7.6 percent in March 2013
(Chart 4.1.5). However, the unemployment
rate continues to be much higher than it was
before the crisis, and long-term unemployment
remains elevated. In March 2013, about 40
percent of unemployed workers had been
out of work for more than six months (Chart
4.1.6). Meanwhile, labor force participation
edged down 0.5 percentage point in the 12
months ending March 2013, and has fallen 3.1

3
1982

1987

1992

Source: BLS, Haver Analytics

1997

2002

2007

2012

3

Note: Gray bars signify NBER recessions.

Chart 4.1.6 		 Long-Term Unemployment
4.1.6 Long-Term Unemployment
Percent
50

As Of: Mar-2013

Percent
50

40

40

30

30

20

20

10

10

0
1982

1987

Source: BLS,
Haver Analytics

1992

1997

2002

2007

2012

0

Note: Long-term unemployment as a
percent of total unemployment. Gray
bars signify NBER recessions.

Macroeconomic Environment

23

Chart 4.1.7 		 Labor Force Participation Rate
4.1.7 Labor Force Participation Rate
Percent
68

As Of: Mar-2013

Percent
68

67

67

66

66

65

65

64

64

63
1982

1987

1992

1997

2002

2007

63

2012

percentage points since the beginning
of 2007 (Chart 4.1.7), in part due to ongoing
demographic change as the baby boomers
retire. Wage growth for those employed
remains subdued.
The high rate of unemployment in the current
economic expansion has raised concerns that
the level of structural unemployment has risen
over the past few years in the United States.
However, recent research suggests that the rise
in structural unemployment is modest.4

Note: Gray bars signify NBER recessions.

Chart 4.2.1 		 Financial Ratios for Nonfinancial Corporations
4.2.1 Financial Ratios for Nonfinancial Corporations
Percent
30

28

As Of: 2012 Q4

Percent
6.5

6.0

Debt to Total
Assets (left axis)

26

5.5

Liquid Assets to
Total Assets
(right axis)

24

22
2000

2003

2006

Source: Flow of Funds,
Haver Analytics

2009

5.0

4.5

2012

Note: Gray bars signify NBER recessions.

Chart 4.2.2 		 Bank Business Lending Standards and Demand
4.2.2 Bank Business Lending Standards and Demand
Percent
100

As Of: Jan-2013

Percent
100

Reporting Stronger
Demand from Large and
Medium-Sized Firms

50

50

0

0

-50

-100
2000

2002

Source: SLOOS,
Haver Analytics

24

-50

Reporting Tighter
Standards for Large and
Medium-Sized Firms
2004

2006

2008

2010

2012

-100

Note: Gray bars signify NBER recessions. Data
includes firms with annual sales of $50 million or more.

2 0 1 3 F S O C / / Annual Report

4.2

Nonfinancial Balance Sheets

4.2.1

Source: BLS, Haver Analytics

Nonfinancial Corporate Sector

Corporate balance sheets remained strong
in 2012. The ratio of liquid assets to total
assets of the sector was near its highest level
in more than 20 years, and debt has declined
significantly relative to total assets over the
past few years (Chart 4.2.1). Cash flows were
solid, helping to support further increases in
the equity market valuations of nonfinancial
corporations and allowing them to boost capital
through retained earnings (see Section 5.1.3
for equity market valuations).
Robust credit quality and corporate profits,
as well as the low level of interest rates and
declining spreads on corporate debt, supported
substantial gross borrowing in corporate
bond markets by nonfinancial firms (see
Section 5.1.1). Total outstanding loans to the
nonfinancial corporate sector, which includes
loans from bank and nonbank sources,
increased modestly in 2012. Commercial
and industrial (C&I) loans funded by banks
continued to rise, and over the course of 2012,
respondents to the Federal Reserve’s Senior
Loan Officer Opinion Survey on Bank Lending
Practices (SLOOS) reported less stringent
underwriting standards and increased demand
for C&I loans to large and medium-sized firms
(Chart 4.2.2).

Available indicators of corporate credit quality
point to further improvement. The default rate
on nonfinancial corporate bonds fluctuated in
2012 at low levels by historical standards (Chart
4.2.3), and delinquency rates on C&I loans
declined further last year (Chart 4.2.4). As will
be discussed in Section 7.4, other indicators,
such as the prevalence of more relaxed
underwriting and covenants in recent leveraged
lending originations, suggest that investors and
lenders have begun to take on more risk.

4.2.2

Noncorporate Business Sector

Compared to conditions in the nonfinancial
corporate sector, conditions in the nonfinancial
noncorporate business sector have improved
at a much slower pace. This sector, composed
primarily of small businesses, accounts for
slightly less than one-third of total nonfinancial
business debt outstanding. However, since small
businesses generally have access to a narrower
range of financing options than corporations,
the majority of small business debt is composed
of bank loans, usually tied to the personal credit
score of the owners or secured by real estate.
Therefore, developments in the noncorporate
business sector are especially important for the
health of many banks’ balance sheets, especially
at smaller banks.
Real estate represents the majority of assets
owned by noncorporate businesses (Chart
4.2.5), and since the beginning of the financial
crisis, lower real estate collateral values and
stress in the banking sector have constrained
credit availability to the sector. However,
there are signs that credit conditions for
small businesses are gradually improving.
Net borrowing by nonfinancial noncorporate
businesses, which had dropped dramatically
through 2010, was slightly positive in 2012
(Chart 4.2.6). Small loans to businesses on
bank balance sheets grew modestly in 2012,
but much of this growth, concentrated at the
end of the year, may have been transitory in
nature due to an increase in bonuses and
other special distributions before higher tax
rates took effect for some households in 2013.
Respondents to the SLOOS noted some easing

Chart 4.2.3 		 Nonfinancial Corporate Bond Default Rate
4.2.3 Nonfinancial Corporate Bond Default Rate
Percent

As Of: 2012 Q4

Source: MoodyĀs
Investors Service

Percent

Note: Default rates are annual rates calculated on a
quarterly basis. Gray bars signify NBER recessions.

Chart 4.2.4 		 Noncurrent Commercial and Industrial Loans
4.2.4 Noncurrent Commercial and Industrial Loans
Percent
4

As Of: 2012 Q4

Percent
4

3

3

2

2

1

1

0
2000

2002

2004

Source: FDIC, Haver Analytics

2006

2008

2010

2012

0

Note: Percent of total C&I loans.
Gray bars signify NBER recessions.

Chart 4.2.5 		 Noncorporate Assets
4.2.5 Noncorporate Assets
Share of Total Assets
As Of: 2012 Q4
1.0
Accounts Receivable
Other Assets
0.8

Share of Total Assets
1.0
0.8

Cash and Securities

0.6

Nonresidential Real Estate

0.4

0.4
Residential Real Estate

0.2
0.0
1990

0.6

1994

1998

2002

2006

2010

0.2
0.0

Source: Flow of Funds, Haver Analytics
Macroeconomic Environment

25

Chart 4.2.6 		 Borrowing by Nonfinancial Noncorporate
Net
Businesses
4.2.6 Net Borrowing by Nonfinancial Noncorporate Businesses
Billions of US$
600

Billions of US$
600

As Of: 2012 Q4

400

400

200

200
0

0

-200

-200
-400
2000

2002

2004

2006

Source: Flow of Funds,
Haver Analytics

2008

2010

2012

-400

Note: Seasonally adjusted at an annual rate.
Gray bars signify NBER recessions.

Chart 4.2.7 		 Bank Business Lending Standards and Demand
4.2.7 Bank Business Lending Standards and Demand
Percent
100

50

As Of: Jan-2013

Percent
100

Reporting Stronger
Demand from Small Firms

50

0

-50

-100
2000

0

Reporting Tighter
Standards for Small Firms

2002

2004

Source: SLOOS,
Haver Analytics

2006

-50

2008

2010

-100

2012

Note: Gray bars signify NBER recessions. Data includes
firms with annual sales of less than $50 million.

Chart 4.2.8 		 Small Businesses’ Difficulty Obtaining Credit
4.2.8 Small Businesses' Difficulty Obtaining Credit
Percent
16

As Of: 2012 Q4

Percent
16

12

12

8

Net Percent of Small
Businesses Reporting Credit
Harder to Get than Three
Months Prior

8

4

4

0
2000

2002

2004

2006

2008

2010

2012

0

Note: Net Percent = small businesses reporting credit harder to get than three months prior minus those
reporting credit easier to get than three months prior. For the population borrowing at least once every
three months. Depicts quarterly averages of monthly data. Gray bars signify NBER recessions.

Source: NFIB, Haver Analytics

26

2 0 1 3 F S O C / / Annual Report

on loan standards and spreads, and stronger
demand for C&I loans last year (Chart 4.2.7).
The fraction of firms surveyed by the National
Federation of Independent Businesses (NFIB)
which reported that credit had become more
difficult to obtain also trended down in recent
years, despite an uptick at the end of 2012
(Chart 4.2.8), and less than 5 percent
of respondents reported that financing was
their top problem. That said, the fraction
of firms that reported difficulty in obtaining
credit remained elevated relative to the
pre-crisis period.

4.2.3

Household Sector

Household debt increased sharply in the years
leading up to the financial crisis, reaching a
high of 130 percent of disposable personal
income in the third quarter of 2007. Since
then, households have been deleveraging. By
the end of last year, the ratio of household debt
to disposable income declined to its 2003 level
(Chart 4.2.9), largely due to lower mortgage
debt outstanding.
Continuing reductions in home mortgages,
which account for about three-fourths of
outstanding household debt, more than
offset an increase in consumer credit last year
(Chart 4.2.10). The reduction in outstanding
mortgage debt reflects a low volume of
mortgage originations for new home purchases,
household efforts to pay down their existing
debt, and the effects of foreclosures and short
sales. Despite a pick-up in housing activity
and low mortgage rates, the volume of new
mortgage originations remained subdued,
largely due to tighter underwriting standards,
including lower loan-to-value ratios, as will
be discussed in Section 5.1.4. In particular,
reduced origination capacity and continued
uncertainty over mortgage put-backs to lenders
contributed to reduced access to mortgage
credit. More conservative underwriting
standards and depressed home values
have also resulted in a low volume of
cash-out refinancings.

Household deleveraging, low interest rates,
and modest increases in employment and
income reduced the household debt service
ratio (the ratio of debt service payments to
disposable personal income) to a historic low
(Chart 4.2.11). Reduced debt burdens allowed
households to slowly but steadily become
more current on their debts. Since 2009, the
percentage of delinquent household debts has
decreased from 11.9 percent to 8.6 percent, but
remains significantly above pre-crisis levels;
however, the share of seriously delinquent
debts remains stubbornly high (Chart 4.2.12).
While aggregate measures of the debt burden
improved, many households continue to
struggle to meet their financial obligations and
many are still underwater on their mortgages.
Looking at the entire balance sheet of the
sector, aggregate household net worth (the
difference between assets and debts) rose
about $5.5 trillion in 2012, to an estimated
$66.1 trillion (Chart 4.2.13), and the ratio of
household net worth to disposable personal
income increased over the year. Price increases
of corporate equities, and to a lesser extent
of homes, accounted for most of the increase
in net worth. Active saving, and the declines
in outstanding debt discussed above, also
contributed in smaller part. Due to reductions
in mortgage debt and increases in home prices,
the share of owners’ equity in housing started
to move up last year, although it still remains
very low: roughly 13 percentage points below its
1990 to 2005 average (Chart 4.2.14). However,
renters and lower-income households with
smaller exposures to the stock market have not
benefitted much from the recovery in equity
and home prices over the past few years.
Unlike mortgage debt, non-mortgage consumer
credit, which accounts for slightly more than
20 percent of total household debt, has been
growing over the past two years. During 2012,
non-mortgage consumer credit outstanding
increased nearly 6 percent to $2.8 trillion.
Non-revolving credit, which consists primarily
of auto loans and student loans and is over twothirds of total consumer credit, accounted for

Chart 4.2.9 		
Household Debt as a Percent of Disposable
Personal a Percent
4.2.9 Household Debt asIncome of Disposable Personal Income
Percent

As Of: 2012 Q4

Source: BEA, Flow of Funds,
Haver Analytics

Percent

Note: Other Household Debt includes
debts of both households and nonprofits.

Chart 4.2.10		 Private Nonfinancial Debt
4.2.10 Private Nonfinancial Debt
Percent of Nominal GDP
200

150

As Of: 2012 Q4

Percent of Nominal GDP
200

Nonfinancial Noncorporate Debt
Nonfinancial Corporate Debt
Consumer and Other Household Debt
Mortgages

150

100

100

50

50

0
1992

1996

2000

Source: BEA, Flow of Funds,
Haver Analytics

2004

2008

2012

0

Note: Other Household Debt includes
debts of both households and nonprofits.

Chart 4.2.11 		 Household Debt Service Ratio
4.2.11 Household Debt Service Ratio
Percent
15

As Of: 2012 Q4

Percent
15

14

14

13

13

12

12

11

11

10
1980

1985

1990

Source: Federal Reserve,
Haver Analytics

1995

2000

2005

2010

10

Note: Ratio of debt service payments to disposable
personal income. Seasonally adjusted. Gray bars
signify NBER recessions.

Macroeconomic Environment

27

Chart 4.2.12 		 Share of Household Debt by Delinquency Status
4.2.12 Share of Household Debt by Delinquency Status
Percent
15

Percent
15

As Of: 2012 Q4
Derogatory
120+ Days Late
90 Days Late
60 Days Late
30 Days Late

12
9

12
9

6

6

3

3

0
2003

2006

2009

Source: FRBNY Consumer Credit
Panel, Equifax, Haver Analytics

2012

0

Note: Derogatory loans are loans for which
there are reports of a repossession,
charge off to bad debt, or foreclosure.

Chart 4.2.13 		 Household and Nonprofit Balance Sheets
4.2.13 Household and Nonprofit Balance Sheets
Trillions of US$
100

As Of: 2012 Q4

Other Assets*
Equities
Credit Market Instruments
Cash Instruments
Real Estate

80
60

Trillions of US$
100

Net Worth

80
60

40

40

20

20

0

0
Mortgages
Consumer Credit
Other Debt**

-20
-40

2000

Source: Flow of
Funds, Haver
Analytics

2002

-20

2004

2006

2008

2010

2012

-40

Note: *Noncorporate equities, mutual fund shares, security credit, life insurance and pension
fund reserves, tangible assets excluding real estate, miscellaneous assets. **Security credit,
trade payables, unpaid life insurance premiums, other credit market instruments.

Chart 4.2.14 		 Share of Owners’ Equity in Household Real Estate
4.2.14 Share of Owners' Equity in Household Real Estate

Percent
70

As Of: 2012 Q4

Percent
70
1990-2005
Average

60

60

50

50

40

40

30
2000

2002

2004

Source: Flow of Funds,
Haver Analytics

28

2 0 1 3 F S O C / / Annual Report

2006

2008

2010

2012

30

Note: Gray bars signify NBER recessions.

most of this increase. Federal student loans are
the dominant source of student loans, which
continue to expand at a rapid pace (Chart
4.2.15). Federal student loans are administered
based on statutory eligibility criteria, and
origination decisions are generally not based
on a borrower’s credit characteristics. Interest
rates on new federal student loan issuance are
currently fixed in statute and generally range
from 3.4 percent to 7.9 percent, depending on
the federal loan program for which the student
or their parents are eligible. Federal student
loans currently comprise over 90 percent of
annual issuance and approximately 85 percent
of the outstanding portfolio of student loans.
Growth in auto loans also picked up last year,
reflecting widespread availability of credit and
rising consumer demand for motor vehicles.
About $90 billion of auto loan asset-backed
securities (ABS) were issued in 2012—the
most since 2006. Subprime auto loan ABS
issuance reemerged, although reportedly
with stronger credit support than in most
pre-crisis structures.
Indicators of changes in the demand for
credit were mixed last year. Respondents to
the SLOOS reported stronger demand for
credit by consumers, on net, especially for auto
loans. However, credit applications decreased
slightly over the past year and remained largely
subdued relative to the pre-crisis period
(Chart 4.2.16).
Delinquency rates for most types of consumer
credit continued to decline from the high rates
experienced during the crisis. 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. Lower
delinquency rates for revolving credit and
auto loans in 2012 likely reflected, in part,
the composition shift toward higher-quality
borrowers. The delinquency rates on these
loans to super prime and prime consumers were

more stable through the crisis and are currently
near their historical averages.
While households are becoming more current
on most types of debt, the propensity for
student loans to become delinquent increased
in 2012, with 11.7 percent of student loans more
than 90 days delinquent at the end of the year
(Chart 4.2.17). Large and growing student debt
burdens and a poor job market have pushed
many borrowers into delinquency, especially
among younger borrowers. About half of all
loans to borrowers under 30 years old are in
periods of payment deferral or forbearance
and cannot become delinquent, but 35 percent
of borrowers under 30 who are required to
make principal-reducing payments are more
than 90 days delinquent on their student loans.
However, risk to lenders is mitigated by the
fact that both federal and private student loans
are difficult to discharge in bankruptcy, and
that the federal government has extraordinary
collection authorities. Federal student loans
also have a number of flexible payment terms
that act as loan modifications for distressed
borrowers. High student debt burdens may
impact demand for housing, as young
borrowers may be less able to access mortgage
credit. Student debt levels may also lead to
dampened consumption.

Chart 4.2.15 		 Components of Consumer Credit
4.2.15 Components of Consumer Credit
Billions of US$
1000
Auto Loans

Billions of US$
1000

As Of: 2012 Q4

800
600

800
Credit Card Debt

600
Other Household
Debt

400
200

400

Student Loans

0
2003

200

2006

2009

0

2012

Source: FRBNY Consumer Credit
Panel, Equifax, Haver Analytics

Note: Gray bar signifies
NBER recession.

Chart 4.2.16 		 Applications for Credit
4.2.16 Applications for Credit
Millions of Inquiries
300

As Of: 2012 Q4

Millions of Inquiries
300

250

250

200

200

150

150

100
2000

2002

2004

2006

Source: FRBNY Consumer Credit
Panel, Equifax, Haver Analytics

2008

2010

2012

100

Note: Number of Equifax inquiries within 6
months. Gray bars signify NBER recessions.

Chart 4.2.17 		 90+ Day Delinquency Rate by Loan Type
4.2.17 90+ Day Delinquency Rate by Loan Type
Percent
15
12

As Of: 2012 Q4

Percent
15
12

Credit Card Loans

Student Loans
9

9
Mortgage
Loans

6
3
0
2003

Auto Loans

2006

Source: FRBNY Consumer Credit
Panel, Equifax, Haver Analytics

6

HELOC

2009

2012

3
0

Note: Gray bar signifies NBER recession. Student loan
delinquency rates in 2012 Q3 are inflated by the reposting
of a large number of delinquent loans by a single servicer.

Macroeconomic Environment

29

4.3

Chart 4.3.1 		 Federal Unified Budget Surplus/Deficit
4.3.1 Federal Unified Budget Surplus/Deficit
Percent of GDP
4

As Of: Feb-2013

Percent of GDP
4

0

0

-4

CBO Baseline
Projection

-8

-12
2000

-4

-8

2004

Source: CBO,
Haver Analytics

2008

2012

2016

-12

2020

Note: Negative values denote a deficit. Data for
fiscal years. Years after 2012 are projected.

Chart 4.3.2 		 Federal Held Held by Public as a Percent ofof GDP
4.3.2 Federal Debt Debt by the the Public as a Percent GDP
Percent of GDP
150

As Of: Feb-2013

Percent of GDP
150
120

120
CBO Baseline
Projection

90

90

60

60

30

30

0
1940

1950

1960

1970

Source: CBO, Haver Analytics

1980

1990

2000

2010

2020

0

Note: Data for fiscal years.
Years after 2012 are projected.

Government Finance

4.3.1

Federal Government

The deficit in the federal unified budget
widened significantly during the recession
and has since gradually narrowed. In the 2012
fiscal year, the deficit was 7 percent of nominal
GDP—1.7 percentage points lower than in 2011
but substantially above the average value of 1.3
percent of GDP during the pre-crisis fiscal years
of 2000 to 2007 (Chart 4.3.1). 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 budget outlook over the medium term is
subject to considerable uncertainty with respect
to both the performance of the economy
and the path of future fiscal policy. In the
Congressional Budget Office’s (CBO) February
2013 baseline projection, which assumes
current laws generally remain unchanged, the
deficit shrinks appreciably over the next several
years. The deficit is then forecasted to drift up
through the end of the projection in 2023, as
federal health care and entitlement spending
increase, along with the number of retirees.
Consistent with this projection for the deficit,
federal debt held by the public is expected to
move in a fairly narrow range, hovering around
75 percent of GDP through 2023 (Chart 4.3.2).
Rating agencies’ assessments of Treasury
debt are unchanged since late 2011. Moody’s
and Fitch give U.S. sovereign debt their top
ratings, while Standard & Poor’s (S&P) issued
a one-notch downgrade in mid-2011. All three
ratings agencies have negative outlooks on U.S.
sovereign debt. Demand for Treasury securities
appears well maintained, as market participants
continue to purchase U.S. debt for its relative
safety and liquidity. Bid-to-cover ratios at
auctions of Treasury securities remain at the
top end of historical ranges, and indicators of
foreign participation have remained on trend
with recent years.

30

2 0 1 3 F S O C / / Annual Report

Despite the sizable increase in public debt
outstanding, net interest costs have only
amounted to about 1.5 percent of GDP in recent
years, in line with their average over the past
decade, but considerably lower than during
the 1990s, when net interest costs were about 3
percent of GDP (Chart 4.3.3). Historically low
interest rates have allowed net interest costs to
decline relative to GDP even as outstanding
federal debt grew rapidly. The average maturity
of public debt outstanding has risen sharply
since late 2008 and is close to its 30-year
average, although the Federal Reserve has
taken on an increasing amount of longer-term
debt since the initiation of its Treasury
Large-Scale Asset Purchase programs
(LSAPs) in March 2009.

Interest Outlays and Average Maturity
Chart 4.3.3 		
4.3.3 Interest of U.S. PublicAverage Maturity of U.S. Public Debt
Outlays and Debt
Percent of GDP
3.4

Months
72

As Of: 2012 Q4

Average Maturity of
Outstanding Debt
(right axis)

3.0
2.6

68
64
60

Interest Outlays
(left axis)

2.2

56
52

1.8

48
1.4
1.0
1981

44
1986

Source: BEA, OMB,
Haver Analytics

1991

1996

2001

2006

2011

40

Note: Gray bars signify NBER recessions.

The economic and financial market impacts
of the fiscal cliff and debt ceiling are discussed
in Box A.

Macroeconomic Environment

31

BOX A:  ACROECONOMIC AND FINANCIAL MARKET IMPACTS OF THE FISCAL
M
CLIFF AND DEBT CEILING
Last year, a series of automatic tax increases and
spending cuts—referred to as the fiscal cliff—were set
to take effect at the start of 2013; it is likely that the
magnitude of this fiscal retrenchment would have been
sufficient to send the economy into recession. Specifically,
income tax rate reductions enacted in 2001 and 2003,
the payroll tax cut authorized in late 2010, extended
unemployment benefits, and a number of other tax
provisions were all scheduled to expire on December 31,
2012. In addition, the Budget Control Act of 2011 put in
place $85 billion in across-the-board spending cuts to the
federal budget for fiscal year 2013, effective January 2,
2013. Taken together, the CBO estimated that the fiscal
tightening resulting from these policies was close to $500
billion in fiscal year 2013, or roughly 3.25 percent of GDP.
Complicating matters, the statutory debt ceiling was
reached on December 31, 2012, although extraordinary
measures authorized by law were available to postpone
the date that the United States would otherwise default
on its obligations by about two months.5
Last-minute legislation mitigated the full impact of the
fiscal cliff; the passage of the American Taxpayer Relief
Act of 2012 (ATRA) on January 1, 2013, extended existing
tax rates for the majority of taxpayers while raising rates
on the highest earners. ATRA also delayed the federal
budget cuts until March 1. Separately in February,
legislation suspended the federal debt ceiling through
May 18. Because the public and financial markets largely
anticipated the emergence of similar policy solutions, the
observable effects of these fiscal developments on the
economy and financial markets have so far been minimal;
however uncertainty about the resolution of budget cuts
and the debt ceiling remains.
The observable economic impact of the fiscal cliff
negotiations was limited. The average pace of growth
of real, seasonally adjusted personal consumption
expenditures in the second half of the year was roughly
unchanged from the first half, suggesting households did
not significantly adjust their spending habits in advance
of the fiscal cliff. Business investment in E&S was also
roughly unchanged over 2012. However, increased tax
rates on higher-income households may have accelerated
32

2 0 1 3 F S O C / / Annual Report

some economic decisions. For example, corporate
dividend payments increased 20 percent in the fourth
quarter, likely in an effort to bring forward tax liabilities
before higher rates became effective in 2013.
The consequences of failing to increase the debt ceiling
were generally seen by financial markets as more
immediately serious than the effects of the fiscal cliff,
largely because the effects of the fiscal cliff would accrue
over time whereas the inability of the Treasury to borrow
after extraordinary measures were exhausted would be
felt in markets immediately. Moreover, a failure to increase
the debt ceiling would have called into question the U.S.
government’s ability to honor its existing obligations.
Market reaction to the political uncertainty surrounding
the debt ceiling was more sanguine in 2012 than during
the previous episode in the spring and summer of 2011.
At that time, an S&P downgrade of the U.S. sovereign
credit rating in the context of the escalating European
debt crisis caused substantial market impacts: risk assets
sold off dramatically, while Treasury securities rallied in a
flight-to-quality trade (Chart A.1). By contrast, in the more
recent episode in 2012, the movements in Treasury yields
and credit spreads were not nearly as dramatic, in part
because the debt ceiling was suspended well before the
Treasury had exhausted its extraordinary measures.
Chart A.1 	 10-Year Treasury Yield and Corporate
Bond Spreads
A.1 10-Year Treasury Yield and Corporate Bond Spreads
Basis Points
300
250

As Of: 25-Mar-2013
Debt ceiling
increased

Percent
4.0

U.S. Corporate
Investment Grade - OAS
(left axis)

200

3.5
3.0

150

2.5

100

2.0

50

Treasury 10Y Yield
(right axis)

0
Mar:11
Jul:11
Nov:11
Source: U.S. Department
of Treasury, Barclays

Mar:12

Debt ceiling
temporarily suspended
Jul:12

Nov:12

Mar:13

1.5
1.0

Note: Debt ceiling increased on 2-Aug-2011
and temporarily suspended on 4-Feb-2013.

Nevertheless, asset prices reflected a small probability
that Congress might not raise the debt ceiling before
the Treasury’s extraordinary measures were exhausted.
Prices on Treasury bills perceived to be at risk for
extension or missed payments declined relative to other
Treasury bills. Some market participants avoided these
specific securities in the weeks leading up to the debt
ceiling deal in the House—a similar dynamic took place in
July 2011. These movements gave clear indications that
segments of the market were concerned about the debt
ceiling, although the price action was relatively muted.
The approach of the fiscal cliff also had a transient effect
on financial markets. During the last week in December,
the implied volatility on S&P 500 futures contracts (the
VIX) spiked to a level not reached since the first half
of the year, and the prices of safe haven assets rose,
including longer-dated Treasury securities and agency
mortgage-backed securities (MBS) (Chart A.2). Over
three trading days surrounding passage of the ATRA
on January 1, 2013, the S&P 500 rose 4 percent and
the yield on 10-year Treasury securities jumped 21
basis points, as the threat of widespread tax increases
was averted.
Chart A.2 	 10-Year Treasury Yield and Market Volatility
A.2 10-Year Treasury Yield and Market Volatility
Percent
30

As Of: 25-Mar-2013

Percent
2.5
2.3

25

Treasury 10Y Yield
(right axis)

20

2.0
1.8
1.5

15

10
Jan:12

VIX
(left axis)
Apr:12

1.3

Jul:12

Oct:12

Jan:13

1.0

Source: U.S. Department of Treasury, Capital IQ

Macroeconomic Environment

33

4.3.2

Chart 4.3.4		 State and Local Government Tax Revenues
4.3.4 State and Local Government Tax Revenues
Trillions of US$

As Of: 2012 Q4

Trillions of US$

Note: Gray bars signify NBER recessions.
Revenue shown represents the trailing 4 quarters.

Source: Census Bureau

Chart 4.3.5 		 Long-Term Mutual Fund Flows: Municipal Bonds
4.3.5 Long-Term Mutual Fund Flows: Municipal Bonds
Billions of US$
15

As Of: Feb-2013

Billions of US$
15

10

10

5

5

0

0

-5

-5

-10

-10

-15
2007

2008

2009

2010

2011

2012

2013

-15

Source: ICI, Haver Analytics

Chart 4.3.6 		
Federal Grants-in-Aid to State
and Local Governments
4.3.6 Federal Grants-in-Aid to State and Local Governments
Billions of US$
600

As Of: 2012 Q4

Billions of US$
600

500

500

400

400

300

300

200
2000

2002

2004

Source: BEA,
Haver Analytics

34

2 0 1 3 F S O C / / Annual Report

2006

2008

2010

2012

200

Note: Gray bars signify NBER recessions.

State and Local Governments

The fiscal position of state and local
governments continues to improve, although
many budgets are still strained. State and
local governments are replenishing their cash
reserves, and aggregate nominal tax revenues
continued to grow modestly after declining
in the aftermath of the financial crisis (Chart
4.3.4). Net credit flows to state and local
governments were also mostly positive in 2012.
Long-term municipal bond funds experienced
inflows 49 weeks out of the year in 2012 (Chart
4.3.5), and long-term bond issuance was up
31 percent to $376 billion in 2012—the highest
level since 2010, when the Build America Bond
program expiration led to a wave of
new issuance.
However, the resources available to state and
local governments to finance their spending
remain constrained. An uneven level of
unemployment, disparate property tax revenue,
and ongoing spending pressure from Medicaid
and pension liabilities continue to challenge the
outlook at the state and local level. Additionally,
the federal stimulus grants provided under the
American Recovery and Reinvestment Act of
2009 have largely wound down, leading to a
substantial decline in nominal federal transfers
to state and local governments (Chart 4.3.6).
States have also reduced capital expenditures,
which have fallen to their lowest levels since
the late 1990s. The reduction in real capital
expenditures can be seen in declining public
construction spending, the vast majority
of which is undertaken by state and local
governments (Chart 4.3.7).
Ongoing fiscal challenges have also led to
a rising number of municipal defaults and
Chapter 9 bankruptcy filings in 2012. However,
the number of Chapter 9 filings remains very
low and recent bankruptcies have been caused
by a variety of challenges, such as regions hit
hard by the financial crisis, poorly planned
financing of public works projects, one-time
legal judgments, or obligations related to
large unfunded pension liabilities. While total
municipal bond issuance was robust in 2012,

net new municipal bond issuance remains well
below historical averages (Chart 4.3.8). Net
new issuance is depressed due to decreased
issuer appetite for debt following the financial
crisis and expectations that interest rates will
remain low for the foreseeable future, allowing
issuers to delay financing. Municipal interest
rates also reached historic lows in 2012, which
bolstered incentives to refinance. This is seen
in the cost of municipal bonds—as measured
by the yield ratio to similar maturity Treasury
securities—which has been falling across the
credit spectrum since the summer of 2012
(Chart 4.3.9).
Finally, state and local governments will need to
continue addressing the underfunded status of
their pension plans. A decade of low financial
market returns and low economic growth
since 2008 has exacted a heavy toll on funding
levels, while at the same time benefit costs
have continued to rise. Greater transparency
in this area is also needed, as exemplified by
the SEC’s recent enforcement case against the
State of Illinois. A similar challenge applies
to other post-employment benefits, as many
municipalities have not yet set aside funding for
their ongoing obligations to provide health care
to retired state and local municipal employees.

Chart 4.3.7 		 Total Public Construction Spending
4.3.7 Total Public Construction Spending
Billions of US$
350

As Of: Feb-2013

Billions of US$
350

300

300

250

250

200
2006

2007

2008

Source: Census Bureau,
Haver Analytics

2009

2010

2011

2012

2013

200

Note: Gray bar signifies NBER recession.

Chart 4.3.8 		 Municipal Bond Issuance
4.3.8 Municipal Bond Issuance
As Of: 2012

Billions of US$

Source: Thomson
Reuters, SIFMA

Billions of US$

Note: Excludes maturities of 13 months
or less and private placements.

Chart 4.3.9 		 Municipal Tax-Exempt Bond Yield Ratios
4.3.9 Municipal Tax-Exempt Bond Yield Ratios
Percent
260

As Of: 25-Mar-2013

Percent
260

Illinois
California
New York
Generic A-rated
Generic AAA-rated

220
180

220
180

140

140

100

100

60
2007

2008

2009

Source: Bloomberg, L.P.

2010

2011

2012

2013

60

Note: General obligation 10-year municipal
bond yields to 10-year Treasury yields.

Macroeconomic Environment

35

4.4

Chart 4.4.1 		 Real GDP Growth
4.4.1 Real GDP Growth
Percent
10

As Of: Jan-2013

Percent
10

Emerging
Economies

8

8

6

6

4

4

2

2

0

0

-2

Advanced
Economies

-4
-6
2000

2002

2004

2006

Source: IMF, Haver Analytics

2008

2010

2012

-2
-4
-6
2014

Note: IMF estimates are used when actual
data is unavailable. Year-over-year percent
change. Data after 2012 is projected.

Chart 4.4.2 		 Advanced Economies Real GDP Growth
4.4.2 Advanced Economies Real GDP Growth
Percent
6

As Of: Jan-2013

Percent
6

4

4

2

2

0

0

-2
-4

-2

United States
Canada
United Kingdom
Euro Area
Japan

-6
2000

2002

2004

Source: IMF, Haver Analytics

-4

2006

2008

2010

2012

-6
2014

Note: Year-over-year percent change.
Data after 2012 is projected.

External Environment

4.4.1

Advanced Foreign Economies

In the aggregate, GDP growth in the advanced
economies slowed in 2012 (Chart 4.4.1). The
euro area fell back into recession, and growth
was subdued in other advanced economies.
Among the major foreign advanced economies
(the euro area, Japan, the United Kingdom,
Canada), real GDP is estimated to have
contracted 0.3 percent from the fourth quarter
of 2011 to the fourth quarter of 2012 on a
GDP-weighted basis. Severe financial stress
in the euro area over the summer restrained
business and consumer spending in the core
and periphery, and weighed on global growth
more broadly. In Japan, exports and industrial
production slumped in the third quarter
of 2012, producing a sizeable contraction
in output.
Foreign economic activity appears to have
stabilized in early 2013, reflecting an easing
of financial stresses in the euro area, signs of
stable trade flows among major economies,
and ongoing accommodative monetary policies
(see Box B: Global Monetary Policy Actions).
The International Monetary Fund (IMF)
projects major foreign advanced economies
to expand a modest 1.2 percent from the
fourth quarter of 2012 to the fourth quarter
of 2013 on a real basis. Growth in the foreign
advanced economies is expected to remain
sluggish over the medium term, reflecting fiscal
consolidation and deleveraging in the wake of
the global financial crisis (Chart 4.4.2).
European authorities at the country and
regional level responded to the crisis in 2012
through ongoing policy reform; actions to
provide financial support to countries under
stress pursuing reform and adjustment policies;
establishment of the Single Supervisory
Mechanism (SSM); and from the European
Central Bank (ECB), the creation of a
program to reduce financial fragmentation by
purchasing sovereign debt. Cumulatively, these
policy actions have served to reduce concerns
about a systemic event in the euro area and

36

2 0 1 3 F S O C / / Annual Report

have substantially eased severe market pressures
since mid-2012. Sentiment particularly turned
in August, after the ECB announced its
willingness to purchase sovereign debt (subject
to a formal request and policy conditionality),
through the Outright Monetary Transactions
(OMT) program. Although the OMT has
not been utilized, periphery sovereign debt
spreads have narrowed sharply, equity markets
have rebounded, and bank debt markets have
partially reopened (see Section 5.1.2 for a
discussion of sovereign markets). Improved
confidence and the return of some private
capital is expected to gradually ease the deep
recession in the periphery over the course of
this year, along with a modest easing in the
pace of fiscal tightening and strengthened
external demand, though downside risks to the
economic forecast remain (Chart 4.4.3).
At the same time, countries across the euro
area periphery continued to implement fiscal
consolidation to shrink their fiscal deficits and
reduce public debt burdens, structural reforms
to reshape their economies and improve
competitiveness, and banking sector repair
and restructuring. Altogether, governments
are estimated to have reduced fiscal deficits by
2.5 to 8.0 percentage points of GDP from 2009
peak levels by the end of 2012, demonstrating
meaningful progress on their medium-term
adjustment plans. Euro area periphery public
debt levels are now projected to peak over the
period from 2013 to 2015 (Chart 4.4.4).

Chart 4.4.3 		 Euro Area Real GDP Growth
4.4.3 Euro Area Real GDP Growth
Percent
6

As Of: Jan-2013

Percent
6

4

4

2

2

0

0

-2
-4

Spain
France
Euro Area
Italy
Germany

-6
2002

-2
-4

2005

2008

Source: IMF, Haver Analytics

-6
2014

2011

Note: Year-over-year percent change.
Data after 2012 is projected.

Chart 4.4.4 		 Peripheral Europe: Gross Public Debt
4.4.4 Peripheral Europe: Gross Public Debt
Percent of GDP
200
Greece
Italy
Portugal
160
Ireland
Spain
120

As Of: Oct-2012

Percent of GDP
200
160
120

80

80

40

40

0
2006

2008

2010

Source: IMF, Haver Analytics

2012

2014

2016

0

Note: Data after Oct-2012 is projected.

In the case of Greece, after political
uncertainties and plunging output pushed
the adjustment program off-track in mid2012, European Union (EU) and IMF lenders
agreed at the end of 2012 to provide Greece
with two extra years to build to a primary
budget surplus of 4.5 percent of GDP, and to
a number of initiatives to ease the terms of
official loans to Greece. Greek sovereign debt
sustainability was enhanced through a debt
buyback in December, which followed its debt
exchange in March. Ireland and Portugal
continued to make progress implementing
their EU/IMF programs and both countries
Macroeconomic Environment

37

have issued their first long-term bond offerings
since they lost international market access in
late 2010 and early 2011; however, a recent court
decision striking down part of Portugal’s deficit
reduction program for 2013 could complicate
the process in that country. The Spanish and
Italian governments have pressed on with their
fiscal and structural reform agendas and, to
support the Spanish bank restructuring, the
EU approved a bank recapitalization program
covering financing needs of up to €100 billion.
At year end, Spain’s weakest state-controlled
banks (holding 18 percent of bank assets)
were recapitalized with €37 billion (equivalent
to 4 percent of GDP) of European Stability
Mechanism (ESM) funding, and their real
estate-related assets were transferred to a
centralized asset management company. As
will be discussed in Section 5.1.2, the Cypriot
government restructured its two largest banks,
forcing losses on their senior bond holders and
uninsured depositors, in order to meet the
requirements for a loan package.
Meanwhile, European authorities pledged to
pursue deeper financial, economic, fiscal, and
political integration to enhance the resilience
of the monetary union. Leaders agreed to
establish a SSM for banks by mid-2014, housed
at the ECB, and to consider a proposal for a
single bank resolution mechanism applicable
to the member states participating in the SSM.
Under this agreement, the ECB—working with
national supervisory authorities—would have
direct oversight responsibilities for the largest
financial institutions and for those institutions
receiving official sector support. The European
Council has called for legislators to further
advance proposals for a single resolution
mechanism in 2013, although progress
toward a legislative agreement is expected
to be challenging. With respect to fiscal and
economic integration, the focus has been on
strengthening the EU’s governance framework
through enhanced rules, stronger euro-level
enforcement authority, and ex-ante policy
coordination. In December 2012, the President
of the European Council was charged with
preparing proposals for the June 2013
38

2 0 1 3 F S O C / / Annual Report

summit to explore modest financial
incentives to support contractually agreed
competitiveness reforms.

4.4.2

Emerging Market Economies

In 2012, economic growth across the emerging
market economies (EMEs), including China,
India, Brazil, and Russia, slowed as earlier
policy tightening and weakened external
demand for exports weighed on performance
(Chart 4.4.5). Indeed, 2012 EME growth was
the lowest since 2002, with the exception of the
2008 to 2009 crisis period. A gradual recovery
now appears underway across the EMEs,
according to recent high frequency indicators,
such as exports, industrial production,
and purchasing manager surveys. This year,
the IMF forecasts a modest acceleration in
EME growth to 5.9 percent (Q4/Q4) from
5.5 percent in 2012.
The EMEs continue to be a significant source
of global growth. Over the past year, EMEs
contributed four times as much to world growth
compared to advanced economies (Chart
4.4.6). Chinese growth remains a critical factor,
contributing 37 percent alone to total real
global growth in 2012. Indications that trend
growth has slowed across the largest EMEs are
of potential concern for the medium term: the
IMF now forecasts EME real GDP trend growth
at 6 percent. In this context, structural reforms,
such as measures to improve the investment
regime for infrastructure, improvement of
public services and the business climate, and
efforts to overhaul tax systems, could enhance
medium-term growth prospects.
EME inflation pressures eased modestly in
2012. Most recent inflation prints remain well
below 2008 and 2010 peaks, but still stand
above inflation in the advanced economies
(Chart 4.4.7). Moreover, inflation generally
remains near the upper end of emerging
market (EM) monetary authorities’ inflation
targets or tolerance zones. Food prices, given
their large weight in EME CPI baskets, remain
a risk for inflation dynamics and have social
ramifications. India, in particular, has to

Chart 4.4.5 		 Emerging Market Economies Real GDP Growth
4.4.5 Emerging Market Economies Real GDP Growth
Percent
15

As Of: Jan-2013

Percent
15

10

10

5

5

0

0

-5

-5

China India
Mexico Russia
Brazil

-10
2005

2007

2009

Source: IMF, Haver Analytics

2011

-10

2013

Note: Year-over-year percent change.
Data after 2012 is projected.

Chart 4.4.6 		 Contribution to World GDP Growth
4.4.6 Contribution to World GDP Growth
As Of: Oct-2012

Percent
6

Percent
6

4

4

2

2

0

0

-2
-4

BRIC
Emerging Economies Ex-BRIC
Advanced Economies Ex-US
United States
2000

2002

2004

-2

2006

2008

2010

2012

-4

Note: IMF estimates are used when actual data
is unavailable. Data after Oct-2012 is projected.

Source: IMF

Chart 4.4.7 		 BRIC and U.S. Inflation Rates
4.4.7 BRIC and U.S. Inflation Rates
Percent
16

As Of: Feb-2013

Percent
16

India

Russia

12
8

12
China

8
Brazil

4

4
United States

0
-4
2007

2008

2009

2010

2011

2012

0

2013

-4

Source: Haver Analytics

Macroeconomic Environment

39

cope with elevated inflation at the same time
economic growth has slowed to its weakest pace
in a decade. Additionally, property sectors in
some Asian EMEs are undergoing sharp price
increases, which policy makers are attempting
to contain via imposition of macroprudential
measures. Given the forecasts for only modest
growth rebounds and elevated inflation, market
expectations generally forecast limited shifts in
EM monetary policy stances this year.

Chart 4.4.8 		 Inflows to EMEs
4.4.8 Inflows to EMEs
Billions of US$

Source: EMED

As Of: 2012 Q3

Billions of US$

Capital flows to the EMEs have rebounded
substantially from the 2008 to 2009 crisis lows,
attracted by higher EME growth rates and a
large interest rate differential with advanced
economies. Foreign direct investment (FDI)
inflows into EMEs remained relatively robust.
Beginning in late 2011, however, portfolio
capital flows were volatile, reflecting sudden
reversals in risk appetite due to concerns
about the euro area and the strength of the
global recovery. Pullbacks were evident in
portfolio inflows to EMEs as well as reduction
in European bank lending, stemming from
home-market liquidity and capital pressures.
Still, many of the larger EMEs possess ample
reserve cushions, partially mitigating risks
associated with capital flow volatility (Chart
4.4.8). Currency appreciation pressures also
moderated across EMEs and the pace of reserve
accumulation slowed.
Despite the reductions in European bank
lending, short-term trade finance appears
to have held up, due in part to increased
lending activity by local EM banks. Financing
availability has been reduced for longer-term
trade and commodity transactions, and for
project finance, but increased bond financing
has helped EM corporations meet longer
term financing needs. The volume of foreign
currency bonds sold by EM companies and
banks reached more than $360 billion in
2012—a nearly 65 percent increase over 2011
issuances. This trend could create risks of
currency mismatch if EM borrowers fail to place
prudent limits on their currency risk exposures.

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2 0 1 3 F S O C / / Annual Report

China
The Chinese economy appears to have
experienced a soft landing in 2012, with average
annual growth slowing to 7.8 percent from 9.3
percent in 2011. Contributing factors include
the lagged effects of prudential tightening in
2010 and 2011 targeting speculative property
and local government infrastructure investment
which continued to filter through the economy,
and sluggish external demand in the advanced
economies (particularly Europe) which
contributed to lower growth via weakened
exports (Chart 4.4.9). China’s current account
surplus declined from 10.1 percent of GDP in
2007 to under 3.0 percent last year, driven by
factors such as exchange rate appreciation,
weak external demand, and increased imports
for domestic investment purposes. Faced
with the risk of a sharper-than-expected
growth downturn in the first half of 2012, the
authorities shifted footing by mid-year, lowering
administered interest rates, and accelerating
the pace of new infrastructure project
approvals. These measures effectively placed a
floor under Chinese growth and contributed
to a modest growth re-acceleration toward year
end, following seven consecutive quarters of
slowdown. Signs of a growth re-acceleration
also appear to have firmed external market
sentiment towards China, with the pace of
net non-FDI financial outflows abating in the
fourth quarter of 2012.
A source of concern related to China’s domestic
economy is the flow of new credit, which has
increased notably in recent years. Growth
in nonbank financing channels (off-balance
sheet lending, trust loans, and corporate
bond issuance) has comprised an increasing
share of the flow of new credit (Chart 4.4.10).
Moreover, incremental increases in new
credit have significantly outpaced increases in
nominal GDP growth, raising questions about
the efficiency of credit allocation and the
potential for defaults over the medium term.
The rise in nonbank finance in China has also
coincided with the rapid proliferation of wealth
management products and the potential risks
associated with new financial innovation.

Chart 4.4.9 		 China Real GDP Growth
4.4.9 China Real GDP Growth
Percent

As Of: 2012 Q4

Source: CEIC Data

Percent

Note: Quarterly data. Percentage change
on the same quarter of the previous year.

Chart 4.4.10 		 China: Annual Increases in Credit and GDP
4.4.10 China: Annual Increases in Credit and GDP
Trillions of Renminbi

As Of: 2012

Trillions of Renminbi

Incremental Increase in
Nominal GDP

Source: Haver Analytics,
CEIC Data

Note: Additional sources of credit include the following components
of "total social financing" as reported by the People's Bank of
China: trust loans, entrusted lending, undiscounted bankers'
acceptances, and net new corporate bond issuance.

Macroeconomic Environment

41

5

Financial Developments

This section provides an overview of financial
market developments by reviewing (1) asset
valuations; (2) wholesale funding markets;
(3) bank holding companies and depository
institutions; (4) nonbank financial companies;
(5) investment funds; and (6) financial market
infrastructure. Special topics in this section
include global monetary policy actions,
convexity event risks, and collateral availability.

5.1

Asset Valuations

5.1.1

Fixed Income Valuations

Across many of the fixed income markets,
benchmark rates, spreads, and volatilities have
remained low and tended to decline, including
investment grade corporate, high-yield
corporate, and mortgage-backed (CMBS and
MBS) securities. Asset purchases by the Federal
Reserve and lowered investor perceptions of
solvency risk for credit products led to further
declines in Treasury and credit yields. Fixed
income valuations were also supported by
improved performance amongst financials and
corporates, and changes in demand and supply
across the credit and interest rate spectrum.
The level of U.S. 10-year Treasury yields
averaged 1.8 percent during the past year,
down from its 2011 average of 2.8 percent
(Chart 5.1.1). While the slope of the 2- year to
10-year Treasury curve remains upward sloping
at around 165 basis points, it is below the
recent historical average of 205 basis points
(Chart 5.1.2). Corporate bond yields are also
quite low relative to longer-run historical
averages. As of March 2013, investment grade
debt (rated BBB- and above) traded at a
spread of 175 basis points, while speculative
grade spreads (rated BB+ and lower) exceeded
500 basis points. Although spreads on these
instruments relative to Treasury securities are
not excessively narrow, the low base level of
yields suggests institutions can obtain funding

Chart 5.1.1 		 Treasury Yields
5.1.1 Treasury Yields
Percent

As Of: 25-Mar-2013

Percent

10Y

5Y
2Y

Source: U.S. Department of Treasury

Chart 5.1.2 		 Slope of the Treasury Yield Curve
5.1.2 Slope of the Treasury Yield Curve
Basis Points

As Of: 25-Mar-2013

Basis Points

Source: U.S. Department of Treasury

Financial Developments

43

Chart 5.1.3 		 Realized and Implied Interest Rate Volatility
5.1.3 Realized and Implied Interest Rate Volatility
Basis Points
300

Basis Points
300

As Of: 25-Mar-2013

250

250
Realized Volatility, 10-Year
Swap Rate, 1-Year Forward

200

200

150

150

100

100
Option-Implied Volatility, 10-Year
Swap Rate, 1-Year Expiry

50
0
2006

2007

2008

2009

2010

50

2011

2012

2013

0

Source: JP Morgan estimates

Chart 5.1.4 		 Implied Volatility
5.1.4 Implied Volatility
Points
250
200

As Of: Feb-2013

MOVE Index

Points
250
200

SMOVE Index

150

150

100

100

50

50

0
2005

2007

2009

Source: Bank of America Merrill
Lynch, Haver Analytics

2011

2013

0

Note: MOVE and SMOVE are the yield curve
weighted indices of the normalized implied
volatility on 1-month interest rate options.

Chart 5.1.5 		 U.S. Corporate Bond Spreads – Investment Grade
5.1.5 U.S. Corporate Bond Spreads – Investment Grade
Basis Points

As Of: 25-Mar-2013

Basis Points

Financials

Non-financials

Source: Barclays

44

on relatively inexpensive terms. At the same
time, the low rate environment might constitute
a risk for investors (see Section 7.4 for
elaborations on these risks).

2 0 1 3 F S O C / / Annual Report

Interest rate volatility, both implied and
realized, have continued to decline towards
pre-2008 levels in spite of the range of
uncertainties faced by market participants in
recent years (Chart 5.1.3). There are several
factors contributing to the decline in volatility.
First, the Federal Reserve’s asset purchases
reduced the amount of aggregate duration risk
held by the public. Second, communications
by the Federal Reserve’s Federal Open Market
Committee (FOMC) around its forward rate
guidance might contribute to reduced market
volatility and hedging activity on short-term
interest rates. Third, nominal yields are close
to the zero lower bound, which limits downside
volatility. An important driver of implied
volatility is the reduced hedging activity of
government-sponsored enterprises (GSEs) and
mortgage originators—traditional natural
buyers of rate volatility—who have reduced
demand significantly. Active selling of volatility
by hedge funds, money managers, and banks
for yield enhancement, and the perception of
decreased tail-risk emanating from Europe, also
contributed to downward pressure on implied
volatility. Implied volatility can be gauged from
the Merrill Lynch Option Volatility Estimate
Index (MOVE), which measures market
sentiment of future interest rate volatility. In
October 2008, at the height of the financial
crisis, the MOVE reached its historical peak
in excess of 200 basis points. Currently, the
MOVE is at about 60 basis points, a level last
seen in spring 2007. A similar decline in market
expectations of future volatility is apparent
for options on interest rate swaps as gauged by
the Merrill Lynch Swaption Volatility Estimate
Index (SMOVE) (Chart 5.1.4).
Credit markets experienced strong issuance
and declining spreads (Charts 5.1.5).
Declining solvency risk and greater demand
for investment and speculative grade
credit products contributed to the strong

performance. Corporate bonds and leveraged
loans (loans provided to companies with noninvestment grade credit metrics) experienced
record or near-record issuance (Charts 5.1.6,
5.1.7, and 5.1.8), while issuance of collateralized
loan obligations (CLOs) picked up markedly
(Chart 5.1.9). Simultaneously, market sentiment
over tail risks in the second quarter improved
considerably following actions by the Federal
Reserve, the European Central Bank (ECB),
and other central banks in response to weak
economic growth. That is, yield differentials
between these credit instruments and risk free
equivalents have fallen.
The consequences of a search for (and
compression of) yield manifested in a variety
of ways. In some cases, investors shifted
down the credit spectrum, from AA- to BBBrated bonds, or increased duration through
investment in longer maturity bonds. In recent
quarters, credit terms and conditions for newly
issued institutional loans and high-yield bonds
loosened further along certain dimensions.
The share of loan issuance without financial
maintenance covenants, known as covenant-lite
loans, has risen steeply over the past two years,
accounting for about 30 percent of institutional
loan issuance in the fourth quarter of 2012. For
loans with maintenance covenants, looser terms
and conditions were evident in the persistent
decline in the average number of covenants.
As an additional consequence of the search
for yield, issuance of Payment-In-Kind (PIK)
bonds—which allow the issuer to capitalize
and defer interest through an increase of face
value—increased sharply in 2012, though
levels are still noticeably lower than those
seen in 2007. Reach for yield also expanded
to peripheral credits, such as in CMBS, where
issuance increased from $30 billion in 2011 to
$45 billion in 2012. Such compensatory shifts by
investors imply a trade-off between increasing
near-term income and more severe price risk to
their portfolios in the event of a steep increase
in yields.
Changes of pricing across other asset classes
were attributable to demand and supply factors.

Chart 5.1.6 		 U.S. Corporate Bond Issuance
5.1.6 U.S. Corporate Bond Issuance
Billions of US$

Source: Thomson
Reuters, SIFMA

As Of: 2012

Billions of US$

Note: Includes all non-convertible corporate debt, MTNs, and
Yankee bonds, but excludes all issues with maturities of one
year or less and CDs.

Chart 5.1.7 		 High-Yield Bonds: Issuance and Market Size
5.1.7 High-Yield Bonds: Issuance and Market Size
Billions of US$

As Of: 2012

Billions of US$

Total Issuance (left axis)
Net Issuance (left axis)

Market Size
(right axis)

Source: Bank of America Merrill
Lynch Global Research, S&P LCD

Chart 5.1.8 		 Institutional Loans: Issuance and Market Size
5.1.8 Institutional Loans: Issuance and Market Size
Billions of US$

As Of: 2012

Billions of US$

Gross Issuance (left axis)
Net Issuance (left axis)

Market Size
(right axis)

Source: Bank of America Merrill
Lynch Global Research, S&P LCD

Financial Developments

45

Chart 5.1.9 		 CLOs: Issuance and Market Size
5.1.9 CLOs: Issuance and Market Size
Billions of US$

As Of: 2012

Gross Issuance (left axis)
Net Issuance (left axis)

Billions of US$
Outstanding
(right axis)

Source: Bank of America Merrill
Lynch Global Research, Intex

Chart 5.1.10 		 Agency MBS Spreads to Treasuries
5.1.10 Agency MBS Spreads to Treasuries
Basis Points
250

As Of: 25-Mar-2013

Basis Points
250

200

200

150

150

100

100

50

50

0
2006

2007

2008

Source: Bloomberg, L.P.

46

2 0 1 3 F S O C / / Annual Report

2009

2010

2011

2012

2013

0

Note: Fannie Mae 30-year MBS
spreads to 10-year Treasuries.

The primary investors in CLOs, particularly
for AAA tranches, are currently Japanese and
U.S. banks. Other CLO investors include large
financial accounts such as money manager,
insurance companies, and pension funds.
Hedge funds and private equity funds as well
as specialized CLO managers are primarily
reported to be buying mezzanine and equity
tranches. Spreads also fell for MBS as the
Federal Reserve’s renewed purchases of MBS
sharply reduced the available supply, causing
the spread between yields on MBS and 10-year
Treasury notes to narrow significantly
(Chart 5.1.10). Within corporate credit, cash
bond spreads decreased significantly as the
result of strong investor demand against the
expectation of little downside risk. Evidence
of this appetite is found in the CDS-bond
basis, the spread of credit default swaps over
comparable cash bonds, which has tightened
recently. Although the basis was strongly
negative during the financial crisis, reflective
of financial intermediaries’ unwillingness to
hold corporate bonds, it has since returned to
nearly zero. U.S. dollar interest rate swap rates,
at maturities greater than 10 years, remained
negative to Treasury yields over the course
of 2012. Market participants attribute these
negative swap spreads to overwhelming demand
by both investors and corporate issuers to
receive fixed rates on interest rate swaps.

5.1.2

Sovereign Debt and Foreign Exchange

U.S. Sovereign Debt
The total amount of outstanding U.S.
sovereign debt held by the public, (including
Federal Reserve holdings, but not other
intragovernmental debt), rose to $11.8 trillion
as of February 28, 2013 (Chart 5.1.11). Despite
this increase in supply, long-term Treasury
yields declined in the first half of 2012. Longterm yields, at historical lows, are a reflection
of both residual flight to quality and continued
monetary policy accommodation associated
with the below-trend pace of economic growth.
The Federal Reserve’s flow-based purchases
of both agency MBS and Treasury securities,
and the introduction of language in the FOMC
statement linking changes in the federal funds
rate to economic variables, are reflective of
accommodative monetary policy.
Longer-term Treasury yields have risen since
the summer of 2012 against a backdrop
of factors relating to European sovereign
and U.S. domestic considerations. Specific
factors include the ECB’s announcement of
the Outright Monetary Transactions (OMT)
program to purchase European sovereign
debt, a somewhat improved outlook for U.S.
growth, and the passage of the American
Taxpayer Relief Act of 2012 (ATRA), which
prevented substantial tax increases for most
U.S. households.

Chart 5.1.11 		 Publically Held Federal Debt Outstanding
5.1.11 Publically Held Federal Debt Outstanding
Trillions of US$
15

As Of: Feb-2013

Trillions of US$
15

12

12

9

9

6

6

3

3

0
2001

2003

2005

2007

2009

2011

0
2013

Source: U.S. Department of Treasury,
Haver Analytics

Chart 5.1.12 		 Foreign Holders of U.S. Federal Debt
5.1.12 Foreign Holders of U.S. Federal Debt
As Of: Feb-2013

Share

Share

Other

Euro Area
Japan

China

Source: U.S. Department of Treasury,
Haver Analytics

Foreign holdings of U.S. Treasury securities
continue to grow, with the largest investors—
China and Japan—collectively accounting for
$2.3 trillion of U.S. Treasury securities, while
other foreign accounts held $3.3 trillion as of
February 2013. While the share of Treasury
holdings attributed to China and Japan
decreased somewhat since year end 2011, as
their holdings were roughly flat, other countries
added about $540 billion to their stocks
of U.S. sovereign debt since year end 2011
(Chart 5.1.12).

Financial Developments

47

BOX B: GLOBAL MONETARY POLICY ACTIONS
The global financial crisis led central banks in a number of
the advanced economies to cut their policy rates to near
zero. Furthermore, the continued weakness of the global
recovery has led many of them to adopt unconventional
policies involving asset purchases to further promote
economic growth. Monetary policy normally influences
longer-term interest rates by affecting market expectations
of future short-term rates. Unconventional monetary
policies can also affect long-term interest rates through
expectations of future short rates, but also lower yields
by compressing term premia (see Section 7.4). The
purchase of longer-term assets by a central bank
increases overall demand for duration and may therefore
induce investors seeking duration to accept lower yields
on longer-term securities (the duration channel). Another
possible channel is through purchases that reduce the
supply of specific securities preferred by certain investors
(the preferred habitat channel). Unconventional monetary
policies have likely worked through all of these channels
to lower long-term interest rates, and along with the
weak recovery in the many advanced economies and the
restrained levels of inflation, have left long-term rates near
record lows. Even though low long-term interest rates
have helped to support economic growth, they may also
encourage investors to reach for yield and take excessive
risks in order to increase their investment returns.
Accordingly, central banks and other authorities must
monitor financial markets and institutions closely to ensure
that low rates do not threaten financial stability.
Over the past year, the Bank of England (BOE) increased
the size of its asset purchase programs. The BOE
expanded its limit for outright purchases under its Asset
Purchase Facility from £275 billion to £375 billion. In June
2012, the BOE, in conjunction with the U.K. Treasury,
created a temporary Funding for Lending Scheme
designed to reduce the cost of funding new net lending to
the private sector by banks and building societies.
Throughout 2012, the Bank of Japan (BOJ) increased the
size of its Asset Purchase Program from ¥20 to ¥76 trillion
and conducted a funds-supplying liquidity operation of
¥25 trillion. In January 2013, the BOJ announced plans
to begin a new series of open-ended asset purchases
48

2 0 1 3 F S O C / / Annual Report

in conjunction with its adoption of a 2 percent price
stability target. The BOJ also established a new facility to
increase lending more directly, offering long-term funds
to financial institutions against new net lending. On April
4, 2013, the BOJ Policy Board approved a new policy
framework comprised of four main components: (1)
shifting the policy operating target from the overnight call
money rate to the quantity of the monetary base, with a
target of ¥60 to ¥70 trillion annual growth; (2) expanding
the BOJ’s purchases of long-term Japanese government
bonds (JGBs) to an annual pace of about ¥50 trillion on
a net basis (roughly ¥7 trillion in monthly purchases), and
extending the average remaining maturity of JGB holdings
from the current nearly three years to about seven years;
(3) purchasing more risk assets, such as exchange-traded
funds (ETFs) and Japanese real estate investment trusts
(REITs); and (4) committing to maintain the new policy
framework as long as necessary to maintain 2 percent
inflation “in a stable manner.”
In the United States, the FOMC of the Federal Reserve
System provided additional monetary accommodation
over the past year by undertaking additional purchases
of longer-term assets and by modifying its forward
guidance regarding the federal funds rate. The FOMC
took these actions to promote its objectives of maximum
employment and price stability. With respect to purchases
of longer-term assets, the FOMC completed a program
that had begun in the fall of 2011, under which it ultimately
purchased $667 billion in longer-term Treasury securities,
while selling or redeeming an equal amount of shorterterm Treasury securities. In September it announced
additional purchases of MBS at a pace of $40 billion
per month, and in December it announced additional
purchases of longer-term Treasury securities, initially
at a pace of $45 billion per month. With respect to
forward guidance about the federal funds rate, at the
close of its September meeting the FOMC stated that
exceptionally low levels for the federal funds rate were
likely to be warranted at least through mid-2015, longer
than had been indicated in previous FOMC statements.
In December, the FOMC dropped the date-based
guidance and instead indicated that it anticipates that
exceptionally low levels for the federal funds rate would

remain appropriate at least as long as the unemployment
rate remains above 6.5 percent, inflation between one
and two years ahead is projected to be no more than
0.5 percentage point above the Committee’s 2 percent
longer-run goal, and longer-term inflation expectations
continue to be well-anchored.
The ECB has taken conventional as well as
unconventional policy actions. The ECB eased monetary
policy by reducing its main refinancing rate by 25 basis
points to 0.75 percent in July 2012 and cut its deposit
facility rate to zero. The central bank also conducted the
second of two 3-year refinancing operations in February,
which helped alleviate concerns about liquidity in the
context of imminent maturities of bank debt through a
significant increase in excess liquidity in the euro area
banking system. In 2012, the ECB eased collateral rules
in order to maintain or improve counterparty access
to the Eurosystem’s liquidity-providing operations. To
address more directly the financial fragmentation that had
developed in the peripheral euro area economies and the
resulting fears about the future of the currency union, the
ECB announced in August 2012 the Outright Monetary
Transactions (OMT) program. Under the program, the
ECB would make outright secondary-market purchases
of the sovereign debt of any member country establishing
and remaining in compliance with a new program with
the European Financial Stability Facility (EFSF) and the
European Stability Mechanism (ESM) (see Section 5.1).
Sovereign debt with maturities up to three years would
be eligible for the program, with the majority of purchases
concentrated in the 1- to 3-year sector, and all purchases
would be sterilized. Although no country has requested
support under the OMT, its announcement has helped to
significantly lower financial stress within the currency area.
Although central banks in the emerging market
economies have not had to resort to unconventional
monetary policies, many (notably, the central banks of
China, South Korea, and Brazil) cut their policy rates over
the last year in response to the weak global recovery.

Financial Developments

49

Chart 5.1.13 		 Euro Area 10-Year Yield Spreads to German Debt
5.1.13 Euro Area 10-Year Yield Spreads to German Debt

Percent
18
15
12

As Of: 25-Mar-2013
Greece (right axis)
Portugal (left axis)
Spain (left axis)
Italy (left axis)
France (left axis)

Percent
36
30
24

9

18

6

12

3

6

0
2010

2011

Source: Bloomberg, L.P.

2012

2013

0

European Sovereign Debt
European sovereign debt markets dramatically
improved following the announcement of the
ECB’s OMT program. The spreads on Spanish
and Italian 10-year government bonds to
relatively low yielding German equivalents were
respectively 611 and 518 basis points on the
eve of a July 26 speech in which ECB President
Draghi signaled the creation of the sovereign
debt purchase program, and vowed to “do
whatever it takes” to prevent the breakup of
the euro area. By the end of 2012, Spanish and
Italian spreads to German bonds had dropped
210 and 193 basis points, respectively, and
other peripheral debt spreads also narrowed
substantially (Chart 5.1.13). The response
was even more pronounced in OMT-eligible
tenors of up to three years. For example, 2-year
benchmark spreads fell by 348 and 300 basis
points in Spain and Italy respectively.
Additional measures to promote European
stabilization further supported European
sovereign debt markets (see Section 4.4.1).
These measures include a European Council
agreement to create a unified banking
supervision framework for the euro area,
actions to reduce or restructure the sovereign
debt of vulnerable countries, and several
accommodative monetary policy actions by
the ECB (see Box B: Global Monetary Policy
Actions). A second extension of 3-year credit
by the ECB improved the outlook for French
banks, and allowed yields on French 10-year
government bonds to fall 98 basis points
over the course of 2012. Increased appetite
for higher yielding assets broadly attracted
investors to peripheral European sovereign
debt, as official actions to support European
governments reduced the risk of defaults.
Finally, TARGET2 balances, which are related
to cross-border flows within the euro area and
to ECB actions to support the periphery, halted
a multi-year increase and began to gradually
decline, an indication that capital flight
from periphery to core countries has begun
to reverse.

50

2 0 1 3 F S O C / / Annual Report

Although considerable progress has been
made, recent political events in Italy and
Cyprus have served to remind markets that
the situation in the euro area remains volatile.
February elections in Italy resulted in a split
parliament that has thus far been unable to
form a governing coalition, casting doubt on
whether a new government, if formed, would
be strong enough to pursue further reforms.
More recently, the Cypriot government has
agreed to restructure its two largest banks by
forcing losses on their senior bond holders and
uninsured deposits. It also enacted temporary
capital controls in order to stem the potential
for widespread deposit flight. Although the
restructuring met requirements set by the
European Union (EU) and the International
Monetary Fund (IMF) for a new aid package
and protects insured depositors, the imposition
of both capital controls and losses on senior
bondholders and depositors may carry lasting
implications for the funding costs of other
European banks that investors consider
vulnerable. At least initially, developments
in Cyprus resulted in adverse asset price
movements in peripheral European countries
for bank equity prices and funding spreads.

Other Sovereign Debt
Emerging Market sovereign debt spreads
to U.S. Treasury yields, as measured by the
Emerging Market Bond Index Plus (EMBI+),
compressed during the second half of 2012,
reflecting reduced risks in emerging markets
and the improvement in risk appetite. Given
emerging Europe’s tight financial and economic
links with the euro area, the creation of the
OMT and subsequent improvement in euro
area market conditions led emerging Europe’s
sovereign debt spreads to tighten more than in
other emerging market regions (Chart 5.1.14).

Foreign Exchange
Changes in the value of the U.S. dollar this
year followed themes in other financial
markets. While macroeconomic concerns (both
foreign and domestic) weighed heavily on
markets in the summer of 2012, the U.S. dollar
strengthened slightly on a trade-weighted basis,

Chart 5.1.14 		 Emerging Market Bond Spreads
5.1.14 Emerging Market Bond Spreads
Basis Points
1000

As Of: 25-Mar-2013

800

Basis Points
1000
Latin America
Europe
Asia
800

600

600

400

400

200

200

0
Jul:08

Jul:09

Source: JP Morgan,
Haver Analytics

Jul:10

Jul:11

Jul:12

0

Note: JP Morgan EMBI+ Sovereign
Spreads indices for each region.

Financial Developments

51

Chart 5.1.15 		 Dollar Index Volatility
5.1.15 Dollar Index Volatility
Percent

As Of: 25-Mar-2013

Percent

Note: Dollar index represents
30-day historical volatility.

Source: Bloomberg, L.P.

Chart 5.1.16 		 Currency Implied Volatility
5.1.16 Currency Implied Volatility
Percent
20

As Of: 25-Mar-2013

Percent
20

15

15

10

10

5

5

Currency VIX
1-Month Dollar-Yen
1-Month Euro-Dollar

0
Jan:11

May:11

Sep:11

Jan:12

May:12

Sep:12

Jan:13

0

Source: Bloomberg, L.P.

Chart 5.1.17 		 U.S. Dollar Exchange Rates
5.1.17 U.S. Dollar Exchange Rates
Index
150
140
130

As Of: 25-Mar-2013

Index
150

Euro-Dollar
Major Dollar Index
OITP*
Yen-Dollar

140
130

120

120

110

110

100

100

90

90

80

80

70
Jul:08

Jul:09

Source: Federal Reserve,
Haver Analytics

52

2 0 1 3 F S O C / / Annual Report

Jul:10

Jul:11

Jul:12

70

Note: 1-Jul-2008 = 100. *Other Important Trading Partners –
a weighted average of the FX values of the dollar against a
subset of currencies in the broad index that do not circulate
widely outside the country of issue.

while dollar volatility has declined significantly
since last summer (Chart 5.1.15). A notable
increase in implied volatility occurred recently
for dollar-yen (Chart 5.1.16).
Since the Japanese party leadership elections
in September 2012, and through mid-April
2013, the yen has depreciated sharply against
all major and other Asian currencies, including
more than 20 percent against the U.S. dollar
(Chart 5.1.17). In January, the BOJ announced
three major policy actions: adoption of a 2
percent price stability target, plans to begin a
new “open-ended asset purchasing method”
starting in 2014, and a joint statement by the
BOJ and Japanese government on measures
to overcome deflation and achieve sustainable
economic growth. In April, the BOJ Policy
Board approved a new policy framework
comprised of four main components: (1)
shifting the policy operating target to the
quantity of the monetary base; (2) expanding
the BOJ’s purchases of long-term JGBs and
extending the average remaining maturity of
JGB holdings; (3) purchasing more risk assets;
and (4) committing to maintain the new policy
framework as long as necessary to maintain 2
percent inflation “in a stable manner” (see Box
B: Global Monetary Policy Actions).
Between April and late July 2012, the euro
depreciated by roughly 9 percent against
the dollar on concerns about political
uncertainty in the euro area. Since ECB
President Draghi spoke in late July about
stemming redenomination risk and the ECB’s
subsequent announcement of the OMT, the
euro appreciated by about 12 percent through
January 2013, before easing again by the end of
the first quarter.

5.1.3

Equities, Commodities, and Agriculture

Equities
Equity markets in the major economies
performed well over the past year (Chart
5.1.18). All major indices in developed
economies exhibited significant gains, with

only the IBEX in Spain and FTSE MIB in Italy
reflecting losses of 2 percent and 5 percent,
respectively. The rise in equity markets was
bolstered by an improved global outlook and
expansionary monetary policy (see Box B:
Global Monetary Policy Actions). In the United
States, the price performance of equity indices
was positive in 2012, with a year-over-year gain
of nearly 11 percent for the S&P 500. Corporate
equity valuations improved, as the price-toearnings (P/E) ratio for the S&P 500 rose
slightly. Still, valuations remain below historical
averages, reflecting geopolitical uncertainty,
sluggish economic growth, and event risk
related to fiscal concerns (Chart 5.1.19).
Equity markets in emerging economies rose
considerably through year end 2012, but pulled
back at the start of 2013, resulting in substantial
year-over-year declines for Brazil and Russia
as of March 2013. China experienced mixed
results due to economic headwinds and growth
concerns. The Shanghai index fell 1 percent,
while the Hang Seng returned 8 percent yearover-year through March 2013. Despite the poor
performance in emerging markets, the rebound
in equity markets for developed economies
continues into 2013 (Chart 5.1.20). The S&P
500 has gained over 45 percent since year end
2011, while the Euro Stoxx 50 has gained over
20 percent.
During the first quarter of 2013, expectations of
U.S. equity market volatility, as measured by the
VIX, fell to levels not reached since April 2007.
In 2012, volatility of the major stock indices
of developed economies was high during the
summer, but fell significantly in early August
with the announcement of ECB support for
euro area debt markets. Volatility rose again
in the fall, before receding significantly at
year end following the passage of legislation
averting the fiscal cliff (Chart 5.1.21). The
term structure of the VIX, which measures the
difference between near-term and long-term
market expectations of volatility, flattened
markedly around year end, in a similar manner

Chart 5.1.18 		 Returns in Selected Equities Indices
5.1.18 Returns in Selected Equities Indices
Change from
25-Mar-2012 to
25-Mar-2013

Change from
5-Year Low to
25-Mar-2013

Major Economies
U.S. (S&P)
Euro (Euro Stoxx)
Japan (Nikkei)
U.K. (FTSE)

11%
5%
25%
9%

129%
46%
78%
82%

Selected Europe
Germany (DAX)
France (CAC)
Italy (FTSEMIB)
Spain (IBEX)

13%
7%
-5%
-2%

115%
48%
27%
37%

Emerging Markets
Brazil (Bovespa)
Russia (RTS)
India (Sensex)
China (Shanghai SE)
Hong Kong (Hang Seng)

-17%
-12%
8%
-1%
8%

86%
193%
129%
36%
102%

Source: Capital IQ

Chart 5.1.19 		 S&P 500 Key Ratios
5.1.19 S&P 500 Key Ratios
Percent

As Of: 25-Mar-2013

Percent

P/B Ratio
(right axis)

P/E Ratio
(left axis)

Source: Bloomberg, L.P.

Chart 5.1.20 		 Selected Equities Indices
5.1.20 Selected Equities Indices
Index
140
120

As Of: 25-Mar-2013

Index
140

S&P 500
MSCI EM
Euro Stoxx 50
Nikkei 225

120

100

100

80

80

60

60

40
Jul:08

Jul:09

Source: Haver Analytics

Jul:10

Jul:11

Jul:12

40

Note: 1-Jul-2008 = 100.

Financial Developments

53

Chart 5.1.21 		 Market Volatility
5.1.21 Market Volatility
Percent

As Of: 25-Mar-2013

Percent

as in August 2011 during the height of the
debt ceiling debate. This flattening of the term
structure suggested that as a result of increased
fiscal cliff concerns, expectations of near-term
volatility were rising while long-term volatility
expectations remained relatively unchanged
(Chart 5.1.22). With market expectations of
equity volatility declining to pre-crisis levels,
investors may take on increased risk that could
expose them to significant losses in the event
of a severe reversal (see Section 7.4).

Commodities
Source: Capital IQ

Chart 5.1.22 		 VIX Term Premium
5.1.22 VIX Term Premium
Basis Points
1500
1000

As Of: 25-Mar-2013

Basis Points
1500

Spread between 8-Month
and 1-Month Forward Rates

1000
500

500

0

0
-500

-500

-1000

-1000

-1500
2010

2011

2012

2013

-1500

Source: Bloomberg, L.P.

Chart 5.1.23 		 Oil Production
5.1.23 Oil Production
Millions of Barrels/Day
As Of: Feb-2013
40
OPEC (left axis)
United States (right axis)
Iran (right axis)
36

Millions of Barrels/Day
8
7
6

32

5
4

28
3
24
2002

2004

2006

2008

Source: Energy Intelligence, Haver Analytics

54

2 0 1 3 F S O C / / Annual Report

2010

2012

2

Oil prices continued to exhibit heightened
volatility in 2012, as increasing geopolitical
uncertainty in the Middle East caused oil
prices to increase significantly early in the
year. Specifically, in July the Iran oil sanctions
took full effect, sharply reducing oil exports
from the country. Later in the year, substantial
production increases in the U.S. and in
members of the Organization of Petroleum
Exporting Countries (OPEC) (Chart 5.1.23),
coupled with concerns of decreasing global
demand, caused a sharp decline in oil prices
in the summer, with prices moderating by year
end. Unleaded gasoline prices in the United
States also sharply increased in early 2012, and
after moderating in December 2012, advanced
early this year following sharp increases in
crude oil futures prices (Chart 5.1.24). Natural
gas and agricultural prices were volatile
throughout 2012, but ended the year nearly
unchanged and have remained stable in early
2013 (Chart 5.1.25). Industrial metal prices
dropped severely around mid-year, only to
rise again through the fall, and close the year
with only a slight increase. Gold prices rose
dramatically early in the year, but eventually
subsided, increasing only slightly over the
course of 2012 (Chart 5.1.26).

Agriculture
Strong agricultural conditions have spurred
farmland values to rise to record levels. Across
the United States, the average price per acre
of farm real estate increased by 108 percent
over the past decade (Chart 5.1.27). The
most significant drivers of U.S. agricultural

prosperity, including commodity prices, export
levels, and interest rates, have been near cyclical
bests for a few years. A number of Corn-Belt
and Plains states, where a major stock of corn,
soybeans, and wheat are grown, experienced
relatively large crop price increases. These
crops all experienced price spikes in June and
July and remained elevated for most of the year
(Chart 5.1.28).
The current high price of farmland raises
concerns about a repeat of the early 1980s
agricultural crisis, when several hundred
farm banks failed. However, compared to the
early 1980s, the recent increase in farmland
prices have not coincided with a shift towards
higher leverage of either lenders or borrowers.
Although total agricultural real estate debt
outstanding increased by 65 percent over the
past decade, it still remains well below the
levels seen in the early 1980s (Chart 5.1.29).
Moreover, evidence suggests that the most
frequent buyers of farmland are farmers who
are looking to expand their current capacity,
rather than investors who could be speculating
on land prices.

Chart 5.1.24 		 S&P GSCI Unleaded Gasoline Index
5.1.24 S&P GSCI Unleaded Gasoline Index
Index

As Of: 25-Mar-2013

Index

Source: Capital IQ

Chart 5.1.25 		 Commodities
5.1.25 Commodities
Index
140
120
100

As Of: 25-Mar-2013
Agriculture (S&P GSCI Agricultural Spot Index)
Industrial Metals (S&P GSCI Industrial Metals Spot Index)
Crude Oil
Natural Gas

Index
140
120
100
80

60

60

40

While agricultural debt and farmland lending
continues to grow, many of the farm banks
operating in the United States that are issuing
this debt tend to be small, rural, communitybased lenders that have been characterized
as more conservative lenders. Many of these
banks require that the borrower’s existing
farmland also be taken as collateral, limiting
the potential increase in the borrower’s loan-tovalue ratio (LTV) and the bank’s exposure to
a future decline in farmland prices. Although
farmland lending is important to a significant
number of these rural community banks, it
does not represent a significant share of credit
in large U.S. banks. Furthermore, various crop
insurance programs mostly mitigated crop
losses due to the drought during the summer of
2012. Still, increasing farmland values and the
willingness of banks to provide financing based
on those values, warrants increased monitoring.

80

40

20

20

0
Jul:08

Jul:09

Jul:10

Jul:11

Source: Energy Information Administration,
S&P, Wall Street Journal, Haver Analytics

Jul:12

0

Note: 01-Jul-2008 = 100.

Chart 5.1.26 		 Gold Prices
5.1.26 Gold Prices
Dollars/Troy Oz.
2000

As Of: 25-Mar-2013

Dollars/Troy Oz.
2000

1900

1900

1800

1800

1700

1700

1600

1600

1500

1500

1400

1400

1300

1300

1200
Jan:11

May:11

Sep:11

Jan:12

May:12

Sep:12

Jan:13

1200

Source: Wall Street Journal, Haver Analytics

Financial Developments

55

5.1.4

Chart 5.1.27 		 Farmland Prices and Value of Crop Yield
5.1.27 Farmland Prices and Value of Crop Yield
US$ Per Acre

As Of: 2012

US$ Per Acre

Farmland
(left axis)

Crop Yield*
(right axis)

Note: *US$ value of crops grown per
acre for corn, wheat, and soybeans.
Land values estimated as of Aug-2012.

Source: USDA,
FSOC calculations

Chart 5.1.28 		 Agricultural Prices
5.1.28 Agricultural Prices
Index
800

600

As Of: Feb-2013

Index
800

S&P GSCI Soybean Spot Index
S&P GSCI Wheat Spot Index
S&P GSCI Corn Spot Index

600

400

400

200

200

0
2002

2004

2006

2008

2010

2012

0

Source: S&P, Haver Analytics

Chart 5.1.29 		 Agricultural Real Estate Debt Outstanding
5.1.29 Agricultural Real Estate Debt Outstanding
Billions of US$
350

As Of: 2012

Billions of US$
350

Other
Life Insurance Companies
Commercial Banks
Farm Credit System

300
250

300
250

200

200

150

150

100

100

50

50

0
1967

1975

1983

Source: BLS, Federal Reserve,
Haver Analytics

56

2 0 1 3 F S O C / / Annual Report

1991

1999

2007

0

Note: Dollars are presented
using 2011 prices.

Real Estate Markets

Housing Market Overview
The past year witnessed a fragile, but steady,
recovery in the housing market. Home prices
rose 5.5 percent in 2012 according to the
FHFA (Chart 5.1.30). However, house prices
on a national basis remain approximately 30
percent below their 2006 peak, according to
the CoreLogic Home Price Index. A number of
factors continue to affect the recovery in home
prices, including elevated unemployment, large
shadow inventories of distressed homes, and
lingering concerns about economic growth.
At the end of 2012, the fraction of residential
properties with mortgages in negative equity
declined significantly to 21.5 percent, from over
25 percent at the end of 2011 (Chart 5.1.31).
New and existing home sales are rising, though
they remain below pre-crisis highs. According
to the National Association of Realtors, the
seasonally adjusted annual pace of existing
home sales was approximately 4.98 million units
as of February 2013, up 10.2 percent from one
year prior. Census Bureau statistics show the
seasonally adjusted annual pace of new single
family home sales was 411,000 units in February
2013, representing a 12.3 percent increase
from one year prior. These figures suggest that
housing is rebounding, albeit off low levels of
activity, and contributed to economic growth
throughout 2012.
Indicators of credit quality in the residential
mortgage sector continue to improve. As of
fourth quarter 2012, there was a decline in the
number of loans 90 or more days delinquent
but not in foreclosure, continuing a trend that
began in late 2009. Mortgage delinquencies in
this category have declined from a high of 5.1
percent of all mortgages to 3 percent, but the
share of mortgages in the foreclosure process
has declined only modestly and is currently
about 3.7 percent of all mortgages (Chart
5.1.32). Both foreclosures and reductions in
newly-delinquent loans during 2010, 2011, and
2012 have contributed to the decline in 90+ day

delinquency rates. Loans originated in 2009
and 2010 experienced much lower rates of early
delinquency, compared to loans originated
in the middle of the decade. The number
of properties in foreclosure is declining, but
remains high compared to historical levels.

Home Mortgage Originations and Access to Credit
Prior to the financial crisis, private portfolios
and securitizations funded more than half
of all home mortgage originations. This
pattern reversed after the financial crisis, with
mortgages eligible for government and agency
guarantee programs accounting for no less than
three-fourths of annual originations. During
2012, this trend continued with government
and agency guarantees backing approximately
89 percent of all originated mortgages (Chart
5.1.33), 69 percent of which were guaranteed
by the GSEs.
In 2012, the Federal Housing Administration
(FHA) and the Department of Veterans Affairs
(VA) guaranteed 20 percent of originated
mortgages. FHA- and VA-guaranteed loans
make up a majority of Ginnie Mae MBS
issuances. Between 2001 and 2007, FHA lending
accounted for less than 5 percent of annual
originations. The market share for FHA lending
was small at the time because eligible borrowers
were primarily receiving non-agency loans
funded through securitization. After secondarymarket investors retreated from private-label
securities after the crisis, FHA lending became
the dominant avenue for low- to middle-income
mortgage market credit.
The private capital assuming credit risk in
the marketplace today comes predominantly
from depository institutions through portfolio
lending in mostly prime credit for jumbo loans,
or loans that are larger than conforming limits.
There is, however, growing demand amongst
non-depository private capital for both new and
older issues of non-agency loans and securities.
In a related development, many large depository
institutions are reducing their mortgage

Chart 5.1.30 		 National Repeat Sales Home Price Indices
5.1.30 National Repeat Sales Home Price Indices
Index
220

As Of: Jan-2013

Index
220

CoreLogic
(including
distressed sales)

200
180

200
CoreLogic
(excluding
distressed sales)

160

180
160

140

140
FHFA

120
100
2000

2002

2004

2006

Source: CoreLogic, FHFA,
FSOC calculations

2008

2010

120
100

2012

Note: Gray bars signify NBER recessions.

Chart 5.1.31 		 Mortgages with Negative Equity
5.1.31 Mortgages with Negative Equity
Billions of US$

As Of: 2012 Q4

Percent

Source: CoreLogic

Chart 5.1.32 		 Mortgage Delinquency and Foreclosure
5.1.32 Mortgage Delinquency and Foreclosure
Percent
6

As Of: 2012 Q4

Percent
6

5

5

4

4
3

3
2

Mortgage Foreclosure
Inventory
Mortgage Payments
Past-Due 90+ Days

1
0
2000

2

2002

2004

2006

Source: Mortgage Bankers Association,
Haver Analytics

2008

2010

2012

1
0

Note: Percent of all mortgages.

Financial Developments

57

Chart 5.1.33 	 Mortgage Originations by Program
5.1.33 Mortgage Originations by Program
Share of Originations
1.0
0.8

As Of: 2012

Share of Originations
1.0

Private
Portfolio and
Securitized

0.8
0.6

0.6
GSE

0.4
0.2
0.0
2002

0.2

VA
2004

2006

0.4

FHA
2008

2010

0.0
2012

Source: Inside Mortgage Finance

Chart 5.1.34 		 ortgage Servicing Rights at U.S. Commercial
M
Banks andRights at U.S. Commercial Banks and Thrifts
Thrifts
5.1.34 Mortgage Servicing
Billions of US$

As Of: 2012 Q4

Billions of US$

Source: SNL Financial

Chart 5.1.35 		 Mortgage Originations by Type
5.1.35 Mortgage Originations by Type
Trillions of US$

Source: Inside Mortgage
Finance, HUD, CoreLogic

58

2 0 1 3 F S O C / / Annual Report

As Of: 2012

Trillions of US$

servicing activity and removing potential risk
from their balance sheets by selling servicing
rights to nonbank servicers, which are not
subject to the same capital requirements
as banks. Mortgage servicing rights at U.S.
commercial banks and thrifts have declined by
more than half since their peak in mid-2008
(Chart 5.1.34). Driven by refinancing activity,
mortgage origination volumes in 2012 exceeded
$1.8 trillion for the first time since 2009. Over
the past four years, refinances have accounted
for over two-thirds of total originations. With
mortgage interest rates at historic lows during
2012, refinance activity increased from $880
billion in 2011 to $1.4 trillion in 2012, which
represented over 75 percent of all originations
(Chart 5.1.35). Purchase volumes continued to
contract during 2012, falling to $437 billion, the
lowest level in over a decade.
For the fifth year in a row, the average FICO
credit score for borrowers at origination rose in
2012, exceeding 750, with purchase borrowers
with FICO scores above 760 accounting for 45
percent of originations (Chart 5.1.36). The
share of purchase borrowers with a FICO score
below 600 dropped from 14 percent in 2008 to
less than 2 percent in 2012.
Back-end debt-to-income (DTI), which is the
ratio of all debt payments including the new
mortgage payment— inclusive of principal,
interest, insurance and taxes— to the
borrower’s gross monthly income, declined
across all major loan programs during 2012
(Chart 5.1.37). The back-end DTI for GSEguaranteed loans declined from a year end
2007 peak of nearly 39 percent to 33 percent at
year end 2012. The average DTI on the smaller
set of purchase loans originated and retained
in bank portfolios declined from 38 percent in
2011 to 34 percent in 2012.
Overall, current mortgage market conditions
indicate reduced access to credit for many
potential U.S. borrowers. As average
underwriting standards have tightened
considerably, the lower bound of credit
characteristics on approved loans is much more

stringent than the minimum requirements set
by the GSEs and FHA. For example, according
to the FHA guidelines for manual underwriting
of a loan with the maximum 96.5 percent LTV,
borrowers must have a FICO score greater than
580 and a DTI of less than 43 percent (Chart
5.1.38). Despite this minimum requirement,
the fifth percentile FICO score of FHA first
lien purchase loans originated during 2012
was 635, with the average DTI and LTV
associated with those loans at 36 percent
and 95 percent, respectively.
In addition, for manual underwriting of a
one-unit, fixed rate loan with no minimum
reserves, the GSEs require that borrowers have
a minimum FICO score of 620, a DTI of less
than 36 percent, and a LTV of less than 75
percent. But during 2012, the fifth percentile
of first lien GSE purchase loans by FICO score
at origination was 686, while the average DTI
on those loans was 35 percent. Current market
requirements that exceed the minimums set by
the GSEs limit credit availability for borrowers
at the lower end of the FICO distribution.

Chart 5.1.36 		 Origination Volume by Credit Score
5.1.36 Origination Volume by Credit Score
Share of Origination Volume

As Of: 2012

Share of Origination Volume

>760

720-760
700-720
660-700
600-660
<600

Source: CoreLogic

Note: Includes first lien purchases only.

Chart 5.1.37 		 Average Debt-to-Income Ratio at Origination
5.1.37 Average Debt-to-Income Ratio at Origination
Percent

As Of: 2012

Percent
GNMA
Portfolio
All Loans

GSE

Federal Government Programs to Strengthen the
Housing Market
The government has developed a number of
programs to strengthen the housing market,
primarily by providing relief to struggling
homeowners. These programs include
Making Home Affordable (MHA), the Home
Affordable Refinance Program (HARP), the
FHA Streamline Refinance program, and the
Hardest Hit Fund (HHF). MHA provides first
lien modifications primarily through the Home
Affordable Modification Program (HAMP),
and also includes a second-lien modification
program, an unemployment forbearance
program, and a short-sale or deed-in-lieu-offoreclosure program.
As of December 2012, MHA has granted
nearly 1.5 million homeowner assistance
actions. HAMP has enrolled over 1.1 million
borrowers as of December 31, 2012, and
servicers have offered substantial concessions
to borrowers through modifications that

Source: CoreLogic

Note: Includes first lien purchases only.

Chart 5.1.38 		 inimum Eligibility Standards for Government
M
Purchase Standards for Government Purchase Loans
Loans
5.1.38 Minimum Eligibility
FHA

FANNIE MAE

Minimum Manual
Underwriting Standards

Minimum Manual
Underwriting Standards

Purchase, 1-unit, Fixed-rate
with No Minimum Reserves

Purchase, 1-unit, Fixed-rate
with No Minimum Reserves

FICO*

≥ 580

FICO

≥ 620

Debt-toIncome

≤ 43%

Debt-toIncome

≤ 36%

Loan-toValue

≤ 96.5%

Loan-toValue

≤ 75%

*Required for a maximum LTV of 96.5%. FHA will accept FICO
scores between 500 and 579 with a maximum LTV of 90%.

Source: HUD Handbook, Fannie Mae Eligibility Matrix

Financial Developments

59

reduce the borrowers’ monthly payments.
The incidence of principal reduction in
HAMP modifications increased in 2012,
with approximately three-fourths of eligible
underwater homeowners who entered HAMP
that year receiving some form of principal
reduction. According to the OCC, payment
reduction is strongly correlated with permanent
modification sustainability, and HAMP
modifications exhibit lower delinquency and
re-default rates than industry modifications. In
addition, the FHA has offered more than 1.5
million loss mitigation and early delinquency
interventions. The Administration’s programs
continue to encourage improved standards and
processes in the industry, with HOPE Now (a
foreclosure prevention outreach effort) lenders
offering more than three million proprietary
modifications through November 2012. Since
2009, over six million mortgage modifications
have been made, and homeowner assistance
actions have outpaced foreclosures by a
two-to-one ratio.
The HARP and FHA Streamline Refinance
programs, both of which target underwater
borrowers, provided approximately $300 billion
in refinances during 2012. In early 2012, FHFA
expanded HARP eligibility by eliminating the
125 percent LTV cap. As a primary result of
this change, HARP originations grew from
$85 billion in 2011 to $230 billion during 2012,
comprising over 12 percent of all originations.
The FHA’s Streamline Refinance program,
which also aims to help underwater borrowers
lock in lower rates, provided an additional $65
billion in originations during 2012.
The Treasury’s HHF, announced in 2010,
provides $7.6 billion to housing finance
authorities in the 18 states and the District of
Columbia that were most affected by house
price declines and high unemployment.
These funds have been used to develop
programs tailored to local housing markets,
including mortgage payment assistance
for unemployed borrowers, reinstatement
programs, principal reduction, and transition
assistance for borrowers.
60

2 0 1 3 F S O C / / Annual Report

Government-Sponsored Enterprises
As housing and mortgage market conditions
improved this past year, the financial strength
of Fannie Mae and Freddie Mac increased.
For the fourth quarter of 2012, Freddie Mac
reported net income of $4.5 billion, the fifth
quarter in a row that its net income was positive.
Fannie Mae reported significant net income
for the fourth quarter of 2012, and net income
was positive for each quarter of the year
(Chart 5.1.39). In 2012, Fannie Mae did not
request additional capital support from the
government while Freddie Mac requested
additional capital support from the government
of $19 million; both institutions have returned
to profitability.
The GSEs and Ginnie Mae continued to
account for essentially all issuances of
residential mortgage-backed securities (RMBS)
(Chart 5.1.40). In 2012, the GSEs accounted
for 77 percent of RMBS issuances, considerably
higher than pre-crisis levels, with almost all
of the remaining RMBS issuances coming
from Ginnie Mae. As of January 2013, Fannie
Mae and Freddie Mac both reported serious
delinquency rates for single-family mortgages
(90+ day delinquencies and in-process
foreclosures) of 3.2 percent, representing their
lowest rates since 2009. This decline in serious
delinquencies, which has occurred over the past
10 quarters, is driven in part by the reduction in
2005 to 2008 vintage mortgages relative to their
portfolios, and is consistent with the decline in
delinquencies and new delinquencies seen in
the broader mortgage market in 2012.

Chart 5.1.39 		 GSE Net Income
5.1.39 GSE Net Income
Billions of US$
10

As Of: 2012 Q4

Billions of US$
10

5

5

0

0

-5

-5

-10

-10

-15

-15

-20

-20
-25

-25
Fannie Mae
Freddie Mac

-30
-35

2006

2007

2008

-30
2009

2010

2011

2012

-35

Source: SNL Financial

Chart 5.1.40 		 Issuance of RMBS
5.1.40 Issuance of RMBS
Trillions of US$

As Of: 2012

Trillions of US$

Source: Thomson Reuters, Dealogic,
Fannie Mae, Freddie Mac, SIFMA

In 2012, the Treasury and FHFA made key
changes to support provided under the Senior
Preferred Stock Purchase Agreements (PSPAs)
between the Treasury and the GSEs. Three
key changes were made to the agreements with
respect to dividend payments, GSE portfolio
reduction, and additional taxpayer protections.
First, dividends payable to the Treasury are
now a quarterly net worth sweep, or a payment
of income earned in the quarter by the GSEs,
rather than the original terms, which consisted
of a 10 percent dividend on outstanding senior
Financial Developments

61

preferred stock. This change was made to
eliminate the possibility of the GSEs having
to borrow from the Treasury to pay dividends,
which could have eroded market confidence in
the GSEs. Second, the GSEs are now required
to contract their portfolios at an annual rate of
15 percent— an increase from the 10 percent
annual reduction called for previously. This
change implies that the GSEs will reduce their
portfolios to $250 billion four years earlier than
previously scheduled. Third, each GSE, under
the direction of the FHFA, will be required
to submit to the Treasury an annual risk
management plan that will outline the steps
that the GSEs are taking to reduce taxpayer
exposure to mortgage credit risk within the
GSEs’ guarantee books of business and
retained portfolios.
In 2012, FHA continued to play a critical role
in supporting the ongoing recovery of the
nation’s housing market and broader economy.
FHA insured nearly 1.2 million single-family
mortgage loans during the year, with a total
dollar value of approximately $213 billion.
The services that FHA single-family programs
provide to the nation’s housing sector are made
possible through FHA’s Mutual Mortgage
Insurance Fund. On November 16, 2012,
the U.S. Department of Housing and Urban
Development (HUD) released its fiscal year
2012 Report to Congress on the Financial
Status of the FHA Mutual Mortgage Insurance
Fund. That report summarized the results of an
independent actuarial measure of the economic
net worth of FHA’s portfolio— essentially, the
total value of the portfolio after FHA pays all
expected claims for the next 30 years in a runoff scenario in which no new loans are insured.
According to this Report to Congress, in fiscal
year 2012 the capital reserve ratio of the Fund
fell to negative 1.44 percent, and the Fund’s
economic value stands at negative $16.3 billion.
Earlier books of business are the primary
source of stress to the Mutual Mortgage Fund,
with approximately $70 billion in claims
attributable to the 2007 to 2009 vintage books
alone. While the actuary attests to the high
quality and profitability of books insured since
62

2 0 1 3 F S O C / / Annual Report

2010, significant unrecognized risks may remain
in the portfolio. Work is ongoing to mitigate
the impacts to the Mutual Mortgage Fund of
losses stemming from the 2007 to 2009 books,
which were those most severely impacted by the
recession, declines in home prices, and other
risk factors.

Chart 5.1.41 		 CMBS New Issuance
5.1.41 CMBS New Issuance
Billions of US$

As Of: 2012

Billions of US$

Commercial Real Estate
The commercial real estate sector has
improved, with prices rising slightly and CMBS
issuance gaining strength in 2012. The past year
witnessed the strongest post-crisis credit flows
for commercial real estate (CRE), with almost
$100 billion in CMBS issuance (Chart 5.1.41).
This amount of issuance represents an increase
of approximately 50 percent over the prior
year, although these levels are still much lower
than pre-crisis amounts. Given the low interest
rate environment, investor demand has been
quite strong, with non-agency credit spreads
for the most senior debt tightening by about 90
basis points in 2012 (Chart 5.1.42). The loans
underlying these CMBS are mainly backed by
multi-family, office, retail, and other related
properties. Credit performance, as measured
by the ratio of rating upgrades to downgrades,
has risen in recent years. However, the sector
remains vulnerable to refinancing risks in the
event of a sharp rise in interest rates, in which
event some currently-profitable properties
might no longer support their financing
payments, potentially leading to increased
defaults. The greater uncertainty surrounding
interest rates in later years is compounded by
the fact that over $1.2 billion in CRE loans will
be maturing in 2016 to 2018, compared to less
than $1 billion in 2013 to 2015 (Chart 5.1.43).
Market participants have expressed concern
that most commercial real estate credit flows
to date have been concentrated too heavily on
the trophy properties in major markets. While
possibly reflective of differential demand,
this trend is seen in recent commercial
property price indices, which reflect moderate
improvements on the national level since
2010, but more significant price gains in major

Source: Commercial Mortgage Alert

Chart 5.1.42 		 CMBS Senior Debt Spreads
5.1.42 CMBS Senior Debt Spreads
Basis Points

As Of: 21-Mar-2013

Basis Points

Note: Spread of Non-Agency 3.0
AAA 5-Year CMBS to Swaps.

Source: Barclays

Chart 5.1.43 		 CRE Refinancing
5.1.43 CRE Refinancing
Billions of US$

Source: Flow of Funds,
Barclays, Trepp

As Of: 2012

Billions of US$

Note: Issuance and distribution of maturities for
commercial banks and savings institutions, insurance
companies, and GSEs and Fed-related mortgage
pools are estimated.

Financial Developments

63

Chart 5.1.44 		 Commercial Property Price Indices
5.1.44 Commercial Property Price Indices
As Of: Oct-2012

Index

Index

MoodyĀs/RCA CPPI – Non-Distressed, Major Markets
MoodyĀs/RCA CPPI – Non-Distressed, National
MoodyĀs/RCA CPPI – Major Markets
MoodyĀs/RCA CPPI – National
Source: Real Capital Analytics,
MoodyĀs Investors Service

Note: Mar-2008 = 100.

markets. In 2012, non-distressed markets
continued to outperform the national average
(Chart 5.1.44). The variation in credit flows
to different property types can be seen in
the MBA Commercial/Multifamily Bankers
Originations Index, which shows that while
originations across all types of properties rose
in 2012, they rose to significantly different
degrees. Hotel originations led all other groups,
rising 61 percent over the prior year, followed by
multifamily originations, which rose 36 percent
over the prior year. In contrast, health care
originations, which fell significantly during the
crisis, rose only 6 percent over the prior year.

5.2
Chart 5.2.1 		 Large Bank Holding Company Liability Structure
5.2.1 Large Bank Holding Company Liability Structure
Share of Total

As Of: 2012 Q4

Uninsured Domestic Deposits
Insured Deposits
Debt >1yr
Capital

Source: FDIC,
FR Y-9C

Share of Total
Other*
Repo
Debt <1yr
Foreign Deposits

Note: *Other = commercial paper, derivative payables, securities sold
short and everything categorized as Other	 reported in FR Y-9C.

Chart 5.2.2 		 Wholesale Cash Investors
5.2.2 Wholesale Cash Investors
Percent
50
40
30

As Of: 2012 Q4
Long-Term Mutual Funds
Securities Lending Reinvestments right axis
Nonfinancial Corporations
Money Market Mutual Funds

Billions of US$
7000
6000
5000

Wholesale Cash Pools
as a Percent of GDP
(left axis)

4000
3000

20

2000
10
0
1990

1000
1994

1998

2002

Source: Flow of Funds, ICI, U.S.
Department of Treasury, Haver Analytics

64

2 0 1 3 F S O C / / Annual Report

2006

2010

0

Wholesale Funding Markets

5.2.1

Interbank Markets

Short-term wholesale funding markets provide
financial intermediaries with funds that
supplement retail deposits and long-term
debt issuance (Chart 5.2.1). These funds
include large time deposits, certificates of
deposit, repurchase agreements (repos), and
commercial paper. Sources of funds in these
markets are largely wholesale cash pools,
including cash on the balance sheets of
nonfinancial companies, reinvestments of cash
collateral from securities lending, and cash
held by long-term mutual funds, money market
mutual funds, pension funds, and sovereign
wealth funds. These sources of funds have
grown markedly as a percentage of GDP over
the past two decades, although this percentage
has been declining since early 2008 (Chart
5.2.2). Cash on nonfinancial corporate balance
sheets, in particular, has been growing at an
accelerating rate, a pattern that continued
through the fourth quarter of 2012.
Domestic banking firms’ reliance on short-term
wholesale funding continued to decline in
2012, as retail deposits grew (Chart 5.2.3). The
longer-term stability and cost of deposit inflows
during this low interest rate period will be key

to funding and interest rate risk projections in
the future.
Enhanced central bank provisions of liquidity,
combined with a significant reduction of
European banks’ dollar funding needs as they
deleverage their balance sheets, has contributed
to a reduction in the premium for borrowing
dollars via foreign exchange (FX) swap markets
to the lowest level since early 2011 (Chart
5.2.4). This overall normalization in the FX
swap market and the improved access to dollar
funding for European banks, was supported by
the November 2011 decrease in the interest rate
charged on central bank liquidity swaps and
the ECB’s two 3-year longer-term refinancing
operations, along with other actions to
strengthen the euro area’s institutional and
fiscal framework. The decision to include a
levy on bank deposits in the Cyprus bailout
terms was associated to a modest uptick in the
premium for borrowing U.S. dollars against the
euro in March 2013.

Chart 5.2.3 		 Composition of Bank Short-Term Funding
5.2.3 Composition of Bank Short-Term Funding
Trillions of US$
As Of: 2012 Q4
10
Wholesale as a Percent
of Retail Deposits
9
(right axis)
8

Percent
160
Retail Deposits
(left axis)

140
120

7

100

6

80
Short-Term
Wholesale Funding
(left axis)

5
4
2003

2005

2007

2009

60
40

2011

Source: FDIC, Federal Reserve,
Haver Analytics

Chart 5.2.4 		 Premium for Borrowing Dollars for 1 Year
5.2.4 Premium for Borrowing Dollars for 1 Year
As Of: 25-Mar-2013

Basis Points

Basis Points

vs. Euros

5.2.2 Commercial Paper and Asset-Backed
Commercial Paper
Commercial paper (CP) outstanding peaked
at $2.2 trillion in July 2007 and stood at $1.0
trillion in February 2013, primarily due to the
continuing decline in asset-backed commercial
paper (ABCP) outstanding (Chart 5.2.5). As of
February 2013, ABCP accounts for 28 percent
of all outstanding CP, financial CP accounts
for 51 percent, and nonfinancial corporate
CP accounts for 21 percent. Financial CP and
certificates of deposit (CDs) outstanding are
around 40 to 50 percent below their pre-crisis
peaks. After contracting sharply in 2011, largely
due to investor concerns about European
debt, CP outstanding at financial institutions
with European parents remained stable in the
second half of 2012 and has increased notably
in early 2013. Even so, financial CP outstanding
with European parents remains well below the
levels seen in early 2011.

5.2.3

Repo Markets

A repurchase agreement (repo) is the sale
of securities for cash with an agreement to

vs. Yen

Source: Bloomberg, L.P.

Chart 5.2.5 		 Commercial Paper Outstanding
5.2.5 Commercial Paper Outstanding
Trillions of US$
2.5
2.0

Trillions of US$
2.5
Corporate Issuers
Financial Issuers
2.0
ABCP

1.5

1.5

1.0

1.0

0.5

0.5

0.0
2005

2006

As Of: Feb-2013

2007

2008

2009

2010

2011

2012

2013

0.0

Source: Federal Reserve, Haver Analytics

Financial Developments

65

Chart 5.2.6 		 Value of the Repo Market
5.2.6 Value of the Repo Market
Trillions of US$

As Of: Feb-2013

Trillions of US$

FR 2004 Primary
Dealer Repo
Tri-Party Repo
Market

Source: FRBNY, Haver Analytics

Note: Limited data were provided by clearing
banks prior to April 2008. These figures are
estimates based on the data provided. Gray bar
signifies NBER recession.

Chart 5.2.7 		 Primary Dealer Repo Agreements
5.2.7 Primary Dealer Repo Agreements
Trillions of US$

As Of: 20-Mar-2013

Trillions of US$

Source: FRBNY

Chart 5.2.8 		 Tri-Party Repo Collateral Distribution
5.2.8 Tri-Party Repo Collateral Distribution
Agency Agency Debt
Other CMOs
(5.4%)
(2.3%) (5.6%)
Private Label CMOs
(1.9%)
ABS (2.2%)
Corporate Debt
(3.6%)

Agency MBS
(38.2%)

Equities (6.0%)
Treasury STRIPS
(2.4%)

Source: FRBNY,
Haver Analytics

66

Treasuries
(32.4%)

2 0 1 3 F S O C / / Annual Report

As Of: Feb-2013

repurchase the securities at a specified date
and price. This agreement effectively creates
a secured loan with securities as collateral.
Securities broker-dealers play a significant role
in repo markets. There are three repo market
segments: the tri-party market, in which brokerdealers obtain funding from cash investors and
transact utilizing the collateral management
and settlement services of the two tri-party repo
clearing banks (JPMorgan Chase and Bank
of New York Mellon); the General Collateral
Finance (GCF) market, which primarily settles
inter-dealer transactions on the tri-party
repo platform; and bilateral repo, in which
transactions are executed without the services
of the two tri-party clearing banks.6
Repo activity continued to increase in 2012,
both as measured in the tri-party repo statistics
and in the primary dealer survey (Chart 5.2.6).
Market participants have noted that some firms
have extended maturities for certain repo
collateral, indicating an increased willingness
of some participants to provide longerterm funding in this market (Chart 5.2.7).
However, haircuts in the tri-party market on
collateral that is not eligible for use in open
market operations (OMO) have not declined,
indicating an unchanged stance towards
collateral quality and potential price volatility.
The majority of tri-party repo financing
remains collateralized by Treasury securities,
agency MBS, agency debentures, and agency
collateralized mortgage obligations (CMOs).
As of February 2013, these types of collateral
accounted for 84 percent of all tri-party repo
collateral (Chart 5.2.8). The other 16 percent
of collateral used in tri-party repo includes
corporate bonds, equities, private label CMOs,
ABS, CP, other money market instruments,
whole loans, and municipal bonds. As is true
in the securities lending market, repo markets
can be used to effect collateral transformation
(see Section 5.2.4 for more detail on collateral
transformation trades).

5.2.4

Securities Lending

The largest component of securities lending
this past year continued to be undertaken by
long-term securities holders such as pension
funds, mutual funds, and central banks (Chart
5.2.9). The global value of securities lending
transactions remained fairly flat through March
2012, at an average value of around $1.7 trillion
according to available estimates (Chart 5.2.10).
Reinvestment of cash collateral from securities
lending has declined slowly over the past year,
from $659 billion in the fourth quarter of
2011 to $591 billion in the fourth quarter of
2012. The weighted average maturity (WAM)
of cash reinvestment has also continued to
decline, albeit not as markedly as in previous
years (Chart 5.2.11). This decline represents
a continued trend towards more conservative
asset allocation since the financial crisis by cash
collateral reinvestment pools.
Securities lending can be used as a vehicle for
collateral transformation trades, also known
as collateral swaps. In a collateral swap, a
participant with the high-quality asset swaps it
for a lower-quality one to earn fee income. The
participant holding the lower-quality collateral
pays a fee to exchange it temporarily for higherquality collateral that can then be used to meet
margin requirements for derivative transactions
or other liquidity or capital needs. Demand
for high-quality collateral may increase with
the implementation of regulatory regimes
in different countries that require market
participants to hold high-quality collateral
for the purposes of margining and liquidity
coverage ratios.
These trades present two risks: first, should
the value of the lower-quality collateral fall
more than anticipated by the haircut in the
transaction, the lender of that collateral
would have to reduce the size of the collateral
swap or provide more collateral. If more
collateral is unavailable, they may be forced
to rapidly reduce the size of their related
positions. Second, broker-dealers entering
into collateral swaps might generate additional

Chart 5.2.9 		 Securities Lending Loans by Industry
5.2.9 Securities Lending Loans by Industry
U.S. Public
Funds (6%)

Quasi-Government
Bodies (5%)

Insurance
Companies
(8%)
Public Pension
Funds
(9%)

Other
(19%)

Mutual Funds
(18%)

Banks (10%)

Source: Markit
Group Limited

Pension Funds
(12%)

Central Banks
(13%)
As Of: 25-Mar-2013

Chart 5.2.10 		 Value of Securities on Loan
5.2.10 Value of Securities on Loan
Trillions of US$

As Of: 25-Mar-2013

Trillions of US$

Global Market
(including U.S.)

U.S. Market

Source: Markit Group Limited

Chart 5.2.11 		 Securities Lending Cash Reinvestment
5.2.11 Securities Lending Cash Reinvestment
Trillions of US$

As Of: 2012 Q4

Days

Total Cash Reinvestment
(left axis)
Mean WAM
(right axis)

Median WAM
(right axis)

Source: The Risk Management Association

Note: WAM = Weighted
Average Maturity.

Financial Developments

67

layers of counterparty and liquidity risk
exposure, potentially mitigating the benefits of
conservative collateral requirements.
Despite the increased attention paid to these
trades, there is little evidence to suggest that
their volume is presently large.7 For example,
consider securities lending activity by pension
funds. Pension funds hold large portfolios of
high-quality assets, which they use to fund
future liabilities. In the meantime, pension
funds will lend securities in their portfolio to
generate incremental returns on their existing
investments, including high-quality Treasury
securities. As such, pension funds would be
expected to supply high-quality collateral into
collateral transformation trades. However, while
the volume of pension funds’ securities lending
activity increased by around 5 percent over the
past year, the majority of the increase occurred
in lending against cash collateral as opposed to
non-cash collateral. In fact, lending of Treasury
securities against non-cash collateral by pension
funds declined by nearly 8 percent over the
past year. Regulatory limits on the types of
collateral that pension funds can accept is likely
inhibiting the growth of such transactions.
In addition, indemnifications provided by
securities lending agents, which commonly act
on behalf of beneficial owners that lend their
securities, are limited to the securities loaned.
These indemnifications do not commonly
extend to the lower-quality borrowed collateral
and such one-sided indemnification might act
as a further inhibitor for such activity. While
available evidence has yet to suggest that a
meaningful volume of collateral swap activity
is taking place, it is an area that warrants
continued monitoring as market practices and
regulatory changes increase demand for highquality collateral.

68

2 0 1 3 F S O C / / Annual Report

5.3
Bank Holding Companies and
Depository Institutions
5.3.1 Bank Holding Companies and DoddFrank Act Stress Tests
Performance
Bank holding companies (BHCs) are holding
companies with at least one commercial bank
subsidiary. Subsidiaries of BHCs may also
include nonbanks such as broker-dealers,
investment companies, or insurance companies.
As of the fourth quarter of 2012, there were
1,014 top-tier BHCs in the United States
(excluding Puerto Rico), with aggregate assets
of about $16.6 trillion. Aggregate pre-tax
income of BHCs totaled $159 billion in
2012 (Chart 5.3.1), an increase of 8 percent
from 2011.
The domestic banking sector entered 2012
facing revenue pressure from a sluggish
macroeconomic environment, new regulatory
requirements, legal settlements, the challenging
interest rate environment, and risks related
to the euro area sovereign debt crisis. Despite
the difficult operating environment, most
banks grew revenues and earnings in 2012.
For the 77 BHCs with assets greater than $10
billion, aggregate pretax income increased
14.2 percent in 2012 to $154.8 billion. Banks
boosted earnings through controlled expenses
and the release of reserves against losses on
loans and leases, as credit quality continued to
improve. However, the median growth in total
noninterest expense was roughly 3 percentage
points higher than the previous year (based on
72 BHCs reporting data for the year end 2012
and 2011). Noninterest income grew during the
year led by record debt underwriting and strong
mortgage banking revenues. Nevertheless, the
return on average assets for BHCs remained
lower than the levels that prevailed in the 10
years before the crisis (Chart 5.3.2).
Declining BHC net interest margins (NIMs),
defined as net interest income divided by
average interest-earning assets, decreased
earnings in recent quarters (Chart 5.3.3). NIM

Chart 5.3.1 		 Aggregate BHC Pre-Tax Income
5.3.1 Aggregate BHC Pre-Tax Income
Billions of US$
1200
900

As Of: 2012
Noninterest Income
Net Interest Income

Billions of US$
1200
Total Pre-Tax Income
900

600

600

300

300
0

0

-300

-300
-600
-900
-1200

-600

Provisions
Noninterest Expense
Realized Gains/Losses on Investments
2006

2007

2008

2009

2010

-900

2011

-1200

2012

Source: FR Y-9C

Chart 5.3.2 		 Return on Average Assets for BHCs > $10B
5.3.2 Return on Average Assets for BHCs > $10B
Percent
1.5

As Of: 2012 Q4

Percent
1.5
1996-2012 Average

1.0

1.0

0.5

0.5

0.0

0.0

-0.5

-0.5

-1.0

-1.0

-1.5
1996

1998

2000

2002

2004

2006

2008

2010

2012

-1.5

Source: FR Y-9C

Chart 5.3.3 		 Net Interest Margins for BHCs > $10B
5.3.3 Net Interest Margins for BHCs > $10B
Percent

As Of: 2012 Q4

Percent

Net Interest Margin
2000-2012 Average

Source: FR Y-9C

Financial Developments

69

compression has been driven by increased
competition, as well as cyclical factors including
the extended low rate environment across the
yield curve and slow loan growth. BHCs are
susceptible to maturity mismatch, whereby
longer duration assets reprice more slowly than
shorter duration liabilities. BHCs typically have
lower NIMs than insured depository institutions
due to the inclusion of lower interest margin
business lines of nonbank subsidiaries, which
often rely more heavily on fee income than net
interest income.

Chart 5.3.4 Maturity Gap at Large Banks
5.3.4 Maturity Gap at Large Banks
As Of: 2012 Q4

Density
0.25
0.20

Density
0.25

2003: Q3
2010: Q4
2012: Q4

0.20

0.15

0.15

0.10

0.10

0.05

0.05
Years

0.00
-5
Source: Federal
Reserve

0

0.00
5

10

15

Note: Large banks are defined as those with assets exceeding $50 billion.
Approximations are based on the midpoint of the ranges available on Call
Reports. Liquid deposits are assumed to have a maturity of 1 year.

Chart 5.3.5 Maturity Gap at Small Banks
5.3.5 Maturity Gap at Small Banks
Density
0.25
0.20

As Of: 2012 Q4

Density
0.25

2003: Q3
2010: Q4
2012: Q4

0.20

0.15

0.15

0.10

0.10

0.05

0.05
Years

0.00
-5
Source: Federal
Reserve

70

0

0.00
5

10

15

20

Note: Small banks are defined as those with assets less than $50 billion.
Approximations are based on the midpoint of the ranges available on Call
Reports. Liquid deposits are assumed to have a maturity of 1 year.

2 0 1 3 F S O C / / Annual Report

The low rate environment is particularly acute
for NIMs during the current business cycle,
as funding costs are near zero. BHCs have
mitigated the effects of the compressed rate
environment through various non-core revenue
and cost cutting measures, including reserve
releases, restructurings, and compensation
reductions, although there is a limit to the
sustainability of these measures. Supervisors
are attentive to BHCs assuming additional
credit or duration risk, but there does not
appear to be evidence of a substantial move in
this direction at commercial bank subsidiaries
of large BHCs. However, some smaller banks
appear to have lengthened the maturity of asset
portfolios. Maturity extension at small banks
can be observed in the estimates of the asset/
liability maturity and repricing interval gap.
These estimates do not show material change
at large banks from two years ago, and are also
not noticeably different from the distribution
in the third quarter of 2003, when interest
rates were also unusually low (Charts 5.3.4 and
5.3.5).8 However, at smaller banks, the same
distribution has somewhat shifted upward over
the past two years, as the average maturity (or
next repricing date) of loans and securities has
increased (not shown).
Although very low interest rates appear to be
contributing to a compression of BHCs’ net
interest margins, it is unclear whether the
eventual reversal of the rate environment will
benefit BHC profitability. BHCs have increased
their holdings of Treasury and agency securities

amid historically high deposit inflows, so a
rapid rise in rates would decrease the fair value
of these securities. In addition, a rise in rates
could also cause deposit disintermediation,
resulting in higher funding costs pressuring
margins. The more recent modest rise in term
rates appears not to have boosted BHC NIMs,
as growth expectations remain subdued and
lending growth challenged.
Large BHCs made progress in addressing
legal uncertainty last year by settling a number
of outstanding legal matters, highlighted by
a settlement with the attorneys general and
federal banking agencies related to improper
mortgage foreclosure practices (see Section
6.1.5). Banks adjusted their MBS repurchase
reserves to reflect greater clarity surrounding
GSE repurchase obligations, including
Bank of America’s $4.9 billion agreement
with Fannie Mae that resolved substantially
all agency mortgage repurchase claims on
loans originated and sold directly by Legacy
Countrywide and Bank of America to Fannie
Mae from 2000 through 2008.

Market Indicators
The heightened level of duress in capital
markets that was present throughout the
second half of 2011 receded in 2012, reflecting
improved investor sentiment and greater risk
appetite. Accommodative actions taken by
the ECB were largely successful in reducing
perceived tail risk from Europe, resulting in a
large increase in capital markets activities from
the prior year (see Box B: Global Monetary
Policy Actions). Moreover, positive U.S.
macroeconomic developments, particularly
employment and housing data releases late
in the year, boosted sentiment and helped
drive loan growth. As a result of these positive
developments, the outlook for the domestic
financial sector improved significantly during
the year.
BHC shares, which began the year trading
at or near historic low price/tangible book
valuations, rallied sharply during the year.

Financial Developments

71

Chart 5.3.6 		 KBW Bank Index and Implied Volatility
5.3.6 KBW Bank Index and Implied Volatility
As Of: 25-Mar-2013

Index

Percent

30-Day Implied Volatility
of KBW Bank Index
(right axis)

KBW Bank Index
(left axis)

Source: Bloomberg, L.P.

Chart 5.3.7 		
Average P/B and P/E Ratios of 6 Large
Complex BHCs
5.3.7 Average P/B and P/E Ratios of 6 Large Complex BHCs
P/B Ratio

As Of: 25-Mar-2013

P/E Ratio

P/E Ratio
(right axis)

Capital

P/B Ratio
(left axis)

Long-Term
Average P/B
(left axis)

Long-Term
Average P/E
(right axis)
Note: Market-cap weighted average
of BAC, C, GS, JPM, MS, WFC.

Source: Bloomberg, L.P.

Chart 5.3.8 		 CDS Spreads of 6 Large Complex BHCs
5.3.8 CDS Spreads of 6 Large Complex BHCs
Basis Points

As Of: 25-Mar-2013

Source: Markit Group Limited

72

The broad Keefe, Bruyette & Woods (KBW)
bank index increased 30 percent and implied
volatility steadily declined following a jump in
June (Chart 5.3.6). The market capitalization
of the six largest BHCs increased 43 percent
in aggregate, but market valuations remained
at a roughly 20 percent discount to book
value in December 2012. This valuation is still
below both the pre-crisis level and the average
level over the past 12 years (Chart 5.3.7). The
average of the 5-year credit default swap (CDS)
spreads of the six largest BHCs entered 2012 at
very elevated levels, due primarily to euro area
sovereign debt fears. Despite these high levels
during the first half of the year, CDS spreads
narrowed sharply during the second half of the
year and ended 2012 at their lowest levels in
18 months (Chart 5.3.8). Academic measures
of systemic risk for the six largest BHCs have
continuously declined over the past year: these
contemporaneous measures are now low by
historical standards (Chart 5.3.9).9

2 0 1 3 F S O C / / Annual Report

Basis Points

Note: Equal-weighted average
of BAC, C, GS, JPM, MS, WFC.

In aggregate, capital ratios for BHCs improved
from the fourth quarter of 2011 to the fourth
quarter of 2012, with the tier 1 common
capital ratio under current risk-based capital
rules (Basel I) increasing 0.79 percentage
point to 11.46 percent. Increases in retained
earnings, primarily from positive operating
results, contributed to the bulk of this increase,
with additional support from capital raising
(Chart 5.3.10). In addition, risk-weighted assets
decreased slightly, providing additional support
to capital ratio trends.
For the 18 largest U.S. BHCs, capital ratios
continued to improve from post-crisis levels,
with the aggregate tier 1 common capital ratio
under Basel I improving 0.86 percentage point
from the fourth quarter of 2011 to the fourth
quarter of 2012 to 11.3 percent. For U.S. BHCs
with assets less than $50 billion, the average
tier 1 common ratio under Basel I improved
by approximately 0.19 percentage point to 12.2
percent from the fourth quarter of 2011 to the

fourth quarter of 2012 period, with gains
from retained earnings and common stock
issuance partially offset by increases in riskweighted assets.
During this period, many BHCs limited their
capital distributions due to continued economic
uncertainty, forthcoming increases in required
regulatory capital, and enhanced regulatory
scrutiny. Although capital distributions remain
subdued relative to pre-crisis levels, the latter
half of 2012 saw a shift from a net issuance of
equity capital to a net payout in the form of
share repurchases and dividends.

Chart 5.3.9 Systemic Risk Measures
5.3.9 Systemic Risk Measures
Index

As Of: Feb-2013

Index
CoVaR
SES
DIP

Source: Federal Reserve, Markit Group
Limited, Bloomberg, L.P., Compustat

Note: Measures are standardized
by their historical volatility.

Liquidity
Along with higher capital levels, the average
liquidity profile for the largest BHCs has
improved since the financial crisis. In
particular, the volume of liquid assets on
BHC balance sheets is nearly two standard
deviations above its average from the first
quarter of 1995 to the fourth quarter of 2012
(Chart 5.3.11). This increase in average liquidity
partially reflects a change in the composition
of BHCs. Among the six largest BHCs, two
are primarily dealers (Goldman Sachs and
Morgan Stanley), and two others (Bank of
America and JPMorgan Chase) acquired major
broker-dealers throughout 2008 (Merrill
Lynch and Bear Stearns, respectively). Brokerdealers tend to hold a larger fraction of liquid
assets, as the majority of their funding is in
wholesale markets (Chart 5.3.12). In fact, the
ratio of liquid assets to total assets is roughly
proportional to the percentage of non-core
funding to total liabilities. An additional factor
explaining the higher liquidity ratios of BHCs is
the anticipated implementation of the Liquidity
Coverage Ratio (LCR) in the United States
as part of the Basel III reforms (see Section
6.1.1 for an update on the implementation of
the LCR). Once implemented, the LCR would
require banking institutions, including BHCs,
hold a sufficient amount of liquid assets as
protection against withdrawals of funding in
stressed conditions.

Chart 5.3.10 Change in Tier 1 Common Ratios for Aggregate
U.S. BHCs
5.3.10 Change in Tier 1 Common Ratios for Aggregate U.S. BHCs
Percent of RWA
14

As Of: 2012 Q4

13

0.78

12

Percent of RWA
14

12

11.46

0.63
0.19

10.67

11

13

(0.80)

11

10

10

9

9

8

8

7

Tier1 Common RWA Change Net Issuance
(4Q11)
Impact
of Stock

Retained
Earnings

Source: FR Y-9C

Other
Tier1 Common
Adjustments
(4Q12)

7

Note: Domestically owned BHCs.

Chart 5.3.11 Consolidated Liquidity Ratio* for Top 50 BHCs
5.3.11 Consolidated Liquidity Ratio* for Top 50 BHCs
Percent
25

20

As Of: 2012 Q4

Percent
25

+2 Standard Deviation
+1 Standard Deviation

20

Average (17.3%)
15

15
-1 Standard Deviation
Liquidity Ratio*

10
1995

1998

2001

2004

2007

2010

10

Note: *Liquidity Ratio = sum of Cash & Due From, FFS, Repos, U.S. Treasuries, U.S. Gov. Agencies
and U.S. Gov. Sponsored Agencies divided by Total Assets. Top 50 BHCs by asset size.

Source: FR Y-9C, SNL Financial, FSOC calculations

Financial Developments

73

Chart 5.3.12 		 Non-Core Funding* Relative to Liquid Assets**
5.3.12 Non-Core Funding* Relative to Liquid Assets**
As Of: 2012 Q4

Percent
Liquid Assets as a % of Total Assets

GS
MS

BAC
JPM

C

WFC
Percent
Non-Core Funding as a % of Total Liabilities

Source: FR Y-9C

*Non-core funding includes time deposits > $100K, foreign deposits, brokered deposits < 100K,
CP, other borrowed money, FF and repo, other liabilities. **Liquid assets includes cash and cash
equivalents, trading assets, Treasury and Agency HTM and AFS securities, FF and reverse repo.

Chart 5.3.13 		 Nonperforming Loans (30-89 Days)
5.3.13 Nonperforming Loans (30-89 Days)
As Of: 2012 Q4

Percent

BHCs’ asset quality continued to improve in
2012. For 18 large firms (the Comprehensive
Capital Analysis and Review (CCAR) 2013
participants, which account for over 75 percent
of system assets), nonperforming loans declined
in aggregate and across most categories.
However, residential loan delinquencies
remain high despite the decline in early-stage
delinquencies (30-89 days past due) and a
slowdown in the rate at which loans transition
into delinquency status (Chart 5.3.13).
Banks have been slow to reduce the stock of
nonperforming residential loans through
foreclosures, short-sales, or modifications,
reflecting in part greater forbearance in light
of the recovering housing market, as well
as challenges in completing the foreclosure
process (Chart 5.3.14).

Percent

It is worth noting that although net charge-offs
have declined at the largest BHCs, noncurrent
levels continue to remain elevated, especially
among the BHCs with high exposure to singlefamily mortgages. For the largest BHCs, the
allowance for loan and lease losses has been
sufficient to absorb recent levels of net chargeoffs, although an increase in charge-offs to
post-crisis peak levels in 2010 could erode this
cushion considerably (Chart 5.3.15). Reserve
levels remain above post-crisis lows relative
to risk-weighted loans and commitments, but
continue to decline.

Residential
Credit Card

Asset Quality

Other Consumer

CRE
Total NPLs
C&I

Source: FR Y-9C

CCAR, CapPR, and DFAST
Chart 5.3.14 		 Nonperforming Loans (90+ Days and Nonaccrual)
5.3.14 Nonperforming Loans (90+ Days and Nonaccrual)
As Of: 2012 Q4

Percent

Residential
CRE
Total NPLs
C&I
Credit Card
Other Consumer

Source: FR Y-9C

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Percent

The Federal Reserve completed the latest
round of its capital planning and stress testing
program for 2013, which included CCAR
and the supervisory stress tests mandated by
the Dodd-Frank Act of 18 firms as well as the
Capital Plan Review (CapPR) of an additional
11 BHCs with $50 billion or more of total
consolidated assets. The Dodd-Frank Act stress
tests (DFAST) are forward-looking exercises
conducted by the Federal Reserve to help assess
whether institutions have sufficient capital to
absorb losses and support operations during
adverse economic conditions. While the 11

BHCs submitting capital plans as part of the
CapPR were evaluated on their submitted
results, firms participating in the CCAR and
DFAST were evaluated using both the BHC’s
submitted plans and the results of the Federal
Reserve’s supervisory stress tests. The aim of
the CCAR is to ensure that large, complex
banking institutions have robust, forwardlooking capital planning processes that account
for their unique risks, and to help ensure
that these institutions have sufficient capital
to continue operations throughout times of
economic and financial stress (Chart 5.3.16).
Firms’ capital adequacy is assessed against a
number of quantitative and qualitative criteria,
including projected performance under
scenarios provided by the Federal Reserve and
the institutions’ internally-developed scenarios.
In order to project post-stress capital ratios
for the Board’s Dodd-Frank Act stress tests,
the Federal Reserve uses a standardized set
of capital action assumptions. In contrast,
for the CCAR post-stress capital analysis,
the Federal Reserve assessed whether a BHC
would be capable of meeting the requirements
under the Board’s capital plan rule, including
minimum capital ratios under baseline and
stressed conditions using the BHC’s planned
capital actions. Specifically, under Dodd-Frank
Act stress testing rules, firms are assumed to
execute no common stock repurchases and
maintain dividends at a rate consistent with
their historical dividends paid on common
shares outstanding. Thus, the key difference
between capital levels and ratios determined
under the CCAR and DFAST is the capital
distributions. The comparative assumptions
facilitate the Federal Reserve’s assessment of
shareholder distributions and other actions on
BHC capital adequacy.

Chart 5.3.15 		 llowance for Loan/Lease Losses as a Multiple
A
5.3.15 Allowance for Loan/Lease Losses as a Multiple of Charge-offs
of Charge-offs
Multiple of Charge-offs
10

As Of: 2012 Q4

Allowance as a
Multiple of Quarterly
Charge-offs

8
6

Multiple of Charge-offs
10
8
6

4

4
Allowance as a
Multiple of Peak
Charge-offs

2
0
2009
Source: FR Y-9C

2

0
2010
2011
2012
Note: Charge-offs are quarterly. Peak charge-offs are
from 2010 Q1. Data pertains to the 18 CCAR BHCs.

Chart 5.3.16 		 .S. Unemployment Rate: Actual vs. Stress
U
Scenarios
5.3.16 U.S. Unemployment Rate: Actual vs. Stress Scenarios
Percent

As Of: 2012 Q4

Percent

Actual Unemployment Rate
SCAP
CCAR 2011
CCAR 2012
CCAR 2013

S
Source: BLS,
BLS
Federal Reserve

Note: Actual unemployment rate is quarterly average of
monthly data. The remaining series are unemployment
rate trajectories in the respective stress scenarios.

In a change from prior years, the Federal
Reserve provided BHCs with an opportunity
to adjust downward any planned capital
distributions after receiving the Federal
Reserve’s preliminary CCAR post-stress capital
analysis. These adjusted capital actions were

Financial Developments

75

Chart 5.3.17 Initial and Stressed Tier 1 Common Capital Ratios
5.3.17 Initial and Stressed Tier 1 Common Capital Ratios
Percent

Percent

As Of: 25-Mar-2013

Source: Federal
Reserve, FRBNY

Note: Aggregate ratios of 18 participating BHCs.
Stressed estimates are supervisory estimates.

Chart 5.3.18 FDIC-Insured Failed Institutions
5.3.18 FDIC-Insured Failed Institutions
Number of Institutions
600

As Of: 2012

Percent
5

500
400

Assets of Failed
Institutions as a Percent
of Nominal GDP
(right axis)

Number of
Institutions
(left axis)

300

1

100

0
1985

1990

Source: BEA, FDIC,
Haver Analytics

76

3
2

200

0
1980

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2 0 1 3 F S O C / / Annual Report

1995

2000

2005

2010

Note: No FDIC-insured institutions
failed during 2005 and 2006.

then incorporated into the Federal Reserve’s
projections to calculate the adjusted poststress capital levels and ratios. All BHCs but
one maintained a minimum tier 1 common
ratio greater than 5 percent under stressed
conditions, inclusive of all adjusted planned
capital actions, under the severely adverse
scenario. Significant capital accretion during
the last year bolstered the ability of BHCs that
participated in CCAR to weather significant
aggregate net losses, which were projected at
$192 billion on a pre-tax basis in the severely
adverse scenario. Assuming capital distributions
consistent with Dodd-Frank Act rules, the
aggregate tier 1 common ratio for the 18 BHCs
declined from an actual 11.1 percent in the
third quarter of 2012 to a post-stress level of
7.7 percent at the end of 2014. Using BHCs’
planned capital actions, the BHCs’ aggregate
post-stress tier 1 common ratio was projected
to be 6.6 percent in the fourth quarter of 2014.
In both cases, aggregate BHC capital levels
significantly exceeded the 5 percent target
established under the capital plan rule and the
aggregate tier 1 common ratio that existed at
the start of the 2009 stress test (Chart 5.3.17).
The results of the stress test included a nonobjection of capital actions for 14 of the 18
participating BHCs. The Federal Reserve
objected to the capital plans of two firms,
Ally Financial Inc. and BB&T Corporation.
An additional two firms, JPMorgan Chase
& Co. and the Goldman Sachs Group, Inc.,
received conditional non-objections to their
capital plan due to weaknesses in the capital
plans or planning process that required
immediate attention.

Insured Commercial Banks and Savings
Institutions
The banking industry was composed of 7,083
commercial banks and savings institutions at
the end of fourth quarter 2012. Approximately
2,205 institutions had assets under $100 million,
while 4,216 institutions had assets between $100
million and $1 billion, and 662 institutions had
assets over $1 billion. Failures, mergers, and a
decline in chartering activity contributed

to the decline in the number of insured
depository institutions, as the industry lost 274
firms in 2012.
However, failures of insured depository
institutions continue to decline since the
financial crisis; 51 institutions with $11.6 billion
in total assets failed in 2012 (Chart 5.3.18).
Four more insured institutions failed between
January 1, 2013, and March 8, 2013, with
$459 million in total assets. As of December
31, 2012, 651 institutions, or 9.2 percent of
all institutions, were on the FDIC’s problem
bank list. These institutions had financial,
operational, or managerial weaknesses that
require corrective action in order to operate in
a safe and sound manner. Pre-tax net income
for all U.S. commercial banks and savings
institutions totaled $199.8 billion in 2012,
representing an 18.2 percent increase from
2011, and further improvement in the industry
following the crisis. A rebound in credit quality,
with an associated reduction of loan loss
provisions and other expenses, has driven the
improvement in pretax net income since 2009
(Chart 5.3.19). Overall asset quality continued
to improve as net-charge offs and non-current
loans declined across the industry (Chart
5.3.20). Higher asset quality led to a reduction
in portfolio risk and sustained the improvement
in both earnings and capital positions at
commercial banks and savings institutions
(Chart 5.3.21).

Chart 5.3.19 		 Commercial Bank and Thrift Pre-Tax Income
5.3.19 Commercial Bank and Thrift Pre-Tax Income
Billions of US$

As Of: 2012
Noninterest Income
Net Interest Income

Billions of US$

Total Pre-Tax Income

Provisions
Noninterest Expense
Realized Gains/Losses on Investments
Note: Includes all FDIC-insured
commercial banks and thrifts.

Source: FDIC

Chart 5.3.20 	 Net Charge-offs and Noncurrent Loans
5.3.20 Net Charge-offs and Noncurrent Loans
Percent
3.5

As Of: 2012 Q4

Percent
60

Noncurrent Loans and Leases to
Tier 1 Capital and Reserves
(right axis)

3.0
2.5
2.0

50
40

Net Charge-offs to
Loans and Leases
(left axis)

1.5

30
20

1.0

10

0.5
0.0
1984

1988

1992

1996

Source: FDIC, Haver Analytics

2000

2004

2008

2012

0

Note: All FDIC-insured institutions.

Temporary Liquidity Guarantee Program
The end of the FDIC’s unlimited guarantee on
noninterest-bearing transaction deposits on
December 31, 2012, raised concerns that some
portion of the $1.5 trillion in newly uninsured
deposits would rotate into conservative, shortterm asset classes or shift from smaller banks
to larger banks with perceived guarantees of
sovereign support.10 However, Transaction
Account Guarantee (TAG)-related withdrawals
as the guarantee approached its end date
appear to have been modest, as the amount
over $250,000 in noninterest-bearing accounts
remained at $1.5 trillion during the third and
fourth quarters of 2012. According to Federal

Chart 5.3.21 	 Risk-Weighted Assets and Return on Assets
5.3.21 Risk-Weighted Assets and Return on Assets
Percent
2.0

As Of: 2012 Q4

Percent
78

1.5

75

1.0
0.5

72

0.0

69

-0.5
-1.0

66

Return on Assets (left axis)
Risk-Weighted Assets as a Percent of
Total Assets (right axis)

-1.5
1990

1994

1998

Source: FDIC, Haver Analytics

2002

2006

2010

63

Note: All FDIC-insured institutions.

Financial Developments

77

Reserve’s H.8 release, the category containing
TAG-eligible deposits declined by $60 billion
in the first few weeks of 2013, an amount well
below estimates of market analysts, before
stabilizing in early February 2013.

Credit Unions

Chart 5.3.22 	 Concentration of Credit Union Assets
5.3.22 Concentration of Credit Union Assets
Percent

As Of: 2012 Q4

Billions of US$

Assets of 100 Largest
CUs as a Percent of Total
(left axis)
Assets of 100
Largest CUs
Assets of 10 Largest CUs (right axis)
as a Percent of Total
(left axis)
Assets of 10
Largest CUs
(right axis)

Note: Largest by asset size.

Source: NCUA

Chart 5.3.23 	 Federally Insured Credit Union Income
5.3.23 Federally Insured Credit Union Income
Billions of US$

Source: NCUA

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2 0 1 3 F S O C / / Annual Report

As Of: 2012

Billions of US$

The number of credit unions declined from
7,094 at year end 2011 to 6,819 institutions
in the fourth quarter of 2012. This 4 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.
However, this concentration growth has seen
only a slight increase with the top 100 credit
unions growing their share of total credit union
assets to 39 percent (Chart 5.3.22). Corporate
credit unions—which provide critical services
to the broader credit union system—continue
to consolidate and deleverage 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 November 2012, there were
17 corporate credit unions with $22.74 billion
in assets serving consumer credit unions—a
decline from 27 corporate credit unions with
$96 billion in assets in 2007.
The credit union system experienced return
on assets (ROA) in 2012 of 86 basis points
(annualized YTD), an increase from 67 basis
points in 2011, and 50 basis points in 2010.
Reduced provisions for loan losses drove
much of the improvement in ROA. Improved
credit conditions were the primary driver
behind the provision for loan losses declining
to an annualized 0.3 percent of assets from
0.5 percent of assets in 2011 and 0.8 percent
of assets in 2010 (Chart 5.3.23). Aggregate
annualized net income increased to $8.5
billion, a 35 percent improvement from 2011.
Outstanding loans within the credit union
system increased by 3.5 percent to $591 billion
after experiencing weak growth in 2011, and
declines in 2010.

Profitability continued to vary by asset class
based on the size of the institution, with
smaller credit unions historically lagging
behind larger credit unions. The industry faces
lower uncertainty over future losses associated
with failed corporate credit unions as future
resolution costs are currently projected to total
between $1.9 billion and $4.8 billion over the
coming years. Larger concerns for the industry
include challenges related to the low interest
rate environment and, eventually, the transition
process to a higher rate environment. However,
long-term assets, including fixed-rate real
estate loans, (as a share of total assets) have
ranged from flat to slightly down over the past
18 months, and the share of interest sensitive
deposits has also declined since the third
quarter of 2009 (Chart 5.3.24). Nevertheless,
these levels remain elevated relative to historic
levels and warrant an increased emphasis on
managing interest rate risk.

5.3.2 U.S. Branches and Agencies
of Foreign Banks
In addition to the U.S. BHCs, foreign bank
families have a large presence in the United
States. Together, the U.S. branches and
agencies of foreign banks account for more
than $2 trillion of banking assets, or about
13 percent of total U.S. banking assets. These
entities represent an important source of credit
to U.S. businesses.

Chart 5.3.24 	 Credit Union Deposits
5.3.24 Credit Union Deposits
As Of: 2012 Q4

Percent

Percent

Interest Sensitive
Deposit Share
(left axis)

Money Market and
IRA Deposit Share
(right axis)

Source: NCUA

Chart 5.3.25 	 .S. Branches and Agencies of Foreign Banks:
U
Assets
5.3.25 U.S. Branches and Agencies of Foreign Banks: Assets
Trillions of US$
3.0

As Of: 2012 Q3

Other Assets*
Securities Purchased
with Repurchase
Agreements & Fed
Funds Sold

2.5
2.0

Non C&I Loans
C&I Loans
Net Due From Related
Depository Institutions

Trillions of US$
3.0
2.5
2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

2004

2005

2006

Source: Federal Reserve,
Haver Analytics

2007

2008

2009

2010

2011

2012

0.0

Note: *Includes government securities, assetbacked securities, and other trading assets.

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 25 percent
of their balance sheets to loans, but can differ
substantially in the composition of their
lending. Direct commercial and industrial
(C&I) loans outstanding by these banks, which
represent a major source of financing for U.S.
businesses and investment projects, have been
as high as $365 billion, but more recently have
fallen closer to $270 billion at the end of 2012,
out of over $500 billion in total loans (Chart
5.3.25). Other assets rose sharply from about
Financial Developments

79

Chart 5.3.26 	 .S. Branches and Agencies of Foreign Banks:
U
Liabilities

5.3.26 U.S. Branches and Agencies of Foreign Banks: Liabilities

Trillions of US$
3.0
2.5
2.0

As Of: 2012 Q3

Other Liabilities*
Securities Sold with
Repurchase
Agreements & Fed
Funds Purchased

Trillions of US$
3.0

Deposits & Credit Balances
Net Due to Related
Depository Insitutions

2.5
2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0
2004

2005

2006

2007

Source: Federal Reserve,
Haver Analytics

2008

2009

2010

2011

2012

$400 billion pre-crisis to about $1.2 trillion by
the third quarter of 2012, as some branches and
agencies increased their holdings of cash and
liquid securities as protection against potential
liquidity strains.

0.0

Note: *Includes transaction accounts, nontransaction accounts, and other borrowed money.

The liabilities of U.S. branches and agencies of
foreign banks also bear on financial stability
(Chart 5.3.26). Most of these U.S. branches
are not allowed to offer deposits insured by the
FDIC and thus lack access to the stable source
of funds represented by households’ checking,
savings, and other transaction accounts.
Instead, wholesale funding provides the
majority of funding for these institutions.
Some foreign bank branches and agencies,
especially those associated with European
banks, obtain dollar deposits in the United
States, and use those deposits to provide dollar
funding to their parent organizations and
related affiliates, which in turn use the funds
for lending and investment. If deposits are
withdrawn from branches and agencies, the
balance sheets of the affected banks can be
destabilized, leading to deleveraging or a need
for parents to provide dollar-denominated
funding to their U.S. branches and agencies
rather than receiving funding from them.
This occurred at some European banks in the
summer of 2011, leading to a dramatic increase
in funding from parents to branches and
agencies. Subsequent improvements in
the European situation led to marginal
declines in the level of funding support from
parent banks to their U.S. branches and
agencies. Nevertheless, funding from parents
remains elevated relative to levels seen over
the past 10 years.

Proposed Enhanced Prudential Requirements for
Foreign Banking Organizations
In December 2012 (as noted in Section 6.1), the
Federal Reserve invited comment on proposed
rules to implement enhanced prudential
standards and early remediation requirements
for foreign banking organizations (FBOs)
as mandated under Sections 165 and 166 of

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2 0 1 3 F S O C / / Annual Report

the Dodd-Frank Act. The proposal is generally
consistent with the set of enhanced prudential
standards that the Board proposed for large U.S.
banking organizations in December 2011, but would
also require FBOs with a large U.S. presence to form
a U.S. intermediate holding company (IHC) over its
U.S. bank and nonbank subsidiaries, which would
be subject to capital and liquidity requirements. The
U.S. operations of FBOs with combined U.S. assets
of $50 billion or more would be required to meet
enhanced liquidity risk management standards,
conduct liquidity stress tests, and hold a 30-day
buffer of highly liquid assets.
Many of the core elements of the Federal Reserve’s
existing approach to the supervision and regulation
of FBOs were designed more than a decade ago,
when U.S. operations of FBOs were focused largely
on traditional banking activities. Since the
mid-1990s, the U.S. operations of FBOs have
become increasingly concentrated, interconnected,
and complex.
For example, trends in the global balance sheets
of FBOs for this period reveal that short-term U.S.
dollar funding raised in the United States was used
to provide long-term U.S. dollar-denominated
project and trade finance around the world, as well
as to finance non-U.S. affiliates’ investments in
U.S. dollar-denominated asset-backed securities.
The associated material increase in intra-firm flows
during this period also created vulnerabilities for
the U.S. operations of FBOs. The financial stability
risks associated with the increased capital markets
activity and shift in funding practices of the U.S.
operations of FBOs in the period preceding the
financial crisis became apparent during and after
the recent financial crisis.

market participants, thereby compounding the risks
to U.S. financial stability. Although the United States
did not experience a destabilizing failure of an FBO
during the crisis, some FBOs required extraordinary
support from home and host country central banks
and governments.
Beyond the United States, events in the global
financial community underscored the risks posed
by the operations of large multinational banking
organizations to host country financial sectors. The
failure of several internationally active financial
firms during the crisis revealed that the location
of capital and liquidity is critical in a resolution.
In some cases, capital and liquidity related to
operations abroad were trapped at the home entity.
Actions by government authorities during the crisis
period highlighted the fact that, while a foreign
bank regulatory regime designed to accommodate
centralized management of capital and liquidity
can promote efficiency during good times, it
can also increase the chances of home and host
jurisdictions placing restrictions on the cross-border
movement of assets at the moment of a crisis, as local
operations come under severe strain and repayment
of local creditors is called into question. Resolution
regimes and powers remain nationally based,
complicating the resolution of firms with large
cross-border operations. In response to the financial
stability risks highlighted by the crisis, and ongoing
challenges associated with the resolution of large
cross-border firms, other national authorities have
adopted modifications, or considered proposals, to
enhance their regulation of internationally active
banks within their geographic boundaries.

Nonbank Financial Companies

5.4.1
While some FBOs were aided by their ability to
move liquidity freely during the crisis, this behavior
created a degree of cross-currency funding risk
and heavy reliance on swap markets that proved
destabilizing. In many cases, FBOs that relied
heavily on short-term U.S. dollar liabilities were
forced to sell U.S. dollar assets and reduce lending
rapidly when that funding source evaporated. This
deleveraging imposed further stress on financial

5.4

Securities Broker-Dealers

As of the fourth quarter of 2012, there were 4,358
domestic and foreign-owned securities brokerdealers operating in the United States. The U.S.
broker-dealer sector is relatively concentrated;
approximately 60 percent of industry assets were
held by the top 10 broker-dealers at the end of last
year, the largest of which were affiliated with foreign
banks and domestic BHCs. Aggregate annual
pretax income of broker-dealers more than doubled

Financial Developments

81

Chart 5.4.1 		 Broker-Dealer Revenues
5.4.1 Broker-Dealer Revenues
Billions of US$

As Of: 2012

Billions of US$

Source: SIFMA DataBank, FINRA

Chart 5.4.2 		 Broker-Dealer Assets and Leverage
5.4.2 Broker-Dealer Assets and Leverage
Trillions of US$

Leverage Ratio

As Of: 2012 Q4

Leverage
(right axis)

Source: SIFMA DataBank, FINRA

Note: Leverage is total assets
as a multiple of equity.

Chart 5.4.3 		 Primary Dealer Securities
5.4.3 Primary Dealer Securities
Billions of US$

As Of: 20-Mar-2013

Billions of US$

Primary Dealer Net Outright Corporate Securities
Primary Dealer Net Outright Federal Agency Securities and Agency MBS
Primary Dealer Net Outright U.S. Government Securities

Source: FRBNY

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2 0 1 3 F S O C / / Annual Report

in 2012 to $32 billion, as trading revenues
increased almost three times over the previous
year (Chart 5.4.1). Trading revenue increased
primarily due to increased debt trading, led by
near record levels of debt issuance, and gains in
other trading, such as currencies, commodities,
and derivatives.
The broker-dealer industry doubled in size
between 2001 and 2007 before shrinking
abruptly following the financial crisis. Assets
held within the U.S. broker-dealer industry have
stabilized at a post-financial crisis level of about
25 percent below the 2007 peak, reaching $4.8
trillion in the fourth quarter of 2012 (Chart
5.4.2). Broker-dealer leverage also declined
markedly after the crisis, and has stabilized
over the past four years at 10-year lows.
Broker-dealers operate at 22 times leverage
in aggregate, which is significantly higher
than leverage at commercial banks. Brokerdealers obtain leverage primarily through the
use of secured lending arrangements, such as
reverse repurchase agreements and secured
borrowing arrangements. Since the financial
crisis, the broker-dealer sector underwent a
notable decline in asset size—from a peak of
nearly $7 trillion to current total assets just
under $5 trillion—and leverage—from a peak
near 40 to the current level of 22. The run-up
and subsequent decline in balance sheet size
and leverage of the broker-dealers sector was
also accompanied by a notable change in the
types of assets that they hold (Chart 5.4.3).
Primary dealers—the broker-dealers that have a
trading relationship with the Federal Reserve—
experienced a marked decline in the holdings
of corporate securities, agency securities, and
agency MBS. At the same time, net holdings by
primary dealers of U.S. government securities
moved from negative to positive. This switch
in net positions of broker-dealers indicates
a decline in risk appetite and balance sheet
capacity for the sector.
Market participants remain attuned to the
liquidity risks associated with the brokerdealer model, as will be discussed in Section
7.1. Trading and financing undertaken by

broker-dealers is typically short-duration, and
the profitable execution of these activities
requires a flexible and inexpensive funding
profile, typically executed through shortterm secured financing arrangements. While
short-term funding is stable under normal
market conditions, heavy reliance on shortterm funding leaves broker-dealers vulnerable
to liquidity runs during periods of stress. If a
broker-dealer’s secured creditors pull away, its
ability to quickly replace lost funding sources
may be limited. Reduced funding might
cause fire sales with potentially system-wide
implications. Although a broker-dealer’s shortterm liabilities are typically supported by a
very liquid asset base, broker-dealers may be
unable to reduce assets quickly enough to
pay-off liabilities.

5.4.2

Insurance Companies

Chart 5.4.4 		 Life and Other Insurance: Capital and Net Income
5.4.4 Life and Other Insurance: Capital and Net Income
Billions of US$

As Of: 2012

Flat or declining investment portfolio returns
continued to pressure net incomes at life
insurers in 2012. Nevertheless, net income
of life insurance companies increased $26.5
billion in 2012 compared to 2011, after
declining by over $13.6 billion from 2010 to
2011. Increased premium revenue and lower
increases in reserves contributed to increased
net income, aggregate statutory capital, and
surplus (Chart 5.4.4).
The prospect of continued low interest rates
for a prolonged period poses a challenge to
life insurers seeking to balance investment
risks and returns, especially while trying to
build capital and expand product offerings
(Chart 5.4.5). Life insurers earn a spread on
products with guaranteed benefits (such as
fixed annuities, universal life insurance, and
guaranteed investment contracts) from the
excess of the investment yield earned over
the credited rate offered to policyholders.
A protracted low interest rate environment
may stress life insurers’ profits as this spread
compresses. While insurers have responded to
the low interest rate environment by decreasing
crediting rates, the flexibility to lower these
rates is often limited given the guaranteed
minimums on many products. Although the life

Billions of US$

Net Income (left axis)

Capital (right axis)

Note: Includes accident and health.

Source: NAIC

Chart 5.4.5 		 Life Insurers: Impact of Low Rate Environment
5.4.5 Life Insurers: Impact of Low Rate Environment
Percent

As Of: 2012

Percent

Investment Yield Minus
Required Interest Rate
(right axis)
Investment Yield
(left axis)

Required Interest Rate
(left axis)

Source: NAIC, SNL Financial

Financial Developments

83

insurance industry has reduced its minimum
guarantees over time, products with minimum
guarantees still represent a large share of
existing life and annuity products outstanding.
Aside from cutting the crediting rates on their
insurance products, life insurers have also
responded to the low interest rate environment
by reducing exposure to, and increasing
policyholder fees on, interest-sensitive
businesses such as guaranteed investment
products, variable annuities, and long-term
care insurance. Life insurers also pursued
new revenue sources by acquiring businesses
in new markets such as Latin America, and by
acquiring fee-earning pension and retirement
assets. Some life insurers also increased revenue
by leveraging their pre-existing real estate and
private placement platforms to offer investment
opportunities to other institutional investors. To
offset the declining new money yields on their
assets, some life insurers increased portfolio
duration and marginally increased their
allocation to hedge funds, private equity funds,
BBB-rated bonds, and commercial mortgage
loans over the last few years, though total
exposures by life insurers to these assets are
generally below peak levels.
In addition to adversely affecting investment
returns, the current low interest rate
environment affects the present value of life
insurers’ contract obligations. As interest
rates have decreased, the present values of
future obligations have increased. As a result,
life insurers have increased reserve levels,
adding further downward pressure to reported
financial results. Moreover, the increase in
reserves can also be attributed to the asset
adequacy testing of liquid assets and change in
policyholder lapse assumptions at life insurance
companies. The increase in reserves was less
of a factor in 2012 than in 2011 as the decline
in interest rates slowed. Although life insurers
could increase premiums on new products, this
response may affect product sales and is likely to
lag the accounting impact of reserve increases
on existing products. However, premium
revenues increased in 2012.
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Life insurers could also be adversely impacted
by a sudden increase in interest rates, which,
under Generally Accepted Accounting
Principles (GAAP), would increase unrealized
losses in insurers’ fixed income portfolios.
Higher interest rates could also entice
policyholders to surrender contracts for higher
yield elsewhere. Thus, in order to fund contract
surrender payments, insurers could be forced to
seek other facilities for liquidity or to liquidate
fixed income investments just as the market
value has declined.
Property and casualty insurers, which sell
insurance on homes, cars, and businesses,
underwrite products that result in liabilities
that are generally much shorter in duration
(with the exception of workers’ compensation
insurance) as compared to life insurers, and,
therefore, are affected less by the low interest
rate environment. However, property and
casualty insurers continued to be pressured
by large catastrophe losses in 2012. A.M. Best
estimates that insured catastrophe losses
were $43.0 billion in 2012, down from $44.2
billion in 2011. The high losses were driven by
Superstorm Sandy, a post-tropical storm system
that struck the most densely-populated areas
of the U.S. eastern seaboard in October 2012.
Current estimates suggest that Superstorm
Sandy may have caused $25 billion in insured
losses, and up to $50 billion in total economic
damages. Despite Superstorm Sandy, property
and casualty insurers were able to increase net
income and statutory capital and surplus
(Chart 5.4.6).

Interest Rate Risk Management of Insurance
Companies
State insurance regulators require the
appointed actuary to comply with the Actuarial
Standards of Practice promulgated by the
Actuarial Standards Board. These actuarial
standards require that insurance companies
run a range of scenarios that reflect the
variability of the relevant cash flows being
tested. In light of these actuarial standards,
most companies currently use an economic
scenario generator (such as the economic

Chart 5.4.6 		
Property and Casualty Insurance: Capital and
Net Income
5.4.6 Property and Casualty Insurance: Capital and Net Income
Billions of US$

As Of: 2012

Net Income
(left axis)

Billions of US$
Capital
(right axis)

Source: NAIC

Financial Developments

85

scenario generator developed by the American
Academy of Actuaries) to generate a large
number of economic scenarios. In addition,
state insurance regulations traditionally have
prescribed seven scenarios for the potential
path of interest rates in order to test the ability
of insurers’ portfolios to withstand moderate
shocks. These scenarios are often called the
New York 7, since they were established by a
1986 regulation by the New York insurance
regulator. The New York 7 include jumps
300 bps up and down, gradual increases and
decreases of 500 bps, and a level path. Each
scenario is applied as a parallel shift to the
prevailing yield curve and therefore doesn’t
include any change to the slope of the yield
curve, or in the convexity of the curve. This
deterministic approach of the New York
7 scenarios therefore differs from that of
stochastic scenario models, which allow for
changes to the slope of the yield curve and for
periods where the yield curve is inverted.
New York’s requirement to use the seven
scenarios for asset adequacy testing was later
incorporated into model actuarial and opinion
memorandum regulations that were adopted
by the various states, and as a result, most U.S.
life insurers were subjected to such testing even
though they may not have been domiciled or
licensed in New York. Beginning in 2009, the
majority of states have amended their actuarial
and opinion memorandum regulations
to eliminate the prescribed deterministic
scenario requirements of the New York 7.
Under the revised regulations, the New York
7 was replaced by a requirement that each
insurance company run scenarios (stochastic
or deterministic) that provide a wider array of
tests of the adequacy of reserves held, given
the assets the company currently holds. A
number of states (irrespective of whether they
have yet adopted the amended regulation),
also continue to require domiciled insurance
companies to run the New York 7; other
insurance companies also generally run these
scenarios as a matter of practice.

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5.4.3

Specialty Finance Companies

Credit activity in the specialty-lending sector
has moderately improved in the past year,
yet remains below pre-crisis levels. Nonbank
financial companies involved in credit activity
across various segments include issuers of
equipment leases, credit cards, student loans,
and auto finance. Overall, nonbank financial
companies owned approximately $840 billion
of consumer loans, $180 billion of real estate
loans, and $421 billion of business loans at
year end 2012 (Charts 5.4.7 and 5.4.8).
The securitization market for these credit types
originated by both bank and nonbank financial
companies has improved, with significant yearover-year increases in auto ABS issuance (30
percent), credit card issuance (150 percent),
and equipment leasing (100 percent). Although
these increases are large, they follow a period
of low post-crisis issuance. For instance, a
large proportion of the increase in credit card
lending replaced Term Asset-Backed Securities
Loan Facility (TALF)-era issuance that matured
in 2012 (Chart 5.4.9). Credit spreads on these
types of ABS continue to tighten as a result of
a growing appetite for securitized products, a
lower perception of credit risk, and increased
demand for yield by investors (Chart 5.4.10).

5.4.4

Agency REITs

Agency MBS REITs use short-term debt in
the form of repurchase agreements to fund
the purchase of agency MBS and earn the
difference between the yield on the underlying
MBS and the cost of financing. As a REIT,
these earnings are not taxed at the corporate
level but are only taxed when equity holders
receive the earnings in the form of a dividend.
To maintain their REIT status, these entities
return in excess of 90 percent of their earnings
to equity holders. Agency REITs structure their
operations to be excluded from regulation
under the Investment Company Act of 1940.
The market for agency MBS REITs continued
its trend of strong asset growth this past year.
Much of this growth can be attributed to
the high dividend yield that agency REITs

Chart 5.4.7 		 Consumer Loans Outstanding
5.4.7 Consumer Loans Outstanding
Trillions of US$
1.4
1.2

As Of: Feb-2013

Trillions of US$
1.4
1.2

Commercial Banks

1.0

1.0

0.8

0.8
Finance Companies

0.6
0.4
2001

2003

Source: Federal Reserve,
Haver Analytics

2005

2007

0.6

2009

2011

0.4
2013

Note: Loans owned and securitized. Series break in December 2010
for consumer loans outstanding at finance companies due to change
in data collection methodology. Gray bars signify NBER recessions.

Chart 5.4.8 		 Business Loans Outstanding
5.4.8 Business Loans Outstanding
Trillions of US$
1.8

As Of: Feb-2013

Trillions of US$
1.8
1.5

1.5
1.2

1.2

Commercial Banks

0.9

0.9

0.6

0.6
0.3

Finance Companies

0.0
2001

2003

Source: Federal Reserve,
Haver Analytics

2005

0.3

2007

2009

2011

0.0
2013

Note: Loans owned and securitized. Series break in December 2010
for business loans outstanding at finance companies due to change
in data collection methodology. Gray bars signify NBER recessions.

Chart 5.4.9 		 ABS Issuance
5.4.9 ABS Issuance
Billions of US$

As Of: 2012

Billions of US$

Source: Thomson Reuters, SIFMA

Financial Developments

87

BOX C: CONVEXITY EVENT RISK

Basis risks are particularly pertinent in the market for
MBS. MBS investors, broadly speaking, fall into two
categories: those holding MBS on an unhedged or
infrequently hedged basis and those that actively hedge
the interest rate risk exposures of MBS. Unhedged
or infrequently hedged investors include the Federal
Reserve, foreign sovereign wealth funds, community
banks, and mutual funds benchmarked against an MBS
index. MBS holders who actively hedge include pension
funds and insurance companies that endeavor to match
the duration of their assets to that of their liabilities.
The interest rate risk of MBS differs from the interest
rate risk of Treasury securities due to the embedded
prepayment option in conventional residential mortgages.
The purchaser of an MBS is effectively selling an interest
rate option to each home loan borrower, because if
interest rates fall, the borrower is incentivized to refinance
into a lower rate mortgage, thus prepaying or accelerating
payment of their higher rate mortgage into a lower rate
loan. Conversely, if interest rates rise, the borrower is
incentivized to maintain their current mortgage and not
prepay. For the MBS investor a lack of prepayment, or
extension in a rising environment, causes the loan and
thus the MBS, to increase in duration and decrease in
price. When interest rates increase, the price of Treasury
securities falls, but it falls less and less sharply as the level
of yields increases, a feature called positive convexity. The
price of MBS on the other hand behaves very differently
from Treasury securities as rates change. As interest rates
rise, the price of MBS falls at an accelerating rate, that is,
it displays negative convexity (Chart C.1).

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Chart C.1 	 Convexity Risk
C.1 Convexity Risk
Mortgage

Price

Hedging and relative value trading often involves basis
risk, or the risk that changes in prices on closely related
products may suddenly diverge from historical norms
or market expectations. Portfolios exposed to basis risk
tend to have fat-tailed distributions, that is, their shortterm profit-and-loss volatility may be quite low, but may
be susceptible to infrequent but extreme losses. In the
case of large positions, such mark-to-market losses may
compel firms to rapidly unwind, thus creating a vicious
circle of fire sales that can strain market liquidity.

Treasury

Positive Convexity
Negative Convexity

Yield
Note: At low yields (relative to the coupon), MBS display negative convexity because price increases are
more limited as market yields fall, due to borrowers prepayment options being in the money. This
contrasts with the positive convexity of non-callable bonds, for which price gains increase as market
yields fall.

MBS are negatively convex because the likelihood that a
borrower prepays depends on the current level of interest
rates relative to the rate that he pays on his mortgage. As
rates rise from a low level, fewer and fewer households
have an incentive to refinance their mortgages. Increasing
rates thus result in an extension of the duration of MBS,
causing the price of MBS to fall at an ever faster pace.
Managing the interest rate risk sensitivity of MBS
necessitates dynamic hedging to maintain a desired
exposure of the position to movements in yields. The
hedging of the interest rate risk exposure of MBS is often
called duration hedging, as the effective duration of the
MBS changes with the level of yields. The amount of
hedging depends on whether MBS are in the negatively
or positively convex region. When rates decline, hedgers
will seek to increase the duration of their position. This
can be achieved by buying Treasury notes or bonds,
or by receiving fixed payments in interest rate swaps.
Conversely, hedgers will find themselves long duration
when rates increase, which can be achieved by selling
Treasury notes or bonds or by paying fixed in interest
rate swaps.

Convexity event risk is the risk of a sudden, selfChart C.2 	 Outstanding Agency MBS by Holders
reinforcing increase in long- to medium-term rates caused C.2 Outstanding Agency MBS by Holders
State and GSEs
by hedged investors in MBS trying to decrease duration
Local Gov’t (4.1%)
risk by selling Treasury securities or entering into payDepository
Other (4.2%)
Institutions*
(4.6%)
fixed interest rate swaps. This hedging activity in turn can
(24.3%)
Agency REITs
cause interest rates to rise further, which may increase
(4.8%)
the duration hedging need for other MBS holders,
Pension Funds
(5.5%)
inducing another round of duration sell offs. Due to its
self-reinforcing nature, a convexity event could be sparked
Insurance
(6.1%)
by a relatively modest initial increase in medium- to longMutual Funds
term interest rates. In the current environment of yields
(17.0%)
Foreign
near zero, even a modest yield increase may significantly
(13.9%)
Note: *Includes foreign
extend mortgage portfolio durations, potentially forcing
banking offices in the
Source: Fannie Mae,
U.S. and banks in U.S.Freddie Mac, SIFMA,
hedgers to sell duration, or to sell the underlying MBS.
affiliated areas.
Federal Reserve
Federal Reserve, FSOC
(15.5%)
calculations
As Of: 2012 Q3
Any of these actions will tend to drive yields higher,
increasing the need for further hedging.
While the current low rate environment has arguably
set the stage for a convexity event, a key factor in the
likelihood of such an event is who owns the convexity
Chart C.3 	 2003 Convexity Event
risk, as the amount of MBS held by hedged investors
C.3 2003 Convexity Event
Percent
As Of: 31-Dec-2003
determines the intensity of the selloff (Chart C.2).
5
GSEs are important duration hedgers, but their portfolios
Treasury 10Y Yield
have been shrinking compared to the pre-crisis period,
(left axis)
4
when they were the dominant investors in MBS. The
Federal Reserve, through its asset purchase programs,
3
10Y/2Y Spread
is currently the dominant MBS buyer and holds a sizable
(right axis)
portion of the convexity risk. Also, many of the largest
2
holders of MBS have access to sufficient sources of
Treasury 2Y Yield
1
liquidity and funding, even in extreme market conditions,
(left axis)
and in contrast to highly levered investors, are less likely to
0
be forced sellers.
Jan:03
Mar:03
May:03
Jul:03
Sep:03
Nov:03
Whether the current environment is more or less
susceptible to a convexity event than the 2003 episode is
ambiguous (Chart C.3). On the one hand, the GSEs are
smaller, and the Federal Reserve has a larger presence,
making a convexity event risk less likely. On the other
hand, there are fewer natural providers of protection
against convexity and rate volatility risk in the market. In
particular, a potentially amplifying factor in a rates selloff
is the reduced liquidity in fixed income markets since the
crisis, with broker-dealers less active in market making.

Basis Points
280
260
240
220
200
180

Source: U.S. Department of Treasury

Financial Developments

89

Chart 5.4.10 		 Selected ABS Spreads
5.4.10 Selected ABS Spreads
Basis Points

As Of: 21-Mar-2013

Basis Points

Auto Fixed
BBB 3-Year

Credit Card Fixed
BBB 3-Year
Auto Fixed
AAA 3-Year

offer which has generated strong demand by
investors. Although the asset levels of agency
REITs have grown, the amount of leverage
has been relatively stable post-crisis (Chart
5.4.11). The relatively stable level of leverage
can be partially attributed to structural changes
in the requirements for margin on agency
MBS. That is, haircuts on agency MBS have
remained at fairly elevated levels post-crisis and
have prevented agency REITs from increasing
leverage to pre-crisis levels.

Credit Card Fixed AAA 3-Year

Note: Spreads to Treasury securities.

Source: Barclays

Chart 5.4.11 		 Total Agency REIT Assets
5.4.11 Total Agency REIT Assets
Billions of US$

As Of: 2012 Q4

Percent

Total Assets (left axis)

Assets to Equity Ratio*
(right axis)

Note: *Weighted by market capitalization.

Source: Bloomberg, L.P.

Chart 5.4.12 		 Agency REITs: Return on Assets
5.4.12 Agency REITs: Return on Assets
As Of: 2012 Q4

Percent

Basis Points

2Y/10Y Treasury Spread
(right axis)

Near-term returns on assets for agency REITs
are tightly linked to the slope of the yield curve
(Chart 5.4.12). These vehicles hold agency MBS
funded in the bilateral repo market. They earn
longer-term yields paying short-term money
market rates to obtain leverage. This investment
behavior of agency REITs exposes them to
interest rate slope and convexity risk (see Box
C: Convexity Event Risk and Section 7.4 on
risks from fixed income asset valuations).
Convexity event risk is particularly acute for
agency MBS REITs, since their earnings and
capital are most sensitive to a sharp increase
in interest rates. Moreover, agency REITs are
exposed to rollover risk. The financing of
long-term assets with short-term debt in the
form of repurchase agreements is sensitive
to either an increase in financing costs or a
pullback in the willingness of lenders to extend
credit. A significant pullback in financing
availability could put pressure on agency REITs
to sell MBS, which could itself pressure MBS
valuations and further reduce the availability
of short-term financing for agency REITs. The
potential for such negative feedback loops
becomes stronger as the share of agency MBS
financed by short-term debt increases.

5.5

Source: Bloomberg, L.P.

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Note: *Weighted by market capitalization.

Investment Funds

5.5.1

Average ROA*
(left axis)

Money Market Funds

MMFs are open-ended mutual funds permitted
to use certain valuation methods that generally
allow them to redeem shares at a fixed $1 per
share. Among other instruments, MMFs invest
in short-term debt securities and repo. As of

the end of February 2013, MMFs totaled $3.0
trillion assets under management (AUM),
according to SEC data. Total U.S. MMF
assets increased slightly by $51.8 billion from
February 29, 2012 to February 28, 2013. MMF
assets remain far below their 2009 peak. Prime
MMF assets increased from $1.7 trillion to $1.8
trillion, while government and Treasury MMF
assets decreased from $936.5 billion to $929.3
billion during this period. Tax-exempt funds
also declined from $302.8 billion to $289.4
billion (Chart 5.5.1). Comparatively, MMFs
comprised 20 percent of total mutual fund
AUM, according to the Investment Company
Institute (ICI). Consolidation in the number of
MMFs continued in 2012, with 54 MMFs ceasing
operations. In order to prevent MMFs’ net
yields paid to investors from falling below zero
in the sustained low-interest rate environment,
some managers decided to waive management
fees, a practice in place throughout the MMF
industry since 2009. This sustained fee-waiving
practice has continued to erode the profitability
of funds, possibly leading to some managers’
decision to close their MMFs. Other postcrisis factors such as concerns about pressure
on sponsors to cover MMFs’ losses as well
as declining AUM may have pushed some
participants out of the MMF market.

Chart 5.5.1 		 MMF Assets by Fund Type
5.5.1 MMF Assets by Fund Type
Trillions of US$

As Of: Feb-2013

Trillions of US$

Prime
Government
and Treasury

Tax-Exempt

Source: SEC

Concerns about the debt crisis in Europe
continued to be a focus of MMF investment
activities in the first half of 2012. MMF
holdings of overall euro area bank-related
securities reached a low of 11.6 percent of
prime MMF assets in December 2011 and
were still relatively low at 11.9 percent in June
2012. Following ECB indications of a strong
commitment to maintaining the single euro
currency, MMF managers began returning to
euro area bank-related securities in July 2012
(see Box B: Global Monetary Policy Actions).
By February 28, 2013, holdings in euro area
financial institutions comprised 18.7 percent
of prime MMF assets. Throughout 2012, euro
area exposure remained below 2010 levels,
which marked the peak of euro area exposures.
Another indicator of this increased optimism
is the gradual increase in the weighted average
Financial Developments

91

Chart 5.5.2 		 Prime Funds Liquidity
5.5.2 Prime Funds Liquidity
Percent of Total Assets

As Of: Feb-2013

Percent of Total Assets

Weekly Liquidity

Daily Liquidity

Source: SEC

Chart 5.5.3 		 MMF Weighted Average Life*
5.5.3 MMF Weighted Average Life*
As Of: Feb-2013

Days

Days

Prime

All Funds

Source: SEC

Note: *Weighted average lives, weighted by size of fund.

maturity and weighted average life of MMF
managers’ fund portfolios, which allowed
liquidity levels to decline slightly (Charts
5.5.2 and 5.5.3). This gradual decrease in
concerns regarding Europe’s debt crisis in
2012, as demonstrated by MMFs’ increased
euro area exposure, was corroborated by the
broader-based improvement in the outlook for
European resolution of the sovereign debt and
banking sector crisis given such public sector
support as the ECB’s OMT program (see Box
B: Global Monetary Policy Actions). Although
euro area concerns ebbed in the second half of
2012, early 2013 euro area incidents—such as
the decision to impose levies on Cypriot bank
deposits and the uncertainty related to the
February 2013 Italian election results—have
kept euro area debt issues in focus as risks for
MMFs. However, currently, those two early 2013
incidents have not had a significant impact
on MMFs.
Prime MMFs increased their exposure to
non-traditional geographies in 2012. Most
notably, prime MMFs more than doubled
their geographical exposure to Asian
countries compared to 2010 levels, particularly
in Japanese holdings. The increase in
Japanese exposure of prime MMFs has been
concentrated in U.S. dollar-denominated CDs.
Over the past few years, average maturities
of Japanese and U.S. CDs have been similar,
while yields of average Japanese CDs in prime
MMF portfolios have been higher than those
of U.S. banks. Furthermore, Japanese CDs have
been considered by market participants to be
both high in quality and limited in their euro
area exposures. These factors contribute to an
increased exposure of MMFs to Japanese CDs.
Japanese assets comprise U.S. MMFs’ fourth
largest country exposure after the United
States, Canada, and France. MMFs’ Japanese
exposure suggests a potential vulnerability
given the challenging growth outlook for Japan
(see Section 7.5 for further detail on the
Japanese economy).
MMF flows continue to fluctuate with transitory
developments in prime money markets; two

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examples are the temporary effects of the
expiration of the FDIC Temporary Unlimited
Coverage for Noninterest-Bearing Transaction
Accounts as well as then-ongoing fiscal cliff
negotiations. The effects of the expiration
of the Temporary Unlimited Coverage for
Noninterest-Bearing Transaction Accounts,
known colloquially as the Transaction Account
Guarantee (TAG) program, were demonstrative
of transitory effects on MMFs. Leading up to
the TAG expiry, market participants expected
that the expiry would lead to material inflows
to MMFs. Though flows to MMFs did fluctuate
visibly in response to the expiration of TAG,
these inflows coincided with year end and
seasonal effects. Thus, the net impact of TAG
expiration on MMFs on these inflows is difficult
to isolate. One such coinciding, and large,
driver of flows into MMFs over the fourth
quarter of 2012 was the result of equity investors
liquidating positions ahead of an expected
increase in capital gains taxes in 2013 (due to
then-ongoing fiscal cliff negotiations). Proceeds
from these stock sales were then invested in
MMFs. Additionally, some market participants
noted that accelerated corporate dividend
payments ahead of 2012’s year end contributed
to the increase in MMF assets, as investors
parked the dividend payments in MMFs
(at least temporarily). Though the net impact
of the TAG expiry appears to be minimal,
it demonstrates how market developments
might induce temporary fluctuations in the
MMF space.
In January 2013, a number of large MMF
managers announced that they would begin
voluntarily and publicly releasing some or all
of their MMFs’ market-based net asset values on
a daily basis. Under SEC rules this information
was available only on a monthly basis with a
60-day delay.

5.5.2

Mutual Funds

Mutual funds are open-end investment vehicles
made up of a pool of funds for investment
purposes. As of the end of February 2013, longterm mutual funds comprised 80 percent, or
over $10.8 trillion, of total mutual fund AUM,
Financial Developments

93

Chart 5.5.4 		 Total Assets of Mutual Funds
5.5.4 Total Assets of Mutual Funds
Trillions of US$
As Of: Feb-2013
14
Hybrid Funds
Total Bond Funds
12
Money Market Funds
Equity Funds
10

Trillions of US$
14
12
10

8

8

6

6

4

4

2

2

0
2000

2002

2004

2006

2008

2010

2012

0

Source: ICI, Haver Analytics

Chart 5.5.5 		
Mutual Fund Flows by Asset Class (Mar-2012
to Feb-2013)
5.5.5 Mutual Fund Flows by Asset Class (Mar-2012 to Feb-2013)
Billions of US$

As Of: Feb-2013

Billions of US$

Note: *Includes sector stock
funds with intĀl exposure.

Source: Morningstar

Chart 5.5.6 		
Mutual Fund Taxable Bond Flows (Mar-2012
to Feb-2013)Bond Flows (Mar-2012 to Feb-2013)
5.5.6 Mutual Fund Taxable
Billions of US$

Source: Morningstar

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As Of: Feb-2013

Billions of US$

according to ICI (Chart 5.5.4). Commensurate
with global market gains, mutual funds have
recovered value post-crisis. Mutual fund flows
for the 12 months ending February 2013
reflected current investor preference for capital
preservation, income generation, and lower
volatility. Mutual funds had an estimated
$305 billion net inflow for the period, largely
attributable to taxable bond funds, which
received a net $256 billion (Chart 5.5.5). From
March 2012 through February 2013, the net
asset outflows from government funds and
relatively higher inflows to high-yield funds and
emerging market bond funds likely demonstrate
investor preference for yield among lowervolatility fixed income products (Chart 5.5.6).
In contrast, U.S. equity funds had net outflows
of $72 billion, with net outflows occurring
every month since March 2012. Globally, fixed
income funds saw large inflows (Chart 5.5.7).
Equity and hybrid inflows in the first month
of 2013 picked up significantly, totaling $51
billion, possibly compounded by year end U.S.
legislative action on tax reform as compromise
on financial assets ameliorated some concerns,
including avoiding more severe dividend and
capital gain tax rate hikes.
Among mutual funds, corporate bond holdings
have grown substantially since 2009. While
the Securities Industry and Financial Markets
Association (SIFMA) reports that the total U.S.
investment grade and high-yield corporate
bond market increased by 28 percent from 2009
to 2012, over the same period, corporate and
foreign bond holdings among mutual funds
increased by 54 percent (Chart 5.5.8). Mutual
fund holdings of high-yield bonds and loans
have grown even more quickly, at 74 percent
and 169 percent, respectively. The yields
of corporate bond and loan mutual funds,
relatively attractive in comparison to Treasury
mutual funds, are likely the main reason
for these flows. The rapid rise in AUM,
particularly in high-yield bonds, may result in
dislocations in response to a sharp sell-off in
credit assets. This risk could be exacerbated by

dealer balances in corporate bonds that remain
quite low by historical standards and may signal
less willingness to deploy capital to corporate
bond trading.

5.5.3

Chart 5.5.7 		 Annual Net Worldwide Fund Flows
5.5.7 Annual Net Worldwide Fund Flows
As Of: 2012

Billions of US$

Billions of US$

Pension Funds

As of the third quarter 2012, the combined
AUM of private and public pensions, including
federal pensions and defined contribution
(DC) plans, were over $16 trillion (Chart 5.5.9).
While some large pension plans manage their
own portfolios without outside help, others
may invest some portion of their portfolios with
investment managers.
Both public and private defined benefit (DB)
plans remain significantly underfunded relative
to the present value of their liabilities due to
inadequate contributions, losses incurred in
2007 and 2008, and, in the case of corporate
plans, declines in liability discount rates.
Estimates of aggregate funded status vary.
Some estimate that public DB plans were 75
percent funded in aggregate as of year end
2012, while private DB plans were 78 percent
funded (Chart 5.5.10). Some private pension
funds have received contributions to make
up for shortfalls or have been able to adjust
their benefit plans to reduce future outlays.
Even more underfunded are multiemployer
private sector DB plans, which are only 48
percent funded. Recent projections issued by
the Pension Benefit Guaranty Corporation
(PBGC) substantiate these concerns. Based
on these projections, which assume no
changes either in multiemployer plans or in
PBGC’s multiemployer program, there is a 36
percent probability of insolvency in PBGC’s
multiemployer program by 2022 and a 91
percent probability of insolvency by 2032.
In July 2012, the Governmental Accounting
Standards Board (GASB) released
modifications to accounting standards for
public pensions. Among the most notable
changes were valuation methods for pension
assets and liabilities as well as enhanced
disclosure requirements. As a result, industry
analysts expect most public pension plans to

Source: Morningstar

Chart 5.5.8 		 Mutual Fund Holdings
5.5.8 Mutual Fund Holdings
Billions of US$

As Of: 2012

Billions of US$

High-Yield Bonds (left axis)
Institutional Loans (left axis)
Corporate and Foreign Bonds (right axis)

Source: Flow of Funds, S&P LCD, Lipper

Chart 5.5.9 		 Retirement Fund Assets by Plan Type
5.5.9 Retirement Fund Assets by Plan Type
Trillions of US$
20
16

As Of: 2012 Q3

Individual Accounts
Private Defined Contribution Plans
Private Defined Benefit Plans

State and Local
Federal

Trillions of US$
20
16

12

12

8

8

4

4

0
Dec:06

Dec:07

Dec:08

Dec:09

Dec:10

Dec:11

0

Source: Flow of Funds, Haver Analytics

Financial Developments

95

Chart 5.5.10 		 Public and Private Pension Funding Level
5.5.10 Public and Private Pension Funding Level
Percent

As Of: 2012

Percent

Private Defined
Benefit Plans
Public Defined
Benefit Plans

report a larger underfunded status despite
unchanged plan economics; this is due mostly
to the lower liability discount rate for already
under-funded plans. Many analysts also
anticipate that public pension funding status
will become more volatile year-on-year. Plans
are beginning to adapt gradually to these
changes, though full GASB implementation
is not expected to begin until fiscal years 2014
and 2015.

5.5.4
Source: Goldman Sachs Asset Management,
Public Fund Survey, NASRA, NCTR

Note: 2012 figures
are preliminary.

Chart 5.5.11 		 U.S. Private Equity AUM
5.5.11 U.S. Private Equity AUM
Trillions of US$

As Of: 2012 Q3

Trillions of US$

YTD
Source: Preqin

U.S. private equity AUM increased to nearly
$2 trillion in 2012 (Chart 5.5.11). Although
leveraged buyout funds account for 39 percent
of U.S. private equity AUM, advisers continue
to diversify their investment strategies into such
areas as real estate, natural resources, distressed
assets, and emerging market opportunities
(Chart 5.5.12). Following the 2005 to 2007
period of robust deal activity, advisers remain
focused on realizing returns on historically
high levels of existing portfolio investments.
Given the tepid environment for initial public
offerings (IPOs), exits remain concentrated in
sales to corporate buyers and to other private
equity firms. In addition, private equity advisers
continue to seek investment opportunities
for over $500 billion in undeployed capital
commitments stemming from record levels of
fundraising during 2005 to 2007.

5.5.5

Chart 5.5.12 		 U.S. Private Equity AUM by Strategy
5.5.12 U.S. Private Equity AUM by Strategy
Mezzanine Growth
(1%)
Infrastructure (5%)
(5%)
Other
(9%)

Leveraged
Buyouts
(39%)

Distressed
Capital
(10%)

Venture Capital
(13%)
Source: Preqin

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Real Estate
(17%)

As Of: 30-Sep-2012.

Private Equity

Hedge Funds

Hedge fund industry assets continued to
grow in 2012, fueled by a balance of positive
investment performance and net asset flows
into the industry of $34.4 billion (Chart 5.5.13).
As of year end 2012, hedge funds managed
approximately $2.22 trillion in assets, a 14
percent increase from 2011 (Chart 5.5.14).
Flow data indicate that larger, more established
funds continued to receive a disproportionate
share of capital inflows in 2012 (Chart 5.5.15).
Institutional investors continued to show
interest in hedge funds as an asset class in
part because of the perception that they offer
attractive volatility adjusted returns with less
correlation to traditional asset classes. On
an absolute basis, major hedge fund strategy

returns lagged some broader equity indices,
such as the S&P 500, although, when adjusted
for volatility, most strategies outperformed
their benchmarks (Chart 5.5.16). According to
available data, aggregate hedge fund balance
sheet leverage remained in a modest range
during calendar year 2012, in-line with the
reduced levels of leverage observed since the
2008 financial crisis. Hedge fund managers
noted global and domestic risk events as well as
concerns regarding the global economic growth
outlook as factors subduing risk appetites.

5.5.6

Exchange-Traded Products

Early 2013 marked the twentieth anniversary of
the creation of the first U.S. exchange-traded
fund (ETF). Most ETFs are registered under the
Investment Company Act of 1940 (Investment
Company Act) and may track a securitiesbased index or be actively managed. ETFs are
part of a broader category of exchange-traded
investment products (ETPs), which may include
not only funds that track commodities or other
non-securities based indices, but also exchangetraded notes. Currently, all ETPs trade at an
intra-day market price.
Since their creation, ETPs have expanded
from covering primarily equity markets to also
include investments in commodities, currencies,
and other non-securities instruments, such
as precious metals. As of February 2013, ETFs
comprised over 90 percent of ETP AUM. ETPs
remain a popular investment vehicle, primarily
used as a means to achieve exposure to a market
sector or index in a manner potentially more
efficient and cost-effective than a traditional
mutual fund, investment product, or financial
instrument.

Chart 5.5.13 		 Change in Hedge Fund AUM
5.5.13 Change in Hedge Fund AUM
Billions of US$

As Of: 2012

Billions of US$

Source: Hedge Fund Research, Inc.

Chart 5.5.14 		 Hedge Fund Assets and Net Asset Flows
5.5.14 Hedge Fund Assets and Net Asset Flows
Billions of US$

As Of: 2012

Thousands of Funds

Source: Hedge Fund Research, Inc.

Chart 5.5.15 		 Hedge Fund Net Asset Flows by AUM
5.5.15 Hedge Fund Net Asset Flows by AUM
Billions of US$

As Of: 2012 Q4

Billions of US$

While the ETP industry is still a fraction of
the size of the traditional open-end mutual
fund industry, ETPs continue to outpace the
growth of similar investment vehicles in overall
asset accumulation. In 2012, the number
of U.S.-listed ETFs grew to 1,131 products
and ETF assets grew by 22 percent to $1.29
Source: Hedge Fund Research, Inc.

Financial Developments

97

Chart 5.5.16 		 Hedge Fund Performance by Strategy
5.5.16 Hedge Fund Performance By Strategy
Percent

As Of: 2012

Percent

Source: Hedge Fund Research, Inc.

Chart 5.5.17 		 ETP Net Assets by Product Type
5.5.17 ETP Net Assets by Product Type
Trillions of US$

As Of: Feb-2013

Trillions of US$

Exchange-Traded Note
Exchange-Traded Vehicle
Exchange-Traded Fund

Source: Morningstar

Chart 5.5.18 		 ETP Net Flows by Product Type
5.5.18 ETP Net Flows by Product Type
Billions of US$

Source: Morningstar

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As Of: Feb-2013

Billions of US$

trillion (Chart 5.5.17). ETPs saw net inflows
in 2012 (Chart 5.5.18); fixed income-based
ETFs and international equity funds had
particularly high growth relative to existing
asset bases, consistent with asset inflows to
similar investment vehicles. As discussed in the
Council’s 2011 annual report, fixed income
was widely viewed by industry observers as a
likely avenue of growth for the ETP industry;
this view materialized primarily in the highyield and investment-grade credit space as
investors searched for yield in an environment
of low interest rates. Combined, high-yield and
investment grade ETPs saw a $39.3 billion net
inflow in 2012.
The U.S. ETP market remains heavily
dominated by passively-managed products that
track widely-followed indices in equity, fixed
income, and commodity markets. Furthermore,
concentration among ETF fund sponsors
remains high, with the top three sponsors
of ETFs accounting for about 80 percent of
industry assets. Both asset growth and trading
volumes are concentrated and the top 10 funds
account for 36 percent of net ETP assets. As
the landscape for passive index and sector
funds has become more saturated, product
sponsors have begun to focus on alternative
strategies. For instance, some fund complexes
have recently launched products focusing
on volatility-adjusted returns, lower beta
(volatility), and short-dated active fixed income
strategies (a potential alternative to traditional
money market funds), among others.
There have been some regulatory developments
in the U.S.-listed ETP space. In late 2012, the
SEC lifted a 3-year moratorium on the use
of derivatives by actively-managed ETFs and
the fund industry. This may have an effect on
hedging activities and investor disclosures. The
SEC is reviewing applications for products that
make extensive use of derivatives. Additionally,
some ETP providers have approached the SEC
with proposals for new ways to operate activelymanaged ETPs, such as disclosing holdings less
frequently or disclosing a mirror portfolio daily,
thereby balancing the need for protecting the

provider’s active strategy with the need to create
both a transparent as well as liquid basket of assets.
Currently, actively-managed ETFs and certain indexbased ETFs disclose their holdings daily.
As the global ETP market continues to grow, market
participants remain attentive to potential risks of
ETPs, particularly synthetic European-listed ETPs,
the risks of which may not yet be fully understood. A
synthetic ETP typically aims to replicate the return
of an index through a total return swap with a bank,
whereas a physical-based ETP holds the actual index
constituents. Some market participants continue to
highlight the synthetic ETP structure as a potential
transmission mechanism for risks. Furthermore,
some regulators and market participants are
concerned about the potential liquidity mismatch
between the index that a synthetic ETP tracks and
the securities pledged as collateral by its sponsor’s
swap counterparty. Synthetic ETPs are not common
in the United States, due largely to the Investment
Company Act’s prohibition of affiliated transactions,
and represent a declining share of the European
market. In fact, synthetic ETPs now comprise less
than 40 percent of European ETP assets, down
from about 45 percent of all European ETP assets in
2009 to 2010. Some market participants continue to
voice concerns about the potential for the affiliation
between the ETP’s derivatives counterparty and
the ETP sponsor to amplify counterparty risks.
For example, European-based synthetic ETPs have
traditionally had counterparties that are historically
affiliates of the sponsor. As noted above, U.S.-listed
ETFs are prohibited by the Investment Company Act
from having affiliated derivatives counterparties.
The continued development of new types of
ETPs and similar products, such as leveraged and
inverse-leveraged ETPs, is an ongoing trend in the
market and a focus of regulators. Another focus for
regulators is ETFs with less liquid underlyings, such
as fixed income products discussed above. Finally,
as the ETP market continues to evolve, the ongoing
trend of concentration in the ETP market remains
of interest.

5.6

Financial Market Infrastructure

5.6.1

Payment, Clearing, and Settlement

U.S. payment systems, central counterparties
(CCPs), securities settlement systems, and central
securities depositories are the building blocks of
the U.S. financial market infrastructure. Payment
systems include wire transfer networks, automated
clearinghouses, check clearing services, and
payment card networks. On the securities settlement
side, Fedwire Securities Service and the Depository
Trust Company provide services.
In new developments, the Fixed Income Clearing
Corporation’s (FICC) Mortgage-Backed Securities
Division (MBSD) launched CCP services for
U.S. MBS in April 2012. MBSD processes passthrough MBS issued by Ginnie Mae, Fannie Mae,
and Freddie Mac. MBSD also processes options
trades for to-be-announced (TBA) transactions.
Through netting and guarantees, the MBSD CCP
reduces overall costs and risks in the MBS market.
MBSD guarantees the completion of matched
MBS trades in the event that a counterparty to
the trade defaults. In the final step of MBSD’s
clearance process, it nets and novates certain pool
delivery obligations, which further reduces the
amount of securities and payments to be delivered,
and interposes itself as the counterparty to those
obligations. The CCP is required to have an
effective risk management framework to protect
itself from the risks associated with the provision
of its services, including the risks associated with a
member default. While the new MBSD CCP cleared
a significant $104 trillion of transactions in agency
MBS in 2012, the overall market is larger, and many
bilateral agency MBS transactions are not submitted
to the MBSD. Because most bilateral agency
MBS transactions settle once a month, trading is
conducted months in advance of the settlement
date, the size of unsettled positions is substantial,
and the transactions are not typically margined,
unsettled MBS transactions can represent significant
counterparty risk. To address this risk, the Treasury
Market Practices Group, an industry group
sponsored by the Federal Reserve Bank of New York,
has recommended that bilateral MBS transactions
be margined appropriately.

Financial Developments

99

Pursuant to Title VIII of the Dodd-Frank Act,
in July 2012, the Council designated eight
U.S.-based financial market utilities (FMUs)
as systemically important. These FMUs are
The Clearing House Payments Company
LLC, on the basis of its role as operator of
the Clearing House Interbank Payments
System, CLS Bank International (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,
and The Options Clearing Corporation
(OptionsCC). The designation subjects
these FMUs to enhanced risk-management
standards, including stronger risk management
requirements and annual examinations. The
FMUs are subject to enhanced oversight by the
appropriate Supervisory Agency, meaning the
federal agency with primary jurisdiction over
the designated FMU under federal banking,
securities, or commodity futures laws. Title VIII
also provides the Federal Reserve discretionary
authority to permit Federal Reserve Banks to
establish accounts for and provide financial
services to designated FMUs. In addition,
FMUs that are clearing agencies must register
with the SEC under the Securities and
Exchange Act of 1934. FMUs that are derivatives
clearing organizations must register with the
CFTC under section 5b of the Commodity
Exchange Act.
Under Section 807 of Title VIII of the DoddFrank Act, the CFTC and SEC are required
to consult annually with the Federal Reserve
regarding the scope and methodology for any
examination of a designated FMU conducted
under Section 807. The Federal Reserve is
authorized to participate in any examination
conducted under Section 807 of a designated
FMU for which it is not the supervisory agency.
The CFTC is the supervisory agency for both
the CME and ICE Clear Credit, and has
accordingly engaged the Federal Reserve for a
consultation for the first Title VIII examination
of a designated FMU. The SEC is separately
required by the Exchange Act to conduct
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periodic examinations of registered clearing
agencies, including those dual-registered as
designated clearing organizations for swaps.
In addition, the three agencies continue
to participate in discussions about current
risk management of swaps for systemically
important derivative clearing organizations.
The Basel Committee on Banking Supervision/
Committee on Payment and Settlement Systems
(BCBS/CPSS) issued updated supervisory
guidance in February 2013 on the settlement
of FX transactions to supervisors and banks,
which replaces guidance from 2000.11 Since
the 2000 guidance, payment-versus-payment
(PVP) settlement systems, such as CLS, have
significantly mitigated FX settlement risk;
however, further FX settlement risks remain
due to rapid market growth and undisciplined
market practices. For enhanced risk reduction
effectiveness, the revised supervisory
guidance offers seven guidelines that focus on
governance, replacement cost, and principal
risk among other FX settlement-related risks.

Chart 5.6.1 		 Global OTC Derivatives Market
5.6.1 Global OTC Derivatives Market
Trillions of US$
As Of: 2012 Q2
800
Credit Default Swaps
Commodity Contracts
700
Equity-linked Contracts
Interest Rate Contracts
600
FX Contracts
Unallocated
500

Trillions of US$
800
700
600
500

400

5.6.2

Derivatives Infrastructure

G-20 leaders committed at the 2009 Pittsburgh
Summit to improve the governance of
derivatives market activities by year end 2012.
The four resulting reforms focus on central
clearing, trade repositories, electronic trading,
and higher capital and margin on non-centrally
cleared derivatives. Progress on the initiatives
has been mixed globally, with the U.S. having
enacted the Dodd-Frank Act and established
many regulations. In face of these broad
transformations, notional outstandings of overthe-counter (OTC) derivatives and exchangetraded derivatives have moderated.

Global Derivatives Volumes
In the 12 months ending June 30, 2012, the size
of the OTC derivatives market declined by 9.6
percent to $639 trillion, while exchange-traded
derivatives declined by 28 percent to $60 trillion
according to the BIS survey of global market
activity (Charts 5.6.1 and 5.6.2). Derivatives
notional volumes declined in the first half of
2012, with exchange-traded derivatives falling

400

300

300

200

200

100

100

0

2000

2002

2004

2006

2008

Source: BIS, Haver Analytics

2010

2012

0

Note: Notional values.

Chart 5.6.2 		 Global Exchange-Traded Derivatives
5.6.2 Global Exchange-Traded Derivatives
Trillions of US$
100

Trillions of US$
As Of: 2012 Q4
100
Equity-linked Contracts
Foreign Exchange Contracts
Interest Rate Contracts
80

80

60

60

40

40

20

20

0

2000

2002

2004

Source: BIS, Haver Analytics

2006

2008

2010

2012

0

Note: Notional values.
Financial Developments

101

Chart 5.6.3

Global OTC and Exchange-Traded
Derivatives Growth
5.6.3 Global OTC and Exchange-Traded Derivatives Growth

Indexed Growth
1000

As Of: 2012 Q4

Indexed Growth
1000

OTC

800

800

600

600

400

400
Exchange Traded

200
0
1998

200

2002

2006

2010

0

Note: Notional values, indexed
such that 1998 Q2 = 100.

Source: BIS, Haver Analytics

Chart 5.6.4 Exchange-Traded Derivatives Globalization
5.6.4 Exchange-Traded Derivatives Globalization
Billions of Contracts Traded

As Of: 2012

Source: Futures Industry Association

Billions of Contracts Traded

by a greater percentage than OTC derivatives
(Chart 5.6.3). The BIS OTC global survey
reported gross notional outstandings of $494
trillion in interest rate derivatives, $66 trillion
in FX derivatives, and $27 trillion in credit
derivatives as of June 30, 2012.
Data on the geographic trading locations
of derivatives is limited, yet available data
suggests that trading within the U.S. accounts
for about one-third of derivatives activity on
exchanges and OTC markets. As measured by
number of contracts, two-thirds of exchangetraded derivatives were traded outside of North
America in 2012 (Chart 5.6.4). The share
of derivatives volume traded on non-North
American exchanges continued to increase
over the past several years until 2012, when
it declined to 66 percent from 69 percent.
The most recent BIS Triennial Survey (2010)
indicated that more than two-thirds of turnover
in OTC interest rate derivatives took place in
two countries, with the U.S. share trailing the
U.K. share, 24 percent to 46 percent. Further
market information from the BIS derivatives
market survey at June 30, 2012 estimates that
outstanding credit derivative trades where both
sides occur in the home country are 20 percent
of trades, meaning that cross-border trades
total 80 percent of all credit derivative trades.
These figures highlight the importance of
international coordination in derivatives market
reforms.

Trade Repositories
In the United States, Title VII of the DoddFrank Act implements the G-20 trade reporting
commitment. Prior to the Dodd-Frank
Act, international major derivatives market
participants in derivatives collaborated with
global regulators to establish certain trade
repositories that receive voluntary reports on
credit, equity, and interest rates derivatives
trades. Continued efforts resulted in a
commodities trade repository in 2012 and an
FX trade repository in 2013. Under Dodd-Frank
and related rules, the details of cleared and
non-centrally cleared U.S. activity-related swaps
are required to be reported to a registered
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Swap Data Repository or Security-Based Swap
Data Repository (SDR) or to the CFTC or
SEC, as appropriate, if no SDR is available.
The CFTC established a phase-in period that
staggers the reporting requirement for different
market participants and products during 2012
and 2013. The SEC is finalizing rules related
to swap reporting for the products it oversees.
Survey reports to the Financial Stability Board
(FSB) indicate there are 14 trade repositories
operating globally. Aggregation and
understanding of derivatives data by regulators
could be made more difficult if numerous
trade repositories arise. The development of
trade repositories in various jurisdictions may
be due in part to concerns about privacy and
information sharing that would need to be
overcome for regulators to develop the most
complete understanding of global activity in the
derivatives markets.
According to the Depository Trust & Clearing
Corporation’s (DTCC) public trade repository
data, $23.7 trillion (notional) credit derivative
contracts were outstanding on March 22, 2013
(Chart 5.6.5). The trade repository shows that
credit derivatives are comprised of 55 percent
single-name credit derivatives and 45 percent
credit indices and tranches. For complete credit
derivative trade records, the trade repository’s
copper (incomplete legal record and more
bespoke) trades of about $3.7 trillion (last
reported at December 31, 2010) need to be
added to the $23.7 trillion gold (complete legal
record) trades. This implies total notional
value of credit derivatives outstanding is
approximately $27.4 trillion. Finally, public data
show interest rate derivatives trades outstanding
as of March 22, 2013 tallied $536.8 trillion, of
which only 15 percent were dealer-to-dealer,
while 58 percent were dealer versus CCP, and
27 percent were dealer versus non-dealer
transactions (Chart 5.6.6).
Through portfolio compression, market
participants reduce (or compress) the size of
their respective swap portfolios. This results
in fewer outstanding derivatives contracts and
a lower gross notional size of their portfolio.

Chart 5.6.5 		 Credit Derivatives Market
5.6.5 Credit Derivatives Market
As Of: 22-Mar-2013
Dealer vs Non Dealer
(38%)
Dealer vs Dealer
(61%)

Non Dealer vs
Non Dealer
(1%)
Source: DTCC

Total = $23.7 Trillion
Note: Percentages based off
of total notional outstanding.

Chart 5.6.6 		 Interest Rate Derivatives Market
5.6.6 Interest Rate Derivatives Market
As Of: 22-Mar-2013
Dealer vs Dealer
(15%)

Dealer vs CCP
(58%)

Dealer vs
Non Dealer
(27%)

Source: DTCC

Note: Percentages based off
of total notional outstanding.

Financial Developments

103

Several benefits accrue from reducing the
number of individual bilateral transactions,
including lower operational risk and reduced
capital requirements. In the first half of 2012,
rates derivatives were compressed by $25.7
trillion and credit derivatives by $2.5 trillion.12
The industry reports that the cumulative effect
of compression over the past several years has
led to the elimination of nearly $230 trillion in
notional value of credit and rates derivatives.

Central Clearing of Derivatives
The anticipation of Dodd-Frank requirements
and G-20 commitments mandating central
clearing of certain OTC derivatives transactions
has led to an increase in the number of
transactions concentrated in CCPs. A
CCP reduces risks to participants through
multilateral netting of trades and by imposing
risk controls on its participants. Critical
components needed to reduce risk through a
CCP include robust risk management practices
and adequate financial resources.

Chart 5.6.7 		
Notional Amounts Outstanding on CCPs
by Asset Class
5.6.7 Notional Amounts Outstanding on CCPs by Asset Class
Notional Amounts Outstanding on CCPs
(as reported by CCPs participating in FSB survey)
(USD equivalents, in billions)
ASSET CLASS

31-Dec-2010

31-Dec-2011

30-June-2012

Credit

1,231

1,645

1,800

Commodities

25

17

13

Equity

11

2.8

2.4

FX

73

93

124

Interest Rates

124,398

142,088

152,972

TOTAL

125,738

143,846

154,911

Source: FSB

104

Note: Not all CCPs participating in survey provided data for all time
periods. Where conversion to USD was necessary, exchange rates for a
given currency on 31-Dec-2010, 31-Dec-2011, and 30-June-2012 were
used.

2 0 1 3 F S O C / / Annual Report

The FSB Fourth Progress Report on
Implementation of OTC Derivatives Market
Reforms indicates that at mid-year 2012, there
were approximately 12 OTC derivatives CCPs
globally, including some that clear multiple
asset classes. At mid-year 2012, the notional
amounts outstanding in those CCPs had
risen by about 23 percent from year end 2010
levels, reflecting movement of some activity to
centralized clearing (Chart 5.6.7). Global policy
initiatives seek to increase these shares and to
implement central clearing by firms on behalf
of their clients.
CCP data show that 45 percent of rates and
11 percent of credit derivatives trades were
centrally cleared at June 30, 2012 at LCH.
Clearnet and IntercontinentalExchange (ICE),
respectively. The OTC derivatives market,
as mentioned previously, is predominately
compromised of interest rate derivative (IRD)
contracts. The majority of those contracts are
cleared on London-based LCH.Clearnet, which
has been clearing rates contracts for more than
a decade. At mid-year 2012, LCH.Clearnet’s

SwapClear indicates trade sides notional
amounts of about $305 trillion against a total
rates market size per BIS of $494 trillion (Chart
5.6.8). Trade sides are both novated contracts
resulting from the CCP interposing itself
between a seller and buyer. LCH.Clearnet’s
SwapClear further reports that the outstanding
notional value of cleared IRDs has grown from
about $70 trillion in 2007 to over $372 trillion
in February 2013. The number of new IRDs
cleared per month has risen from slightly over
20,000 in 2007 to almost 188,000 in February
2013. The credit derivatives market clearing
volumes have also continued to grow, with
U.S.-based ICE Clear Credit’s open interest
increasing to $842 billion as of December 2012,
with similar trends at ICE Clear Europe (Charts
5.6.9 and 5.6.10).
Given the increase in activity at CCPs, it is
important that CCPs have in place robust risk
management standards that keep pace with
current and future growth. U.S. regulators
have worked with other members of CPSSIOSCO to revise international principles for
all financial market infrastructures (FMIs)
to enhance risk management standards for
payment, clearing, and settlement systems,
culminating in the publication of the Principles
for Financial Market Infrastructures (PFMI).13
The PFMI, which were finalized in April 2012,
seek to address the potential risks resulting
from increased use of infrastructure such
as CCPs. The CFTC, Federal Reserve, and
SEC are taking into consideration the PFMI,
consistent with Title VIII of the Dodd-Frank
Act, in assessing whether further rulemaking
is needed with respect to risk management
standards applicable to the FMUs designated as
systemically important.
Many of the largest globally active financial
institutions are members of CCPs or act
as agent banks and/or liquidity providers
to CCPs. As a result, it is critical that these
institutions fully understand their potential
liability in the event of a default by one or
more members of a CCP. To help ensure that
members understand and can anticipate

Chart 5.6.8 		 SwapClear Volume
5.6.8 SwapClear Volume
Thousands of Trade Sides

Trillions of US$

As Of: Feb-2013

Monthly Registration (left axis)

Source: LCH.Clearnet

Chart 5.6.9 		 ICE Clear Credit
5.6.9 ICE Clear Credit
Thousands of Trades
As Of: 25-Mar-2013
25
Open Interest (right axis)

Billions of US$
1000

20

800

15

600

10

400

Monthly Registration
(left axis)

5
0
Mar:09

Mar:10

Mar:11

Source: ICE, Bloomberg, L.P.,
FSOC calculations

200

Mar:12

0
Mar:13

Note: Only trading days shown. Nondollar denominated contracts converted
using end of day exchange rates.

Chart 5.6.10 		 ICE Clear Europe
5.6.10 ICE Clear Europe
Thousands of Trades
25

As Of: 25-Mar-2013

Billions of Euros
750
Open Interest (right axis)

20

600

15

450
300

10
Monthly Registration
(left axis)

5
0
Jul:09

Mar:10

Nov:10

Source: ICE, FSOC calculations

Jul:11

150

Mar:12

Nov:12

0

Note: Only trading days shown.

Financial Developments

105

potential losses from participating in CCPs, CPSSIOSCO finalized a framework requiring an FMI14
to disclose information about its activities, risk
profile, and risk management practices to facilitate
a comprehensive understanding of the FMI. In
addition, the Payments Risk Committee, an industry
group sponsored by FRBNY, developed a set of
recommendations in support of a clearing member’s
due diligence of CCPs to further address this issue.15
In the event of a CCP member default, the CCP
uses the defaulting member’s initial margin and
guarantee fund contribution to cover any losses. If
losses exceed these amounts, the CCP may use its
own resources and/or the default fund contribution
of non-defaulting members. These pre-funded
resources are required to be sufficiently sized to
cover the one or two largest exposures created
by the participants in stress tests of extreme but
plausible circumstances. Should that prefunded
amount prove insufficient to cover losses, CCPs may,
to the extent permitted by their rules, then require
non-defaulting members to contribute additional
funds. This mutualization of losses across nondefaulting members underscores the importance of
members using the information made available to
estimate their potential obligations in stress periods.

Electronic Trading of Cleared Derivatives
Dodd-Frank set forth requirements that align with
the G-20 commitment to electronically trade and
clear derivatives that are subject to clearing. Under
the Dodd-Frank Act, transactions that are subject
to clearing will be executed by counterparties on
designated contract markets, exchanges, or the
newly-developed security-based swap, or swap
execution facilities (SEFs) unless the derivatives are
not made available to trade. A SEF must register and
may have dual registration with the CFTC and SEC.
To promote more pre- and post-trade transparency,
the Dodd-Frank Act requires the CFTC and SEC
to establish rules that define which swaps can be
cleared and SEF core principles. Core principles
focus on position limits, timely publication of
trading information, and recordkeeping. CFTC
transparency initiatives such as a proposed rule
on a request-for-quote system to provide no fewer
than five quotes to counterparties have proved to be
problematic. Compliance with certain SEF-related
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2 0 1 3 F S O C / / Annual Report

rules applies to registered persons, so until release
of final rules on SEF registration, the related rules
will not come into effect.

Margin and Capital Initiatives for Non-CentrallyCleared Derivatives
In the United States, global coordination continues
to inform the federal prudential regulators’
(OCC, Federal Reserve, FDIC, Farm Credit
Administration (FCA), and FHFA), CFTC’s, and
SEC’s review of their proposed rules on the G-20
margin and capital commitments for non-centrally
cleared derivatives. The BCBS/IOSCO Working
Group on Margin Requirements (WGMR) Second
Consultative Document (Febuary 2013), prepared in
consultation with the CPSS and the Committee on
the Global Financial System (CGFS), recommends
that all financial firms and systemically important
nonfinancial entities that engage in non-centrally
cleared derivatives exchange two-way initial
and variation margin for non-centrally cleared
derivatives, to be applied on a prospective basis.
Industry practice has been to exchange variation
margin and to collect initial margin only in some
circumstances. In drafting the Consultative
Document, global regulators have been mindful that
the collateral requirements for non-centrally cleared
derivatives should be stricter than those of CCPs, to
reflect the less liquid nature of bilateral derivative
contracts and as a means to incentivize use of
CCPs. The initial margin proposal could potentially
have a material quantitative impact (see Box D:
Collateral Availability). The WGMR has engaged in
a quantitative impact study (QIS) to gauge the need
for collateral that the proposed rule would require.
Some market participants have voiced concerns
about the potential shortage or scarcity of collateral
and its impact on market functioning and pricing.
In response to potential collateral scarcity, various
initiatives have emerged. For example, many have
suggested that regulators broaden the types of
assets that qualify as eligible collateral (subject to
appropriate haircuts) to assist market participants
in collateralization alternatives. In the case of
non-centrally cleared OTC derivatives margin,
80 percent is posted in cash according to the
International Swaps and Derivatives Association’s
(ISDA) margin survey.16 However, incremental

initial margin is anticipated to include a
higher fraction of non-cash eligible collateral.
Furthermore, collateral transformation trades
such as collateral swaps (see Section 5.2.4
for an explanation of such trades) might
lead to wider collateral availability. Collateral
transformation could channel risk in new ways,
resulting in additional counterparty exposures
and increased market interconnectedness while
concentrating lower-quality assets with banks or
providers of collateral transformation services.
Margin requirements have the potential to
be procyclical. This is because margins and
collateral haircuts increase when market
volatility rises. As a result, demand for eligible
collateral could jump significantly in response
to market stress, forcing market participants
to exit positions quickly if they do not have
continued access to eligible collateral, which
exacerbates volatility. Some industry experts
anticipate that margin requirements under
stressed market conditions could perhaps raise
collateral requirements by multiples, not just
percentages. Through-the-cycle margining
to stressed market conditions can potentially
alleviate such procyclicality, but it comes at
the cost of lower leverage in benign periods.
Initial margins fixed at the trade date can
also help to mitigate procyclicality. While
reform efforts have attempted to reduce the
procyclicality of margin setting, they do not
prohibit market participants from behaving in a
procyclical manner.

Financial Developments

107

BOX D: COLLATERAL AVAILABILITY
The availability of global non-cash eligible collateral for
certain transactions is likely to be affected by financial
market reforms. Such reforms include the mandatory
clearing of certain derivatives, margin requirements for
many non-centrally cleared derivatives, restrictions on
the ability to re-hypothecate collateral, and the Basel III
liquidity standards. Eligible collateral refers to a pool of
liquid assets that can be pledged for the purchase and
sale of risky assets or derivatives by financial market
participants. Non-cash eligible collateral is estimated
at $74 trillion (Chart D.1). The increased demand for
collateral proposed by these reforms will be phased into
the market over an extended time period; there is no
immediate collateral cliff overshadowing the market.

Chart D.1 	 Outstanding Amounts of Marketable Potentially
Safe Assets

D.1 Outstanding Amounts of Marketable Potentially Safe Assets

Compilation of several international regulatory studies
suggests increased eligible collateral needs will be
approximately $3.5 trillion globally, amounting to a material
4.8 percent of the $74 trillion estimate of outstanding
global eligible collateral (Chart D.2). However, the
incremental eligible collateral estimates are likely
conservative, and the full impact of the reforms is not
expected until the end of 2019. In addition, the estimates
do not yet account for the downward revision of Basel
liquidity requirements that was announced in January
2013. Though the cost of financing these incremental
uses of eligible collateral may be substantial, the modest
percentage use of the large stock of eligible collateral,
efforts by banks to reduce their LCR requirements by
reducing their estimated 30-day net cash outflow,
and the market’s flexibility to adjust the supply of available
eligible collateral, is expected to mitigate some of
these pressures.

D.1 Outstanding Amounts of Marketable Potentially Debt Assets
Gold
Corporate Safe
Gold
(11%)
Supranational Debt (11%)
Supranational Debt
(1%)
(1%)
Covered Bonds
Covered Bonds
(4%)
(4%)

Corporate Grade)
(InvestmentDebt
(Investment Grade)
(11%)
(11%) A/BBB OECD
A/BBB OECD
Government
Government
Securities (7%)
Securities (7%)

Chart D.2 	 Compilation of Potential Impact on Global
Eligible Collateral

D.2 Compilation of Potential Impact on Global Eligible Collateral

ABS, MBS, Other
ABS, MBS, Other
Securitization
Securitization
(17%)
(17%)

AAA/AA OECD
AAA/AA OECD
Government
Government
Securities
Securities
(45%)
(45%)

Regulatory Change

Estimate
(in trillions
of US$)

Proportion of
Global
Collateral
Stock ($74T)

Comments

1

-$0.3

-0.3%

2

Non-Centrally Cleared
– New Initial Margin

-$0.9

-1.3%

Based on survey of 2012 Q2 and future state.
Future non-centrally cleared, globalized equals
$295T. Compiled where thresholds are €50
million. Initial margin estimate based on
modeled calculations and as if all non-cleared
came under margin immediately.

3

Basel III LCR Liquidity
– Needs

-$2.3

-3.1%

Available regulatory 30-Jun-2011 estimate of
dollar impact would overestimate eventual
application of January 2013 revised LCR.
Ongoing new QIS.

Compilation of
Incremental
Collateral Needs – A
Net Use

U.S. Agency
U.S. Agency
Debt (3%)
Debt (3%)

Total = $74.4 Trillion
Total = $74.4 Trillion

CCP Swap Market –
Incremental Initial
Margin

Incremental cleared swaps $252T. Initial
margin on cleared derivatives equals roughly
0.1% of gross against $252T newly clearable
derivatives.

-$3.5

-4.8%

Margin assumes a short range future state
with zero thresholds and rule applied at once.
This LCR overestimates eventual impact of
January 2013 revisions and is applied at once.

Note: Data for government and corporate debt are as of 2011 Q2.

Note: Data for government and corporate debt are as of 2011 Q2.
Source: IMF citing BIS,
Data for supranational debt, covered bonds, and gold are as of
Source: IMF citing BIS,
Dealogic, ECBC, SIFMA, S&P, Data for supranational debt, coveredand securitization are as of 2011
end-2010. Data for U.S. agency debt bonds, and gold are as of
Dealogic, ECBC, SIFMA, S&P,
end-2010. Data for U.S. agency debt and securitization are as of 2011
WGC, IMF staff estimates
Q3.
WGC, IMF staff estimates
Q3.

Source: FSB,
BIS, IOSCO

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2 0 1 3 F S O C / / Annual Report

Note: Negative numbers indicate uses, or
demands, of collateral. $1.32 = €1 at 31-Dec-2012.

The CCP cleared swap market’s incremental initial margin
need of $0.3 trillion draws from the WGMR’s Second
Consultative paper which identified future increases
in cleared swaps and a rule of thumb for related initial
margin amounts. The $0.9 trillion incremental demand
for non-centrally cleared derivatives assumes a threshold
for counterparties of €50 million. Much of the incremental
margin will likely be held in the form of non-cash collateral.
Industry and regulatory entities have considered whether
stressed margins would actually reflect the marketimposed margins in a time of extreme financial stress.
The Basel III QIS for the LCR suggests that banks will
need to raise up to $2.3 trillion in additional world-wide
high-quality liquid assets (HQLA). The ongoing QIS on
the revised standard is likely to result in lower incremental
estimates. A number of global banks may already meet
the revised minimum standards, suggesting that the
estimated additional HQLA may be overstated in
this sense.
The non-regulatory external factors, such as increased
OECD and supranational debt, central bank monetary
intervention, and a decreased pool of U.S. GSE debt, may
have a net positive material incremental impact on the
supply of eligible collateral. The combined impact of these
factors is estimated to add approximately $2.5 trillion
of additional eligible collateral over coming years, thus
mitigating the increased collateral demand arising from
regulatory initiatives.

Financial Developments

109

6

Regulatory Developments; Council Activities

Since the Council’s 2012 annual report, Dodd-Frank Act implementation included further
strengthening of supervision, capital, and risk-management standards for financial institutions and
financial market utilities; procedures for periodic supervisory and company-run stress tests; rulemakings
related to the orderly liquidation authority; regulation of the derivatives markets to reduce risk and
increase transparency; new standards to protect mortgage borrowers and reduce risks in the mortgage
market; and other measures to enhance consumer and investor protection.
In addition, the Council has continued to fulfill its mandate. In particular, the Council is evaluating
nonbank financial companies for potential designation for Federal Reserve supervision and enhanced
prudential standards, and the Council issued a proposed recommendation on money market mutal
fund (MMF) reforms. The Council also continued to monitor potential risks to U.S. financial stability
and served as a forum for discussion and coordination among the member agencies. The following
is a discussion of the significant implementation progress the Council and its member agencies have
achieved since the Council’s 2012 annual report.
This section covers (1) the safety and soundness of financial institutions; (2) financial infrastructure,
markets, and oversight; (3) consumer and investor protection; (4) data standards; and (5) Council
activities. A special topic discussed in this section covers international coordination on derivatives
reform, including global margining.

6.1

Safety and Soundness

6.1.1

Enhanced Prudential Standards, Supervision, and Capital Standards

Framework for Consolidated Supervision of Large Financial Institutions
The Federal Reserve issued a new framework for the consolidated supervision of large financial
institutions in December 2012. This framework strengthens traditional microprudential supervision and
regulation to enhance the safety and soundness of individual firms, and incorporates macroprudential
considerations to reduce potential threats to the stability of the financial system.
The new framework has two primary objectives:
•	

•	

Enhancing the resiliency of a firm to lower the probability of its failure or inability to serve as
a financial intermediary. Each firm is expected to ensure that the consolidated organization
(or the combined U.S. operations, in the case of foreign banking organizations (FBOs)) and its
core business lines can survive under a broad range of internal or external stresses. This requires
financial resilience by maintaining sufficient capital and liquidity, and operational resilience by
maintaining effective corporate governance, risk management, and recovery planning.
Reducing the impact on the financial system and the broader economy in the event of a firm’s
failure or material weakness. Each firm is expected to ensure the sustainability of its critical
operations and banking offices under a broad range of internal or external stresses. This
requires, among other things, effective resolution planning that addresses the complexity and
the interconnectivity of the firm’s operations.

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

111

The framework is designed to support a tailored supervisory approach that accounts for the unique risk
characteristics of each firm and applies to (1) Large Institution Supervision Coordinating Committee
(LISCC) firms, which are the largest, most complex U.S. and foreign financial organizations subject to
consolidated supervision by the Federal Reserve; (2) other large domestic bank and savings and loan holding
companies (SLHCs); and (3) FBOs with combined assets of U.S. operations of $50 billion or more.
The consolidated supervision framework for large financial institutions is being implemented in a
multi-stage approach.

Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations
In December 2012, the Federal Reserve issued a notice of proposed rulemaking (NPR) to implement the
enhanced prudential standards and early remediation requirements in Sections 165 and 166 of the DoddFrank Act for large FBOs. The proposal generally applies to FBOs with a U.S. banking presence and total
global consolidated assets of $50 billion or more. More stringent standards were proposed for FBOs with
combined U.S. assets of $50 billion or more.
The proposal would implement:
•	

•	
•	

•	

A U.S. intermediate holding company requirement. An FBO with both $50 billion or more in global
consolidated assets and U.S. subsidiaries with $10 billion or more in total assets would generally be
required to organize its U.S. subsidiaries under a single U.S. intermediate holding company (IHC).
Direct U.S. branches and agencies of FBOs would remain outside the U.S. IHC.
Risk-based capital and leverage requirements. IHCs of FBOs would be subject to the same risk-based
and leverage capital standards applicable to U.S. bank holding companies (BHCs).
Liquidity requirements. The U.S. operations of FBOs with combined U.S. assets of $50 billion or
more would be required to meet enhanced liquidity risk-management standards, conduct liquidity
stress tests, and hold a 30-day buffer of high-quality liquid assets.
Other requirements: The proposal also includes measures regarding capital stress tests, singlecounterparty credit limits, risk management, and early remediation.

Under the proposal, FBOs with global consolidated assets of $50 billion or more on July 1, 2014 would be
required to meet the new standards on July 1, 2015.

Revised Basel III Liquidity Coverage Ratio
The Basel Committe on Banking Supervision (BCBS) issued the full text of the revised Liquidity Coverage
Ratio (LCR) on January 7, 2013. The LCR is one of the BCBS’s key reforms to strengthen global capital and
liquidity regulations with the goal of promoting a more resilient banking sector. The LCR was first published
in December 2010. The LCR generally requires a bank’s unencumbered high-quality liquid assets to equal or
exceed 100 percent of its stressed net cash outflows over a 30-day period.
The revisions issued in January 2013 incorporated amendments to broaden the definition of high-quality
liquid assets and relaxed liquidity run-off assumptions used to calculate stressed net cash outflows. These
revisions would generally moderate the impact of the earlier version but made some parameters more
stringent. The BCBS has agreed to a revised timetable for the standard to be implemented by January 1,
2015. In the first year, banking organizations would be subject to a LCR requirement of 60 percent. The
LCR requirement would increase by 10 percentage points each year, reaching a 100 percent requirement on

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2 0 1 3 F S O C / / Annual Report

January 1, 2019. However, the BCBS also allows for a more accelerated phase-in. The exact phase-in for the
United States has not been determined.
In the spring of 2013, the BIS updated the ongoing LCR quantitative impact study (QIS) to assess global
impact estimates on which the January 2013 revisions were based. The next QIS is expected to be completed
in the summer of 2013. The FDIC, the Federal Reserve, and the OCC are working jointly to develop a
proposed rule that would implement the LCR in the United States.

Risk-Management Standards for Designated FMUs
Title VIII of the Dodd-Frank Act establishes a new supervisory framework for financial market utilities
(FMUs) designated by the Council as systemically important. FMUs manage or operate multilateral systems
for the purpose of transferring, clearing, or settling financial transactions. The new framework includes
holding designated FMUs to enhanced risk-management standards. In July 2012, the Council designated
eight FMUs as systemically important.
Section 805(a)(1) of the Dodd-Frank Act requires the Federal Reserve, in consultation with the Council and
the supervisory agencies, to prescribe risk-management standards for designated FMUs that are supervised
by the Federal Reserve under Title VIII. Under Section 805(a)(2), the CFTC and SEC may each prescribe
regulations, in consultation with the Council and the Federal Reserve, containing risk-management
standards for designated clearing entities they supervise. Risk-management standards prescribed under
Section 805 must (1) promote robust risk management; (2) promote safety and soundness; (3) reduce
systemic risks; and (4) support the stability of the broader financial system. Furthermore, Section 805 also
directs the supervisory agencies to take into consideration relevant international standards and existing
prudential requirements when prescribing Title VIII risk-management standards.
Section 806 of the Dodd-Frank Act requires the supervisory agencies to prescribe regulations regarding
a requirement for designated FMUs to provide a 60-day advance notice to its supervisory agency of any
proposed changes to its rules, procedures, or operations that could materially affect the nature or level of
risks presented by that FMU.
On July 30, 2012, the Federal Reserve adopted Regulation HH implementing the risk-management standards
and advance notice provisions of Title VIII. The Federal Reserve coordinated closely with the CFTC and
SEC in developing its rules in order to promote consistency and consulted with other member agencies.
Regulation HH establishes the minimum expectations in areas of risk management, including counterparty
credit risk, settlement finality, default management, operational reliability, and governance for designated
FMUs for which the Federal Reserve is the supervisory agency. To date, two of the eight FMUs designated by
the Council are payment systems to which Regulation HH applies.

Short-Term Investment Funds
The OCC adopted a final rule in October 2012 to revise requirements for national banks, federal savings
associations, and federal branches of foreign banks that act as a fiduciary and manage short-term
investment funds (STIFs). The final rule, which becomes effective on July 1, 2013, was informed by the
SEC’s amendments in 2010 to Rule 2a-7 under the Investment Company Act. The final rule adds safeguards
designed to address the risk of loss to a STIF’s principal, including measures governing the nature of a STIF’s
investments, ongoing monitoring of its mark-to-market value, and forecasts of potential changes in a STIF’s
mark-to-market value under adverse market conditions. The final rule also requires greater transparency and
regulatory reporting on a STIF’s holdings, as well as procedures to protect fiduciary accounts from undue
dilution of their participating interests in the event that the STIF loses the ability to maintain a stable net
asset value.
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113

Leveraged Lending
On March 21, 2013, the OCC, the Federal Reserve, and the FDIC adopted, after notice and comment,
updated guidance for leveraged lending by the banking agencies’ supervised entities. While leveraged
lending declined during the crisis, volumes have since increased and underwriting practices have loosened.
The revised guidance provides greater clarity regarding supervisory expectations for a sound risk
management framework, clear underwriting standards, effective pipeline management, strong reporting and
credit analytics, and appropriate risk grading. The guidance applies to all financial institutions supervised by
the banking agencies that engage in leveraged lending activities.

6.1.2

Dodd-Frank Stress Tests and Comprehensive Capital Analysis and Review

In 2012, the Federal Reserve, OCC, and FDIC finalized rules to implement the stress testing requirements of
Section 165 of the Dodd-Frank Act for financial companies with over $10 billion in total consolidated assets.
Section 165 sets forth two stress testing regimes: a supervisory stress test framework that is conducted by
the Federal Reserve and is discussed more fully in Section 5.3.1, and company-run stress tests that certain
financial companies are required to conduct annually, pursuant to regulations prescribed by the company’s
primary financial regulator. BHCs with $50 billion or more in total consolidated assets and nonbank financial
companies supervised by the Federal Reserve are also required to conduct semi-annual company-run stress
tests. The federal banking agencies collaborated extensively on their rules to help ensure that they were
consistent and comparable. The rules define “stress test,” establish methods for the conduct of the companyrun stress tests that must include at least three different scenarios (baseline, adverse, and severely adverse),
establish the form and content of reporting, and compel the covered institutions to publish a summary of the
stress test results.
The Dodd-Frank Act supervisory stress tests and the annual company-run stress tests are conducted under
common scenarios (baseline, adverse, and severely adverse), provided by the Federal Reserve with respect to
the supervisory stress test and the appropriate federal banking agencies with respect to the annual companyrun stress tests. The mid-cycle, company-run stress test required for covered companies uses scenarios
designed by the firms. Certain institutions with total consolidated assets of $50 billion or more were required
to start their company-run stress testing under these rules in 2012, while covered companies with more than
$10 billion but less than $50 billion in total consolidated assets, as well as BHCs with total consolidated assets
of $50 billion or more that did not participate in the 2009 Supervisory Capital Assessment Program (SCAP),
are not required to start stress testing until 2013. The company-run stress tests began with the release of stress
scenarios by the federal banking agencies on November 15, 2012, and were recently concluded, with covered
companies releasing a summary of their results in March 2013.
The annual company-run stress test is conducted concurrently with the Federal Reserve’s Comprehensive
Capital Analysis and Review (CCAR) of the largest BHCs. The Federal Reserve has aligned the timing of the
Dodd-Frank Act stress tests and CCAR, which facilitates comparative analysis of the results of the Dodd-Frank
Act supervisory stress test and CCAR post-stress analysis. On March 7, the Federal Reserve released the results
of the Dodd-Frank Act supervisory stress tests. In particular, the Federal Reserve disclosed the results of its
stress test conducted under the supervisory severely adverse scenario, which included firm-specific results
based on the projections made by the Federal Reserve of each BHC’s losses, revenues, expenses, and capital
ratios over a nine-quarter planning horizon. On March 14, the Federal Reserve disclosed the summary results
of the CCAR 2013 exercise. The Federal Reserve approved the capital plans of 14 BHCs. Two other BHCs
received conditional approval, while the Federal Reserve objected to the plans of two other BHCs.

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6.1.3

Orderly Liquidation Authority and Resolution Plans

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 company
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 generally act as
receiver of the financial company and would resolve the company as provided in OLA.
Section 210 of the Dodd-Frank Act also 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 and U.K. authorities have made substantial progress in identifying and
overcoming impediments to resolution, and in December 2012, the FDIC and the Bank of England (BOE)
published a joint paper that detailed their respective approaches to the resolution of a systemically important
financial institution with operations in both jurisdictions. The FDIC is continuing to negotiate memoranda
of understanding with certain foreign counterparts that provide a formal basis for information sharing and
cooperation relating to resolution planning and implementation under the legal framework of the DoddFrank Act. In recent months, the FDIC concluded such memoranda with regulatory authorities in three
jurisdictions. In addition, the FDIC and the European Commission have formed a senior staff-level working
group to discuss issues related to deposit insurance and the resolution of banks and systemically important
financial institutions. The group convened its initial meeting in February 2013 and plans additional meetings
in 2013.
In October 2012, the FDIC adopted, after notice and comment, a final rule clarifying the conditions and
requirements governing the FDIC’s exercise of its authority to enforce certain contracts of subsidiaries or
affiliates of a financial company placed into OLA 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. In addition, the FDIC will be proposing additional rules to implement or clarify certain
other aspects of OLA, as necessary.
Section 210 of the Dodd-Frank Act requires promulgation of regulations requiring financial companies to
maintain records with respect to qualified financial contracts (QFCs) that are determined to be necessary
or appropriate to assist the FDIC as the receiver of a financial company. QFCs include securities contracts,
commodity contracts, forward contracts, repurchase agreements, swap agreements, and any similar
agreement determined by the FDIC. It is expected that a proposed QFC recordkeeping rule will be issued in
the near future.

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 (including FBOs treated as BHCs) with total consolidated assets
of $50 billion or more (covered companies) to report periodically to the Federal Reserve, the FDIC, and the
Council with plans—also referred to as living wills—for their rapid and orderly resolution under the U.S.
Bankruptcy Code in the event of material financial distress or failure. 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. If the Federal Reserve and FDIC
jointly determine that a resolution plan is not credible or would not facilitate an orderly resolution under the
Bankruptcy Code, then the company must resubmit the plan with revisions, including any proposed changes
in business operations or corporate structure, that demonstrate that the plan is credible and would result in
orderly resolution under the Bankruptcy Code.
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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.
Eleven covered companies filed resolution plans with the Federal Reserve and the FDIC in 2012. The Federal
Reserve and the FDIC have reviewed these plans and on April 15, 2013, issued guidance to the companies
based on the agencies’ review of the plans submitted in 2012. The Federal Reserve and the FDIC also
extended the deadline for filing updated reports, from July 1, 2013 to October 1, 2013, to give companies
additional time to address the guidance.

6.1.4

Insurance

FIO and state regulators serve on the International Association of Insurance Supervisors (IAIS) Executive
Committee and other IAIS committees and subcommittees, including the Technical Committee and the
Financial Stability Committee (FSC). One of the responsibilities of the Technical Committee is to direct the
development of the Common Framework for the Supervision of Internationally Active Insurance Groups
(IAIGs), which will be an integrated, multilateral, and multidisciplinary framework for the group-wide
supervision of IAIGs. Also, through service on the FSC, FIO, state regulators, and the NAIC participate
extensively in the process of identifying global systemically important insurers (G-SIIs) and the policy
measures to be applied to any designated insurer. The IAIS released a proposed methodology in May 2012
and proposed policy measures in October 2012. As directed by the FSB, the IAIS will finalize its list of G-SIIs,
methodology, and policy measures in 2013.
In early 2012, FIO hosted the insurance leadership of state regulators, the European Commission, and the
European Insurance and Occupational Pensions Authority to partner in a dialogue and related project. The
goal of this project is to increase mutual understanding and enhance cooperation between the European
Union (EU) and the United States in order to promote business opportunity, consumer protection, and
effective supervision. The steering committee for the project assembled separate technical committees to
analyze and compare the EU and U.S. regimes on seven topics: (1) professional secrecy and confidentiality;
(2) group supervision; (3) solvency and capital requirements; (4) reinsurance and collateral requirements;
(5) supervisory reporting, data collection, and analysis; (6) supervisory peer reviews; and (7) independent
third party review and supervisory on-site inspections. In December 2012, the steering committee published
an agreed-upon way forward that defines common objectives and initiatives leading to improved convergence
and compatibility between the EU and the United States.
Insurance regulators, through the NAIC, continue work on updating the Insurance Financial Solvency
Framework. NAIC adopted the Own Risk and Solvency Assessment (ORSA) Model Law last year 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. The NAIC continues to work on
implementation of the revised Credit for Reinsurance Model Law and Regulation, and state regulators are
implementing the revised Holding Company Model Law and Regulation, including the Enterprise Risk
Report, upon adoption by state legislatures.
The Council will also continue to monitor relevant domestic and international financial regulatory proposals
and developments involving insurance.
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6.1.5

Mortgage-related Litigation/Settlements

In January 2013, the OCC and the Federal Reserve announced a $9.3 billion agreement with
13 mortgage loan servicers to resolve the 13 servicers’ obligations to conduct an independent
foreclosure review. The review was required by enforcement actions taken against the 13 servicers
by the Federal Reserve, the OCC, and the Office of Thrift Supervision (OTS) in 2011 and 2012 to
address deficiencies in mortgage foreclosure processing. The $9.3 billion in settlement funds will be
allocated as follows:
•	
•	

Approximately 4.2 million borrowers who went through foreclosure from 2009 to 2010
at the 13 servicers will receive cash payments totaling $3.6 billion.
The remaining $5.7 billion will go to providing other assistance to borrowers, such as
forgiveness of deficiency judgments, loan modifications, and principal reductions, support
for borrower counseling and education, and other foreclosure prevention activities.

On January 6, 2013, Bank of America and Fannie Mae reached a settlement that resolved
Fannie Mae’s currently-outstanding and expected repurchase requests arising from breaches of
representations and warranties on loans sold to Fannie Mae by Bank of America and Countrywide
from 2000 to 2008. Bank of America will pay Fannie Mae approximately $10.3 billion, attributed as
follows:
•	
•	

Cash payment to Fannie Mae ($3.55 billion).
Repurchase of approximately 30,000 loans ($6.75 billion).

On February 9, 2012, the Department of Justice (DOJ), Department of Housing and Urban
Development (HUD), and 49 states announced a $25 billion settlement (the National Mortgage
Settlement) with Bank of America, Wells Fargo, JPMorgan Chase, Citigroup, and Ally Financial/
GMAC. Under the settlement, the five banks would be released from liabilities related to
robo-signing and other forms of servicer abuses. In exchange, the five servicers must comply with
new servicing standards and provide for about $25 billion in assistance towards the following:
•	
•	
•	
•	

Principal reduction and other assistance to borrowers ($17 billion).
Refinancing underwater borrowers ($3 billion).
Making direct cash payments to foreclosed borrowers ($1.5 billion).
Funding government consumer protection and foreclosure prevention efforts ($3.5 billion).

In conjunction with the announcement of the National Mortgage Settlement, the Federal Reserve
and the OCC announced penalty actions against the same five servicers for deficiencies in mortgage
foreclosure processing that were addressed in the agencies’ April 2011 enforcement actions against
those servicers. The Federal Reserve’s penalties were just under $770 million, while the OCC’s action
levied approximately $400 million in penalties.

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 new regulatory framework for swaps
and security-based swaps. Among other things, the legislation: (1) provides for the registration and
comprehensive regulation of swap dealers, security-based swap dealers, major swap participants

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(MSPs), and major security-based swap participants; (2) imposes clearing and trade execution requirements
on standardized derivative products; and (3) creates robust recordkeeping and real-time reporting
requirements with respect to swaps and security-based swaps. Title VII provides that the CFTC will regulate
“swaps,” the SEC will regulate “security-based swaps,” and the CFTC and SEC will jointly regulate “mixed
swaps.”
In July 2012, the SEC and CFTC approved foundational joint final rules to further define the terms “swap,”
“security-based swap,” “mixed swap,” and “security-based swap agreement.” This effort followed the CFTC’s and
the SEC’s April 2012 adoption of joint final rules, which further defined the terms “swap dealer,” “security-based
swap dealer,” major swap participant,” “major security-based swap participant,” and other terms. The entity and
product definitional rules went into effect in July and October 2012, respectively, and triggered compliance with
other final rules adopted previously by the CFTC. The effectiveness of these rules did not trigger compliance
with certain other rules the SEC is adopting under Title VII.

Swap and Security-Based Swap Regulatory Reform
A number of significant elements of the CFTC’s swap regulatory regime became effective in the fourth
quarter of 2012 and in the first quarter of 2013. Swap dealer registration began in advance of December
31, 2012, and 73 swap dealers and 2 MSPs provisionally registered with the CFTC as of March 2013. Other
entities are expected to register over the course of 2013 once they exceed the de minimis threshold for swap
dealing activity. Swap dealers (and MSPs) are subject to a number of specific regulatory standards, including
internal and external business conduct, recordkeeping and documentation requirements, and real-time and
regulatory reporting obligations.
The CFTC adopted a final rule in July 2012 implementing an exception to the clearing requirement for
nonfinancial entities and small financial institutions that use swaps to hedge or mitigate commercial risk,
known as the end-user exception. The final rule exempts banks, savings associations, farm credit institutions,
and credit unions with total assets of $10 billion or less from the definition of “financial entity,” making
such “small financial institutions” eligible for the end-user exception. The CFTC also proposed a rule in
August 2012 that would exempt swaps between certain affiliated entities within a corporate group from the
clearing requirement. The proposed rule details specific conditions that counterparties must satisfy to elect
the proposed inter-affiliate clearing exemption. The proposed rule also includes reporting requirements for
affiliated entities that would use the proposed exemption. In December 2012, the CFTC also adopted further
proposed guidance on cross-border issues relating to the implementation of Title VII of the Dodd-Frank Act.
On December 31, 2012, swap dealers began reporting swap transaction data to swap data repositories (SDRs)
for the purposes of real-time public reporting and regulatory reporting of interest rate swap transactions and
credit default swap (CDS) transactions based on broad-based indices. Reporting to SDRs by swap dealers and
certain MSPs for the purposes of real-time public reporting and regulatory reporting in the interest rates,
credit, equity, foreign exchange (FX), and other commodity (including agricultural and energy swaps) swap
asset classes continued, or began, on February 28, 2013. An April 2013 CFTC staff no-action letter established
relief for real-time and regulatory reporting deadlines for non-swap dealer and non-MSP counterparties.
Those that are financial entities (per CEA section 2(h)(7)(C)) began reporting swap transaction data on April
10, 2013 for interest rate and credit default swaps and will report data beginning May 29, 2013 with respect
to equity, FX, and commodity swaps. Non-swap dealer and non-MSP counterparties, that are not financial
entities, will begin swap data reporting on a staggered basis in the second half of 2013.
A third key milestone in swap regulatory reform was achieved in November 2012, with the CFTC’s adoption
of the first clearing requirement determinations. A significant portion of interest rate and credit default
swaps will be brought into central clearing, such as four classes of interest rate swaps (fixed to floating, basis,
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forward rate agreements, and overnight index swaps) and two classes of CDS indices (North American
and European untranched credit derivatives indices). Compliance for central clearing will be phased
in throughout 2013. Swap dealers and the largest hedge funds were required to begin clearing certain
standardized swaps on March 11, 2013, and other financial entities will follow on June 10. Accounts managed
by third-party investment managers and Employee Retirement Income Security Act (ERISA) pension plans
will have until September 9, 2013 to begin clearing.
The CFTC previously adopted a comprehensive set of rules for risk management by swap clearing houses,
and in June 2012 published rules to implement the core principles and other requirements for designated
contract markets, where both futures and swaps may be listed for trading. The compliance dates for the
CFTC’s January 2012 rules governing the protection of cleared swap customer funds occurred in November
2012. In the second half of 2012, the SEC also completed the proposal of substantially all of the rules
required by Title VII and adopted certain rules pertaining to clearing infrastructure. In June 2012, the SEC
adopted rules that establish procedures for its review of certain actions undertaken by clearing agencies.
These rules detail how clearing agencies will provide information to the SEC about the security-based
swaps that the clearing agencies plan to accept for clearing, which will then be used by the SEC to aid in
determining whether those security-based swaps are required to be cleared. The adopted rules also include
rules requiring clearing agencies that are designated as systemically important by the Council under Title
VIII of the Dodd-Frank Act to submit advance notice of changes to their rules, procedures, or operations if
such changes could materially affect the nature or level of risk at those clearing agencies. In October 2012,
the SEC adopted a rule that establishes operational and risk-management standards for clearing agencies,
including clearing agencies that clear security-based swaps. The rule is designed to ensure that clearing
agencies will be able to fulfill their responsibilities in the multi-trillion dollar derivatives market as well
as in more traditional securities markets. In addition to these efforts to improve the resiliency of central
counterparties (CCPs), U.S. regulators continue to actively participate with international regulators, the FSB,
and CPSS-IOSCO to address resolution of CCPs, as well as other financial market infrastructure issues.
In October 2012, the SEC proposed capital, margin, and segregation requirements for security-based swap
dealers and major security-based swap participants. Among other things, the proposed rules would set
minimum capital requirements for nonbank security-based swap dealers and nonbank major security-based
swap participants, establish margin requirements for nonbank security-based swap dealers and nonbank
major security-based swap participants with respect to non-centrally cleared security-based swaps, and
establish segregation requirements for security-based swap dealers and notification requirements with respect
to segregation for security-based swap dealers and major security-based swap participants.
In December 2012, the SEC issued an order providing exemptive relief in connection with a program to
commingle and portfolio margin customer positions in cleared CDS, which include both swaps and securitybased swaps. Portfolio margining may be of benefit to investors and the market by promoting greater
efficiency in clearing, helping to alleviate excessive margin calls, improving cash flow and liquidity, and
reducing volatility.
In addition to its work to propose and adopt Title VII rules, the SEC issued in June 2012 a policy statement
describing and requesting public comment upon the order in which it expects compliance would be
required with the final rules to be adopted by the SEC under Title VII. The aim of this policy statement is to
establish an appropriate sequence in which compliance with these rules would be required so as to avoid the
disruption and cost that could result if compliance with all of the rules were required simultaneously or in a
haphazard order.

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Foreign Exchange Swap and Forward Determination
In November 2012, the Secretary of the Treasury made a determination that FX swaps and forwards should
be exempt from the definition of “swap” in, and thus exempt from most of the provisions of, the Commodity
Exchange Act (CEA), as amended by the Dodd-Frank Act. Prior to issuing this determination, as authorized
in provisions of Sections 721 and 722 of the Dodd-Frank Act, the Treasury solicited public comment in
2010 and 2011, on a range of issues relating to whether FX swaps or forwards should be exempt from the
definition of “swap” in the CEA. In addition to evaluating the statutory factors, the Treasury reviewed public
comments, consulted with regulators, and conducted extensive outreach. The Secretary concluded that
this determination is appropriate given the important differences and risk profiles between FX swaps and
forwards—which are narrowly defined by the CEA—and other types of derivatives. Unlike most other swaps,
FX swaps and forwards have fixed payment obligations that are settled by the exchange of actual currency,
and are predominantly short-term instruments. Even though FX swaps and forwards are not subject to certain
requirements under the CEA as a consequence of the determination, FX swaps and forwards still remain
subject to reporting and business conduct requirements. Moreover, the determination does not extend to
other FX derivatives, such as FX options, currency swaps, and non-deliverable forwards.

Credit Exposures
Section 610 of the Dodd-Frank Act, which became effective on July 21, 2012, amends the definition of
“loans and extensions of credit” in the national bank lending limit statute (also applicable to savings
associations) to include credit exposures arising from derivative transactions and from certain securities
financing transactions. The OCC published an interim final rule on June 21, 2012 to implement the statutory
amendment. The rule adopts a flexible approach that enables institutions to select from a number of
measurement methods suitable to the size and complexity of that institution’s activities and credit exposures,
while reserving for the OCC the discretion to direct individual institutions to use a specific method to
measure credit exposures when safety and soundness requires it. The OCC continues to review comments
received on the interim final rule.
State banking regulators also continue to implement the mandate under Section 611 of the Dodd-Frank Act
to consider derivative exposure in state lending limit laws.

Capital and Margin Requirements
Federal prudential regulators (Federal Reserve, FDIC, OCC, FHFA, and the Farm Credit Administration),
the CFTC, and the SEC issued proposed rules on capital and margin requirements for non-centrally cleared
swaps. The proposed margin requirements would require swap dealers, security-based swap dealers, MSPs,
and major security-based swap participants to collect initial and variation margin on non-centrally cleared
swap transactions from their counterparties.
The United States is currently engaged in an international effort being led by the BCBS and the IOSCO to
establish recommendations for margin requirements on non-centrally cleared swaps to help ensure robust
regulation of derivatives markets and prevent regulatory arbitrage (see Box E: International Coordination
on Derivatives Reform, including Global Margining). The international effort may inform the timing and
nature of the rulemakings being advanced by the federal prudential regulators, the CFTC, and the SEC.

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BOX E:

I
NTERNATIONAL COORDINATION ON DERIVATIVES REFORM, INCLUDING
GLOBAL MARGINING

The recent financial crisis exposed the large, opaque overthe-counter (OTC) derivatives market as a transmission
mechanism for financial distress, demonstrating that
the OTC market posed significant systemic risk in its
existing form. In response, the leaders of the G-20 nations
committed in 2009 to improve transparency and risk
mitigation in this market by mandating reporting, requiring
clearing and public trading of certain derivatives, and
setting additional capital requirements for non-centrally
cleared transactions. In 2011, the G-20 agreed to add
margin requirements on non-centrally cleared derivatives
to the derivatives reform program and called upon the
BCBS and IOSCO to develop consistent global standards
for these margin requirements.
On July 6, 2012, the BCBS/IOSCO-chaired, international
Working Group in Margin Requirement (WGMR), which
includes bank and securities regulators from the major
jurisdictions whose institutions currently play a significant
role in the derivatives market (such as the European
Union, Hong Kong, Japan, Singapore, Switzerland, the
United Kingdom, and the United States) released its
first consultation document proposing global margin
requirements on non-centrally cleared derivatives for
public comment. After considering the initial comments
and consulting with the BCBS and IOSCO boards, as well
as other international standard-setting bodies, a second
consultative document was issued on February 15, 2013
to request further comment.

tables. Initial margin payments would be segregated in
a manner that maximizes their ready availability in the
event of a party’s default, and protects them, to the
extent legally possible, from seizure in the bankruptcy of
the collecting party. The permissible collateral for margin
exchange would include a broad range of liquid assets
(including high-grade corporate bonds and equities
traded on major exchanges), subject to appropriate
risk-sensitive haircuts.
The WGMR used information provided by major derivative
market participants around the globe to complete a
QIS on the predicted impact of these initial margin
requirements. The study, which was published on
February 15, 2013, found that the proposed initial margin
requirement (with the €50 million threshold) would require
roughly €700 billion globally in additional segregated
margin collateral using internal model-based calculations.
Comparing the size of this estimated collateral
requirement to the notional size of the entire derivatives
market, the study estimated that the proposed initial
margin rules would require margin equal to 0.5 percent
of the total notional amount of outstanding non-centrally
cleared derivatives. By comparison, current market
practice varies widely and is estimated to require
initial margin equal to 0.03 percent of total notional
amounts outstanding.

Currently, one of the largest unresolved issues is how to
calibrate initial margin in a way that balances the benefits
of margin, while mitigating counterparty risk against the
The February 15 consultation document generally
proposes that all financial firms and systemically important liquidity cost of maintaining large levels of segregated
initial margin. The WGMR’s study found that, assuming
nonfinancial entities (excluding sovereigns and central
wide use of internal models to estimate margin, the
banks) should exchange variation margin regularly (daily
proposed initial margin requirements would require
where possible) in amounts reflecting the full existing
exposure associated with a given derivative. With respect roughly 8 percent of all currently unallocated liquid assets.
to initial margin, subject to a €50 million threshold, all
market participants with over €8 billion in gross notional
amount of transactions outstanding (again excluding
sovereigns and central banks) would be required to
exchange initial margin on a gross basis calibrated
according to certain technical standards, whether using
regulator-approved modeling or standardized look-up

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6.2.2

Office of Financial Research

The Dodd-Frank Act established the OFR to support the Council and its member agencies by collecting
and standardizing financial data, performing essential research, and developing new tools to measure and
monitor risks to the financial system.
The OFR complements the efforts of Council member agencies by filling gaps in data and analysis to assess
threats to financial stability. In recent work to support the Council, the OFR has been conducting research on
the risks of wholesale funding markets. The OFR has also provided data and analysis for the Council’s work
on nonbank financial company designations.
The OFR is playing a central role in the international initiative to establish a global Legal Entity Identifier
(LEI), a code that uniquely identifies parties to financial transactions and links to their basic “business
card” information. The LEI will give regulators a better view of interconnected markets and will generate
considerable cost savings for the financial industry in collecting, cleaning, and aggregating data
(see Section 6.4.1).
In 2012, the OFR released its Strategic Framework, issued its inaugural annual report, unveiled the first
three papers of its collaborative Working Paper series with top researchers and academics, and launched a
Financial Research Advisory Committee.
As provided by the Dodd-Frank Act, the OFR is led by a Director appointed by the President and confirmed
by the Senate for a 6-year term. In January 2013, the Senate confirmed Richard B. Berner to serve as the
OFR’s first Director.

6.2.3

Accounting Standards

Under the Dodd-Frank Act, the Council’s annual report is required to address financial market and
regulatory developments, including accounting regulations and standards.
In December 2012, the Financial Accounting Standards Board (FASB) issued for public comment a proposal
to improve financial reporting on expected credit losses of loans and other financial assets held by banks,
financial institutions, and other public and private organizations. The proposal, Financial Instruments—
Credit Losses (Subtopic 825-15), is intended to require more timely recognition of credit losses, while also
providing additional transparency about credit risk. In releasing the proposal, the FASB stated that the recent
financial crisis highlighted the need for improvements in the accounting for credit losses on loans and other
financial instruments, and stated that the proposal would require more timely recognition of expected credit
losses and more transparent information about the reasons for any changes in those estimates. Currently,
under U.S. Generally Accepted Accounting Principles (GAAP), credit losses are generally not reflected in
financial statements until it is probable that the losses have been incurred. Under the proposal, a firm’s
balance sheet would reflect management’s current estimate of expected credit losses at the reporting date (as
an allowance for credit losses), and the income statement would reflect the effects of credit deterioration or
improvement that has taken place during the period (as a provision for bad debt expense).
In February 2013, the FASB issued for public comment a proposal to improve financial reporting by providing
a comprehensive measurement framework for classifying and measuring financial instruments held by banks,
financial institutions, and other entities. The proposal, Recognition and Measurement of Financial Assets and
Financial Liabilities (Subtopic 825-10), responds to feedback the FASB received on its May 2010 proposal that
would have required a much greater use of fair value measurement for financial assets and liabilities than
currently exists in U.S. GAAP. Under the new proposal, the classification and measurement of a financial
asset would be based on the asset’s cash flow characteristics and the entity’s business model for managing the
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asset, rather than on its legal form, that is, whether the asset is a loan or a security. Based on this assessment,
financial assets would be classified into one of three categories: Amortized Cost, for financial assets
comprised solely of payments of principal and interest that are held for the collection of contractual cash
flows; Fair Value through Other Comprehensive Income, for financial assets comprised solely of payments of
principal and interest that are both held for the collection of contractual cash flows and for sale; or Fair Value
through Net Income, for financial assets that do not qualify for measurement at either amortized cost or fair
value through other comprehensive income. The proposal also would require financial liabilities to generally
be carried at cost. For most financial assets and financial liabilities measured at amortized cost, public
companies would be required to disclose their fair values, but non-public entities would not be required to
disclose such information.

6.2.4

Operational Risks for Technological Systems

On March 7, 2013, the SEC proposed Regulation Systems Compliance and Integrity, or Regulation SCI,
which would replace the voluntary standards of the existing Automation Review Policy Inspection Program
with enforceable rules designed to help ensure that the core technology of national securities exchanges,
significant alternative trading systems, clearing agencies, and plan processors meet certain standards and
therefore be better insulated from and more resilient to the vulnerabilities posed by systems technology
issues.17 If approved by the SEC, Regulation SCI would require, among other things, that each SCI entity: (1)
establish policies and procedures relating to the capacity, integrity, resiliency, and security of its technology
systems; (2) establish policies and procedures designed to ensure its systems operate in the manner intended,
including in compliance with relevant federal securities laws and rules; (3) take timely corrective action in
response to systems problems; (4) notify and provide the SEC with detailed information when such systems
issues occur, as well as when there are material changes in its systems, and inform its members or participants
about certain systems problems; (5) conduct an annual review of its compliance with Regulation SCI,
and submit a report of the annual review to its senior management and to the SEC; (6) designate certain
individuals or firms to participate in the testing of its business continuity and disaster recovery plans at least
annually, and coordinate such testing with other entities on an industry- or sector-wide basis; and (7) provide
SEC representatives with access to its systems to assess compliance with Regulation SCI.

6.3

Consumer and Investor Protection

6.3.1

Mortgage Transactions and Housing

In January 2013, the FDIC, Federal Reserve, OCC, NCUA, CFPB, and FHFA issued a final rule to implement
Section 129H of the Truth in Lending Act as added by Section 1471 of the Dodd-Frank Act. The rule
establishes appraisal requirements applicable to higher-risk mortgages, referred to as higher-priced mortgage
loans (HPMLs). An HPML is a residential mortgage loan secured by a principal dwelling with an annual
percentage rate that exceeds an average prime offer rate by certain specified percentages. Before making an
HPML, a creditor must: (1) obtain a written appraisal by a certified or licensed appraiser who has physically
visited the interior of the mortgaged property; (2) obtain an additional appraisal from a different appraiser
that analyzes any difference in sales prices, changes in market conditions, and any improvements made to the
property if the property was acquired at a lower price by the seller within 180 days of the current transaction
and the property is being sold at a price that exceeds certain thresholds; (3) provide the borrower with a
statement that any appraisal is for the creditor’s sole use and that the borrower may have a separate appraisal
conducted at personal expense; and (4) provide the borrower with a copy of the appraisal without charge at
least three days prior to closing. The final rule exempts certain transactions from the appraisal requirements.
The final rule becomes effective on January 18, 2014.

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In January 2013, the CFPB issued a final rule setting forth certain minimum requirements for creditors
making determinations regarding a consumer’s ability to repay a mortgage loan (the Qualified Mortgage
Rule). Under the rule’s ability-to-repay requirements, creditors generally must consider eight underwriting
factors set forth in the rule. However, certain qualified mortgages are entitled to a presumption of
compliance with the ability-to-repay requirements. In order to be a qualified mortgage, a loan is generally
prohibited from having certain product features (such as negative amortization, interest-only payment, or
balloon payment) and it generally must satisfy certain affordability underwriting requirements (such as a
43 percent back-end debt-to-income (DTI) limit and other requirements). The 43 percent DTI limit and
other underwriting requirements do not apply to loans that are eligible for certain government guaranty
or insurance programs or to loans that satisfy the requirements for a balloon payment qualified mortgage
(which is available only to small, portfolio lenders operating predominately in rural or underserved areas).
Loans that meet the definition of a “qualified mortgage” and are not higher-priced (generally, prime loans)
receive a safe harbor presumption of compliance with the ability-to-repay requirements. Loans that meet the
definition of a “qualified” mortgage, but are higher priced (generally, subprime loans) receive a rebuttable
presumption of compliance with the ability-to-repay requirements. At the same time it issued the final
qualified mortgage rule, the CFPB issued a proposed rule requesting public comment on certain adjustments
to the qualified mortgage requirements. The CFPB anticipates that the proposed rule will be finalized and
effective by the time the final rule takes effect in January 2014.
In January 2013, the CFPB also issued mortgage servicing rules containing nine significant requirements.
Five of these requirements address servicing of all mortgage loan accounts (including accounts for borrowers
that are current or delinquent on their mortgage loan obligations). These include requirements relating
to periodic billing statements, interest rate adjustment notices, payment crediting and payoff statements,
force-placed insurance restrictions, and procedures for error resolution and information requests. The
mortgage servicing rules also include four sections setting forth additional protections for borrowers who
are delinquent on their mortgage loan obligations. These protections include requirements for servicers
to engage in early intervention outreach with borrowers, to provide borrowers with servicer personnel that
provide continuity of borrower contact and information, to evaluate borrower applications for loss mitigation
options pursuant to certain loss mitigation procedures, and to adopt policies and procedures to achieve
certain operational objectives. Many of the servicing requirements include an exemption for small mortgage
servicers.
The CFPB also issued a final rule regulating loan originator compensation that strengthens and clarifies
existing regulations and commentary on loan originator compensation. Specifically, this final rule clarifies
that a loan originator employee may not receive compensation based on any term of a transaction. The rule
also sets forth requirements to prevent evasion, prohibits dual compensation of brokers by another party to
a broker that has been compensated by a consumer, establishes loan originator qualification standards, and
requires disclosure of a loan originator’s unique identifier number. The final rule also prohibits mandatory
arbitration clauses or financing single premium credit insurance.
The CFPB also issued a final escrow rule that requires creditors to maintain escrow accounts for at least five
years after originating a “higher-priced mortgage loan.” This rule exempts creditors operating predominantly
in rural or underserved areas.
Additionally, the CFPB’s Home Ownership and Equity Protection Act (HOEPA) rule expands the types of
loans that can be subject to HOEPA’s restrictions. Further, the rule revises the existing triggers for HOEPA
coverage, which are based on interest rates, points, and fees, and adds a new trigger based on certain
prepayment penalty features.

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The CFPB also issued a final rule implementing requirements under the Equal Credit Opportunity Act
(ECOA) regarding appraisals. This rule also provides that a consumer is entitled to receive a copy of an
appraisal conducted for the origination of a first lien mortgage loan.

6.3.2

Consumer Protection

In August 2012, the CFPB published a final rule that provides a “safe harbor” from its remittance rule
for providers of 100 or fewer remittance transfers per year. In December 2012, the CFPB proposed three
amendments to its remittance rule, which would temporarily delay the February 7, 2013 effective date of that
rule and provide additional clarity regarding disclosures and error resolution procedures. In November 2012,
the CFPB proposed amendments to rules implementing the credit card ability-to-pay provisions of the Truth
in Lending Act.
The Dodd-Frank Act also charges the CFPB with collecting, investigating, and responding to consumer
complaints with respect to certain consumer financial products and financial institutions. In 2012, the
CFPB received approximately 91,000 consumer complaints. Of these complaints, 50 percent were related to
mortgages, the majority of which were related to the ongoing challenges faced by consumers who could not
make payments. The CFPB provides the public with access to a database of complaints.
In July 2012, the CFPB and the Department of Education issued a report on private student loans as required
by the Dodd-Frank Act. The report assesses the market for private student loans, and the impact of these
loans on consumers, and provides a set of recommendations to improve consumer protections. The CFPB has
also released a Financial Aid Shopping Sheet and a Financial Aid Comparison Shopper to help students and
their families better understand the student loan process.
Among its authorities, 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. In July 2012, the CFPB issued a final rule to define larger
participants in the consumer credit reporting market, and in October 2012, the CFPB issued a final rule to
define larger participants in the consumer debt collection market. The CFPB has started examinations of
both types of entities.
In the course of its supervisory and enforcement activities, the CFPB has discovered numerous violations
of federal consumer financial law. In each case, it has directed the financial institution that committed the
violations to take corrective action. Where warranted, restitution or other relief to consumers has also been
provided. In particular, the CFPB, OCC, FDIC, and Federal Reserve have brought enforcement actions
against three credit card issuers with respect to the marketing of “add-on” products such as debt protection
and credit monitoring. These practices include using deceptive marketing, misleading consumers about fees
or the benefits associated with such products, retaining customers who attempted to cancel such products,
and enrolling customers in products without their knowledge or consent. As a result of these actions, $435
million in relief was provided to approximately 5.75 million consumers.

6.3.3

Investor Protection

Section 952 of the Dodd-Frank Act requires the SEC by rule to direct the national securities exchanges
and national securities associations to prohibit the listing of any equity security of a company that does not
comply with the new requirements regarding the compensation committees and compensation consultants
to such committees. In June 2012, the SEC adopted rules to implement Section 10C of the Securities and
Exchange Act of 1934 and this provision that will (among other things) direct the exchanges to establish
listing standards that will require each member of a listed company’s compensation committee to be a
member of the board of directors and to be “independent.” The exchanges are also required to adopt listing
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standards that identify factors that affect the independence of compensation consultants to the committee,
including other services provided by the consultant to the issuer, the amount of fees received, and the policies
and procedures that are designed to prevent conflicts of interest. To implement the new requirements,
each relevant national securities exchange, including the New York Stock Exchange (NYSE) and NASDAQ,
filed proposed rule changes with the SEC; the SEC issued final orders in January 2013 approving these
changes. Under the rules, all listed companies must expand the authority of their compensation committees
with respect to the oversight of compensation consultants to the committee by July 1, 2013. Thereafter
a compensation committee may select or receive advice from a consultant only after conducting an
independence assessment. Listed companies will be required to comply with the remaining provisions of the
new exchange rules, including enhanced independence standards of compensation committee members, by
the earlier of their first annual meeting after January 15, 2014, or October 31, 2014.
In August 2012, SEC staff released a study regarding financial literacy. The study, which was mandated by
Section 917 of the Dodd-Frank Act, was intended to identify the existing level of financial literacy among
retail investors, and the methods and efforts to increase investors’ financial literacy. The study found that
investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid
investment fraud. The study identifies several methods to improve financial disclosures and transparency.
In 2012, the SEC made the first payout under its Whistleblower Program, which was established in 2011. The
individual who received the payout provided high-quality, significant information that helped stop a multimillion dollar fraud. The whistleblower received an award of 30 percent of the amount collected in the SEC’s
enforcement action, which is the maximum percentage payout allowed by law. In fiscal year 2012, the SEC
received approximately 3,000 tips, complaints, and referrals from whistleblowers.

6.4

Data Standards

Data standards improve the quality of data by providing for their unambiguous and universally accepted
meaning, thus increasing confidence in them, and enabling data comparison, aggregation, sharing, and
exchange. Adoption of data standards also reduces the need for costly conversion and manual intervention
when exchanging data. Building, adopting, and using standards for financial data will facilitate improved
financial stability monitoring and better risk management by firms.

6.4.1

Legal Entity Identifier (LEI)

Although the financial services industry and financial regulators have long employed data standards,
these data standards have not been adopted on a global basis or even universally within the United States.
Consequently, existing standards are plagued by gaps and overlaps. Fortunately, the standards landscape is
beginning to change. In 2012, the global regulatory and supervisory community made significant progress
toward the launch of the global LEI system. Representing the Treasury in this initiative, the OFR has played
a key leadership role, with strong support from the Federal Reserve, the CFTC, the SEC, and other federal
financial regulatory agencies with an interest in data standards.
The LEI is a code that uniquely identifies parties to financial transactions. It is designed to be the first
global and unique entity identifier, enabling risk managers and regulators to identify parties to financial
transactions instantly and precisely. The LEI is expected to generate considerable cost savings for the
financial industry in collecting, cleaning, and aggregating data. Additionally, adoption of the LEI system
should reduce the regulatory reporting burden, allowing industry to use the same data more readily for its
internal business operations and risk-management processes as it uses for reporting to regulators.

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In November 2012, the G-20 endorsed the charter for the Regulatory Oversight Committee (ROC), which is
acting as the governing body for the global LEI system. The ROC, which was established in January 2013, met
for the first time in January 2013. The ROC is composed of financial regulators and authorities from around
the world and is overseeing establishment of a global LEI foundation that will govern the Central Operating
Unit (COU) for the system. With authority over a global federation of Local Operating Units (LOUs) that
will issue and maintain the LEIs, the COU will ensure adherence with LEI governing principles, protocols,
and standards, including reliability, quality, and uniqueness, to produce “one golden standard” for the LEI.
To date, several organizations have been issued prefixes to the 20-digit LEI code to enable them to begin
preparations to issue LEIs. Indeed, tens of thousands of standard-compliant “pre-LEIs” are already in use,
and will converge to be global LEIs. Sponsoring authorities for these organizations include the CFTC and
authorities in Germany, Ireland, Palestine, and Turkey.
The OFR has played a key role throughout the LEI development process, leading work streams, and working
with other regulators and industry to provide recommendations to the G-20 to guide the governance,
development, and implementation of the global LEI system. Earlier in the implementation phase, the OFR
served as a Vice Chair on the LEI Implementation Group and the OFR’s Chief Counsel currently serves as
the Chair of the ROC. The OFR has also worked with other U.S. regulators to embed the concept of the LEI
into rulemakings, and will continue to do so. Mandatory reporting uses of the LEI will facilitate the rapid
deployment of the LEI as the global system becomes more widely available.

Initiatives for the Next Set of Standards
With the LEI on the path toward implementation, the OFR is assessing other critical gaps in data standards.
First is the development and use of entity hierarchies that will facilitate understanding of parent-subsidiary
relationships and promote better analysis of intra-firm exposures. Next are product identifiers, including
those for loans and derivatives—these identifiers will help define attributes for financial instruments. For
example, the Universal Product Identifier (UPI) categorizes swaps according to the underlying reference
in them. The Unique Swap Identifier (USI) identifies a particular swap throughout its existence. The LEI,
UPI, and USI are required for use under CFTC’s swap reporting rules. The Dodd-Frank Act amended the
Home Mortgage Disclosure Act to allow the CFPB to require a unique mortgage loan identifier, if deemed
appropriate. As with LEIs, adoption of such standards offers the benefits of improved data quality, increased
data sharing among regulators, and decreased costs for regulatory reporting by the industry.

6.4.2

Swap Data Repositories

The CFTC reporting rules require that swap transactions be reported to an SDR “as soon as technologically
practicable,” after trade execution for the purposes of real-time public reporting and regulatory reporting. As
of December 31, 2012, swap dealers were required to report interest rate and credit default swap transactions
to SDRs. Registered swap dealers began reporting the other three swap asset classes to SDRs on the required
date of February 28, 2013. Certain MSPs initiated reporting to SDRs for all five asset classes for the purpose
of real-time public reporting and regulatory reporting beginning February 28, 2013. The CFTC phase-in
period staggers the reporting requirements for other swap counterparties.
SDRs for interest rate, credit, equity, FX, and other commodity asset classes are required to publicly
disseminate real-time swap transaction data for these swap transactions “as soon as technologically
practicable” after the SDR receives such data, unless the transaction is subject to a time delay. Time delays for
large trades are based on type of execution, underlying asset, and market participant. Additionally, all trades
are subject to delays during the phase-in of the CFTC reporting rules. Thus far, market participants
have not indicated that the reporting requirements are causing any adverse market conditions such as
reduced liquidity.

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The DTCC’s Data Repository LLC operates a multi-asset class SDR in the United States. The CFTC
provisionally approved the DTCC Data Repository LLC to operate as an SDR for credit, equity, interest rate,
FX, and commodity derivatives. ICE and CME have also provisionally registered as multi-asset class SDRs
but are not yet reporting data. DTCC, the CME, and ICE are currently publicly disseminating swap data.
The Trade Information Warehouse reports that $24.1 trillion (notional) of credit derivative contracts were
reported, of which $15.0 trillion (approximately 62 percent) are dealer-to-dealer.
The SEC is finalizing the rules related to swap reporting for the products it oversees.

6.4.3

Private Fund Data

The annual and quarterly filings of form PF will provide the Council with a new window into the activities
of private funds. The SEC estimates that the activities of approximately 650 private fund advisors, which
collectively manage over an estimated 80 percent of the U.S. hedge fund industry and an estimated 75
percent of the U.S. private equity industry, will be reported quarterly on form PF.

6.4.4

Mortgage Market Data

Capturing consistent and accurate data is essential to strengthening the risk-management capabilities of
the government-sponsored enterprises (GSEs) and other housing finance institutions, along with improving
transparency and creating operational efficiencies that simplify the exchange of data and improve responses
to changing requirements and market conditions and trends. The Uniform Mortgage Data Program is
an ongoing initiative implemented by the FHFA and the GSEs to improve the consistency, quality, and
uniformity of data collected at the beginning of the lending process, as well as for servicing data. Developing
standard terms, definitions, and industry standard data reporting protocols will decrease costs for originators
and appraisers and reduce repurchase risk. It will also allow new entrants to use industry standards
rather than having to develop their own proprietary data systems to compete with other systems already
in the market.
In November 2012, the FHFA and the CFPB announced that they had agreed to partner on the creation
of a National Mortgage Database (NMDB)—the first comprehensive repository of detailed mortgage loan
information. Although the mortgage market is the single largest market for consumer finance, there is a
lack of comprehensive data available on a complete, national scale. The creation of the NMDB will be the
first step in a broader strategy to help streamline data for research and policy analysis and to make accurate,
comprehensive information accessible to regulators.
The SEC also has a rule proposal outstanding that, if adopted, would require the filing of tagged, computerreadable, standardized information about the specific assets or loans backing asset-backed securities offered
and sold in transactions registered with the SEC. The SEC has requested public comment on whether the
proposal appropriately implements the Dodd-Frank Act requirement to adopt regulations requiring issuers
of asset-backed securities to disclose asset-level or loan-level data if such data is necessary for investors to
independently perform due diligence.

6.5

Council Activities

6.5.1

Determination of Nonbank Financial Companies to be Supervised by the Federal Reserve

One of the Council’s statutory authorities is to determine that a nonbank financial company will be subject
to supervision by the Federal Reserve and enhanced prudential standards if the 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.
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In April 2012, the Council issued a final rule and interpretive guidance that describes the three-stage process
that the Council generally intends to use in evaluating nonbank financial companies. 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.
The proposed determination will proceed only if approved by two-thirds of the Council, including the
affirmative vote of the Chairperson. After 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 all determinations made under Section 113 of the Dodd-Frank
Act and the basis for such determinations.
The Council publicly announced that, in September and October 2012, it voted to advance a subset of
nonbank financial companies to the third and final stage of the evaluation process. As of the date of this
report, the Council had not made any determinations under Section 113 of the Dodd-Frank Act.

6.5.2

Proposed Recommendation on MMFs

The financial crisis of 2007 to 2008 demonstrated that MMFs are susceptible to runs and can be a source of
financial instability with serious implications for broader financial markets and the economy. Section 120
of the Dodd-Frank Act authorizes the Council to issue recommendations to regulatory agencies to apply
new standards and safeguards to financial activities and practices that create the risk of problems spreading
through U.S. financial markets.
In November 2012, the Council issued for public comment proposed recommendations to the SEC with
three alternatives for reform to address the structural susceptibility of MMFs to run risk. The Council is
currently considering the public comments on the proposed recommendations. Pursuant to the DoddFrank Act, if the Council issues a final recommendation to the SEC, the SEC would be required to adopt the
recommended standards (or similar standards that the Council deems acceptable) or explain in writing to
the Council, within 90 days, why it has determined not to follow the recommendation of the Council. The
Council must then report to Congress on (1) the recommendation issued by the Council and (2) the SEC’s
implementation of, or failure to implement, the recommendation. The proposed recommendations state
that if the SEC moves forward with meaningful structural reforms of MMFs before the Council completes
its recommendation under Section 120, the Council expects that it would not issue a final Section 120
recommendation to the SEC.

6.5.3

Risk Monitoring and Regulatory Coordination

The Dodd-Frank Act charges the Council with responsibility to identify risks to U.S. financial stability,
promote market discipline, and respond to emerging threats to the stability of the U.S. financial system.
The Council also plays a role in further enhancing and facilitating the coordination that takes place
among federal and state financial regulatory agencies. The Council regularly examines significant market
developments and structural issues within the financial system. For example, over the past year, the Council
has considered issues such as the sovereign fiscal developments in Europe and the United States, the multibillion dollar trading losses by JPMorgan, the state of mortgage foreclosures in the United States, the failure
of MF Global, the impact of Superstorm Sandy on financial markets, weaknesses in the LIBOR process, and
risks to financial stability arising from cybersecurity vulnerabilities. The Council will continue to monitor
potential threats to financial stability and to coordinate regulatory responses, whether from external shocks
or structural weaknesses.

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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.

6.5.4

Operations of the Council

The Dodd-Frank Act requires the Council to convene no less than quarterly. In 2012, the Council met
12 times.18 The meetings bring Council members together to discuss and analyze emerging market
developments, threats to financial stability, 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 2012.19
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 coordinate and
oversee 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) identification and consideration
of nonbank financial companies for designation; (2) identification and consideration of financial market
utilities for designation; (3) making recommendations to primary financial regulatory agencies regarding
heightened prudential standards for financial firms; (4) consultation with the FDIC on orderly liquidation
authority and review of the resolution plan requirements for designated nonbank financial firms and the
largest BHCs; and (5) the collection of data and improvement of data-reporting standards.
In 2012, the Council approved hearing procedures for nonbank financial companies and FMUs subject to
proposed designations. The Council amended its hearing procedures in April 2013 to apply to financial
companies engaged in payment, clearing, or settlement activities subject to proposed designations. The
Council also passed its third budget. In addition, the Council fulfilled its obligations under the Freedom of
Information Act (FOIA) by responding to FOIA requests in accordance with the Council’s FOIA regulation,
and complied with the Council’s transparency policy by conducting its business in an open and transparent
manner whenever possible.20 The Council also re-launched its website, www.fsoc.gov, where members of
the public can now register to receive e-mail notifications regarding the Council’s activities, including
announcements of upcoming Council meetings.

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 certain FDIC
implementation expenses associated with OLA. To implement this provision, the Treasury issued a final
rule on May 21, 2012 that establishes an assessment schedule for semi-annual collections from BHCs 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 to the Financial Research Fund under the
rule were made on July 20, 2012. Under the Treasury regulation, subsequent collections are scheduled each
March 15 and September 15 to replenish the Financial Research Fund.

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6.5.5

Section 119 of the Dodd-Frank Act

Section 119 of the Dodd-Frank Act provides that the Council may issue non-binding 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

Financial stability is threatened when adverse
shocks interact with financial system vulnerabilities.
Adverse shocks potentially induce substantial losses
on a class of assets over a short period of time and
can emerge from, or be exacerbated by, the failures
of specific firms, infrastructure weaknesses, or
breakdowns in market functioning. Not all shocks
necessarily affect the stability of the financial system
or the real economy. However, if the financial system
is particularly vulnerable to shocks due to excessive
leverage, excessive maturity transformation, or
excessive credit risk taking, a shock could threaten
many institutions with insolvency. Vulnerabilities
can also arise from weaknesses in reporting systems
or the possibilities of runs.
In this section, we review six areas of vulnerabilities
that could threaten the stability of the U.S. financial
system if adverse shocks occur. Specifically, this
section (1) provides a review of fire sale and run
risk vulnerabilities; (2) describes operational risks
and draws lessons learned from Superstorm Sandy;
(3) explains why the reliance on reference rates is
a potential vulnerability for the financial sector;
(4) explores the financial system’s vulnerability to a
sudden spike in fixed income yields; (5) lists threats
from foreign economic and financial developments;
and (6) explains the risk-taking incentives of large,
complex, interconnected financial institutions,
followed by financial stability considerations for
bank merger policies.

7.1

Fire Sales and Run Risk Vulnerabilities

Market-based intermediation is exposed to fire sale
and run vulnerabilities. This section investigates
the vulnerabilities that arise along a particular
chain of market-based intermediation. The chain
begins with cash lenders, such as pooled cash
management vehicles and others with excess cash
to invest, including corporate and governmental
entities. These cash lenders invest in tri-party repos
with broker-dealers. The repos are collateralized
by Treasury securities, agency mortgage-backed

securities (MBS) and debt, or corporate bonds (see
Section 5.2.3 for a breakdown of repo funding
by collateral type). This intermediation chain
allows participants to allocate funds to long-term
investments while offering liquid investment
products to investors. However, the intermediation
conducted along this chain makes each step
potentially vulnerable to runs and fire sales. If
cash investors doubt the solvency or liquidity
characteristics of their collateral or counterparty,
they might rapidly unwind their investments. This in
turn leaves broker-dealers who are funded through
tri-party repo vulnerable to sudden collapses in
sources of funding.
Money market funds (MMFs) are among the largest
cash investors in the tri-party repo market.21 Repo
holdings of MMFs have steadily increased over
recent quarters, and currently amount to $545
billion (Chart 7.1.1). The share of MMF assets
allocated to repo and the share of broker-dealer
repo funded by MMFs have been steadily increasing
since experiencing a sharp decline during the
financial crisis. As of the end of 2012, MMFs allocate
over 20 percent of their investments to repos and
fund nearly 25 percent of total broker-dealer repos
(Chart 7.1.2). Because MMFs are susceptible to
runs, their relative importance in the repo market
creates a source of vulnerabilities for the brokerdealer sector.
In the tri-party repo market, a fire sale can occur if
a broker-dealer under stress immediately needs to
sell assets that it can no longer finance. Such predefault fire sales are a risk because broker-dealers
perform maturity and liquidity transformation. As
such, broker-dealers that obtain funding in the triparty repo market could be solvent but illiquid. The
value of the securities they hold might exceed the
face value of the repo if the securities are sold in a
well-functioning market. If, however, the market for
these securities becomes temporarily illiquid, the
securities’ price might drop to a point at which—if
a broker-dealer cannot provide additional collateral
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Chart 7.1.1 		 Total MMF Repo Holdings
7.1.1 Total MMF Repo Holdings
Billions of US$

As Of: 2012 Q4

Billions of US$

Source: Flow of Funds, Haver Analytics

Chart 7.1.2 		 Repo Funding by MMFs
7.1.2 Repo Funding by MMFs
As Of: 2012 Q4

Percent

Percent

Share of MMF Funding
of Dealer Repo

Share of Repo in
Total MMF Assets

Source: Flow of Funds, Haver Analytics

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to make up for the shortfall in the required
coverage—the securities are worth less than
the face value of the repo they collateralize.
This dynamic makes a run by repo creditors
potentially self-reinforcing.
The risk of fire sales is heightened when
collateral is less liquid. In particular, firms that
have a large fraction of their repo transactions
collateralized by illiquid securities tend to be
more vulnerable. Lenders’ incentives to sell
collateral quickly in case of dealer distress
rather than to liquidate over a longer time
horizon or hedge those positions also increase
the risk of fire sales. Large broker-dealers’ repo
books currently range between $100 and $200
billion and, in some cases, reached peak levels
in excess of $400 billion prior to the financial
crisis. While haircuts place some constraint
on the size of a firm’s repo book, so long as
underlying collateral remains liquid, the size
of a firm’s repo book could increase further.
For very large repo books, even the liquidation
of high-quality collateral such as agency
MBS could prove challenging over a
compressed timeframe.
The fire sale risk in the tri-party repo market
generates vulnerabilities for the securities
broker-dealer sector. Although commercial
banks benefit from access to the discount
window and deposit insurance, broker-dealers
do not have such backstop sources of funding.
However, compared to activity before the
crisis, broker-dealers have modestly reduced
their reliance on overnight tri-party repo
funding, instead relying on longer-term repo
funding sources. Furthermore, large brokerdealers have reduced their reliance on MMFs
for funding less liquid assets via repo. In
addition, the largest broker-dealers are now
part of bank holding companies (BHCs), and
are thus subject to comprehensive prudential
oversight at the holding company level. Despite
these mitigating factors, the absence of direct
and pre-specified sources of public liquidity
and credit backstops makes broker-dealers,
as compared to banks, more exposed to
vulnerabilities in their funding sources.

7.2

Operational Risks

Market Infrastructure and Market Continuity
Weaknesses
In 2012, equity markets experienced a number of
systems issues, raising concerns over the impact of
the markets’ technology infrastructure on market
stability. Technological advances have brought many
benefits to markets, but recent events demonstrate
that those benefits are not without risks. When
systems do not operate as intended, there may be
significant consequences not only for the entities
responsible for the errors, but also for a much wider
group of market participants. Among the significant
systems issues that affected U.S. securities markets in
2012, there are three notable examples of the ways
in which the technology failures of individual firms
can potentially threaten market stability and investor
confidence. These include systems malfunctions in
connection with the initial public offerings (IPOs)
of both BATS Global Markets, Inc. (BATS) and
Facebook, Inc., as well as losses suffered by Knight
Capital Group, Inc. (Knight Capital) caused by
errors in its systems related to order routing.
•	

•	

•	

On March 23, 2012, a flaw in software code
forced BATS, an equities exchange, to cancel the
IPO of its own stock, which was to be listed on its
own exchange. According to reports, a coding
error caused the matching engine for certain
ticker symbols to enter into an infinite loop,
making certain securities symbols, including
the symbol for BATS itself, inaccessible on the
exchange.
On May 18, 2012, issues with NASDAQ’s trading
systems delayed the start of trading in the highprofile IPO of Facebook, Inc. According to public
disclosures, NASDAQ’s IPO system encountered
conditions that delayed the determination of
an opening price in the IPO and resulted in
some market participants experiencing delays in
notifications over whether orders had been filled.
On August 1, 2012, the trading firm Knight
Capital experienced a technology issue at
the opening of trading at the New York Stock
Exchange (NYSE) related to the installation of
trading software that caused routing problems.
These issues resulted in Knight Capital sending
a significant number of unintended orders in

NYSE-listed securities into the market. As a
result of the error, Knight Capital accumulated
large positions in certain securities that, when
unwound, led to a substantial loss.
These events occurred notwithstanding current
regulatory requirements and oversight programs
relating to technology standards and safeguards.
For example, under the SEC’s voluntary
Automation Review Policy Inspection Program,
SEC staff conducts inspections of the self-regulatory
organizations’ trading and related systems, monitors
planned significant system changes, and responds
to reports of system failures, disruptions, and
other problems. In addition, Rule 15c3-5 under
the Exchange Act requires a broker-dealer with
market access, or that provides a customer or
any other person with access to an exchange or
alternative trading system, to establish, document,
and maintain a system of risk management controls
and supervisory procedures reasonably designed to
manage the financial, regulatory, and other risks
of its business activity. Financial risk management
controls and supervisory procedures must be
reasonably designed to systematically limit the
financial exposure of a broker-dealer that could
arise as a result of market access.
The SEC, in conjunction with various market
participants, is examining the relationship between
the operational stability and integrity of the
securities market and the ways in which market
participants design, implement, and manage
complex and interconnected trading technologies.
In March 2013, the SEC proposed Regulation
Systems Compliance and Integrity (Regulation SCI)
to strengthen the automated systems of important
participants in the securities markets.

Market Infrastructure and Business Continuity
On October 29, 2012, the landfall of Superstorm
Sandy caused a two-day closure of the NYSE
and NASDAQ, while fixed income markets were
closed for one day. Money markets experienced
only minor disruptions, as market participants
followed the Securities Industry and Financial
Markets Association’s (SIFMA) recommendation
to extend overnight trades to two-day trades. The
Depository Trust & Clearing Corporation’s (DTCC)
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135

clearing and settlement services continued to
operate throughout the storm from an alternate
site, although physical certificate processing was
damaged due to the flooding of its downtown
Manhattan location (see Box F: Lessons Learned
from Superstorm Sandy).

Cybersecurity: Vulnerabilities to Attacks on
Financial Services
Security threats in cyberspace are not bound by
national borders and can range widely from low to
high security risks. Such threats include mechanisms
that compromise computer systems through
software code, which may immediately exploit an
application weakness, coordinate an attack across
systems, or replicate on a single system to the point
that performance is disrupted. Cyber risks can
impact the confidentiality, integrity, and availability
of the information and technologies essential for
the provision of services, resulting in financial,
compliance, and reputation risk. Moreover, cyber
incidents that disrupt, degrade, or impact the
integrity of critical financial infrastructure could
have consequences on operations and efficiency.
During 2012, more than a dozen financial
institutions sustained distributed denial-of-service
(DDoS) attacks to their public websites, all of which
were attributable to a single group. These particular
attacks, which began in September, were targeted,
persistent, and recurring. These attacks targeted
a number of the largest financial institutions, as
well as a few large regional organizations. The
knowledge and skill of the attackers appeared
to increase over time, including incorporation
of blended attacks, which can employ multiple
vectors to ensure higher success rates, and the use
of browser-specific attacks to allow compromises
over multiple operating systems platforms. With
this recent experience, the financial sector has
become increasingly adept in identifying, assessing,
preventing, and mitigating cyber risks.
Financial sector services groups (such as the
Financial Sector Information Sharing and Analysis
Center), trade associations, and coordinating
committees of the public sector (such as the
Financial Services Sector Coordinating Council)
are critical to understanding the risks, trends, and
best practices for mitigation of cyber threats, and
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for disseminating timely information. Enhancing
cross-sector cooperation, particularly with industries
upon which the financial sector is dependent,
such as energy, power, and telecommunications,
is critical to resiliency. Public-private partnership
improvements in the analysis and dissemination of
robust information to improve real-time responses
to cyberattacks will enhance incident management,
mitigation, and recovery efforts. Enhanced
cybersecurity education directed to employees
and consumers, as well as efficient implementation
and testing of response programs, will improve
protection, mitigation, and response to cyberattacks.

Money Laundering
The scale, efficiency, sophistication, and complexity
of the U.S. financial system make it a prime target
for those who seek to conceal and move illicit
money. Money launderers must often, at some
point, rely on the U.S. financial system to move or
launder the illicit funds supporting or derived from
their operations. The technology, products, and
services offered by institutions to give customers
better and quicker access to financial services can
also be used by criminals to instantaneously and
anonymously move money throughout the world,
sometimes through the simple click of a mouse or
the use of a cell phone application. Furthermore,
money laundering schemes are becoming more
complex, involving entities and individuals located
in numerous jurisdictions worldwide. To preserve
the stability of the U.S. financial system, money
laundering and other illicit financial activities need
to be combated, and financial institutions should
continually reassess and enhance their systems for
detecting, reporting, and deterring potential money
laundering activities accordingly.

Model Risk
Model risk presents an increasingly widespread
and important form of operational risk. Just as
technological progress has permitted faster and
more complex transactions, it also has permitted
more complex models for making investment
decisions. Flawed models have been costly to some
financial institutions, and distress due to flawed
models can exert negative externalities onto other
firms. Financial institutions can mitigate model
risk by continuously monitoring and analyzing the

validity of models, comparing alternative models,
understanding the limitations of their models, and
supplementing their models with other information
and analysis.

7.3
Reliance upon Reference Rates as
a Vulnerability
Benchmark interest rates, including the London
Interbank Offered Rate (LIBOR), the Euro
Interbank Offered Rate (EURIBOR), and similar
rates, are referenced in swaps transactions,
commercial and consumer loans, futures contracts,
and other financial derivatives products traded in
over-the-counter (OTC) markets and exchanges
around the world.22 Approximately $350 trillion
notional amount of swaps and $10 trillion of loans
are indexed to LIBOR alone. Furthermore, LIBOR
is a reference rate for 70 percent of the U.S. futures
market, a majority of the swaps market, and nearly
half of U.S. adjustable-rate mortgages (ARMs).
LIBOR, EURIBOR, and other similar benchmarks
play a key role in the financial system’s core
functions of pricing and allocating capital and
risk. The Council believes that the price signals
derived from such benchmark interest rates must
have integrity; be based upon competitive forces
of supply and demand; and be free of fraud,
manipulation, and other abuses. For capital and risk
to be efficiently allocated within the economy and
risk to be appropriately measured, such interest rate
benchmarks should reflect actual price discovery
anchored in observable transactions.
The Decline in Unsecured, Interbank Lending
LIBOR and other similar rates reference a market
that currently has few, and at times, no transactions,
particularly in longer tenors. The decline in trading
in unsecured bank funding markets is attributable
to a significant structural shift in the funding of
balance sheets and trading positions by market
participants since the financial crisis. In particular,
the funding market between banks has shifted
from unsecured borrowing to borrowings that are
secured by posting collateral. Furthermore, the
deterioration in the perception of some banks’
credit risk since the beginning of the European debt
crisis has exacerbated the reluctance of banks to

engage in unsecured lending. The very large volume
of excess reserves in the banking system provided by
central banks has also contributed to significantly
reduced activity in interbank lending markets. In
addition, banks are more closely managing demands
on their balance sheets. Recent changes to Basel
capital rules also move banks even further from
interbank lending on an unsecured basis.
Weakness of Reference Rate Governance
Another key problem with LIBOR and other similar
rate regimes that facilitated the malfeasance that
occurred was the weakness of the governance
structures that were in place. This weakness was
evident both in the processes that existed within
banks for determining their submissions and in the
processes for administering the rates more broadly.
Coupled with the scarcity of transactions in the
unsecured, interbank market, these weaknesses
created the opportunity for banks to manipulate
and misreport rates over long periods of time.
Manipulative Activity
Recent investigations uncovered systematic
false reporting and manipulations of reference
rate submissions dating back many years. This
misconduct was designed to either increase the
potential profit of the submitting firms or to convey
a misleading picture of the relative health of the
submitting banks. These actions were pervasive,
occurred in multiple bank locations around the
world, involved senior bank officials at several
banks, and affected multiple benchmark rates and
currencies, including LIBOR, EURIBOR, and the
Tokyo Interbank Offered Rate (TIBOR). Each of the
banks that faced charges engaged in a multi-year
pattern of misconduct that involved collusion with
other banks. These revelations have undermined the
public’s confidence in these benchmarks.
In the United States, the CFTC issued orders
bringing and settling charges against Barclays,
UBS, and the Royal Bank of Scotland. The orders
charged the banks with manipulation, attempted
manipulation, and false reporting, resulting in
penalties of more than $1.2 billion in the United
States, and over $2.5 billion globally. The banks
also reached resolutions with U.S. Department of
Justice (DOJ) and foreign authorities. The CFTC’s
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BOX F:

LESSONS LEARNED FROM SUPERSTORM SANDY

Financial sector infrastructure operates in an environment
that is threatened daily by natural disasters, human error,
and intentional acts. Core financial infrastructure firms,
including providers of payment, settlement, trading,
and clearing services, must ensure that their daily
operations can function with a high level of confidentiality,
integrity, and availability in the face of these threats.
While these firms continue to successfully identify,
prevent, mitigate, and respond to threats, wide-scale
events still pose potential operational risks, including
disruption or degradation of critical functions supporting
financial transactions.
Superstorm Sandy made landfall near Atlantic City, New
Jersey on Monday, October 29, 2012, as a post-tropical
cyclone. At its peak, the storm left over 6 million people in
16 states without power. The financial services sector was
most affected by the impact of the storm in New York City
and New Jersey. The severe flooding and wind impact
on energy, telecommunications, and transportation
infrastructures highlighted the financial services sector’s
dependency on those systems.
Despite the severity of Sandy’s impact on people’s
lives, the financial services sector continued to operate,
albeit with some notable exceptions. Sandy’s impact on
financial services was limited, with the worst impacts
experienced during the initial two business days. The
NYSE and NASDAQ were closed for two consecutive
days beginning Monday, while money markets and
fixed income markets experienced an early close on
Monday, the day of the storm, and were closed on the
following day.
The most critical financial market utilities (FMUs), including
core payment, clearing, and settlement functions,
operated normally from their primary or contingency sites.
On the retail services side, point-of-sale data flowed,
currency inventories were adequate, and ATMs generally
were available outside the hardest hit areas. The majority
of institutions and third-party providers successfully
leveraged their contingency plans, and disaster recovery

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vendors were able to meet extremely high demand.
The financial services sector’s extensive efforts towards
preparation and planning, and investment in failover, backup, and alternative operations, as well as the fortunate
backdrop of an early warning of the impending storm,
contributed to sector resiliency. Effective governmental
assistance through federal interagency coordination,
federal-state coordination, the public-private partnership
for critical infrastructure protection, and targeted financial
regulatory relief helped to resolve issues and assure
communication among affected parties.
As a result of the storm, several areas were identified
where further improvement is needed to strengthen
business continuity and resiliency, including:
• 	 Planning and testing: It is important that all
market participants, including firms, exchanges,
service bureaus, vendors, and clearing houses, fully
understand the functionality of contingency systems,
and that key operations and business personnel
communicate efficiently to assure enterprise-wide
clarity. Expanded testing exercises would enhance
market-wide assurance of failover reliability. Such
testing should involve major market participants as
well as exchanges, clearing houses, settlement and
payment systems, and data repositories, and should
also involve providers of essential services such as
power, water, and telecommunications.
• 	 Incident management: Protocols for assuring
a timely decision on whether and when to close
or open markets would benefit from review and
streamlining by the responsible public-and privatesector entities. Likewise, protocols for assuring
timely decisions within financial firms and service
providers on whether and when to leverage back-up
sites would benefit from continued regular testing.
Furthermore, market interdependencies need to be
fully incorporated in the decision-making process.
• 	 Personnel: The resilience of critical components
of the financial system, including major market

participants, requires geographic dispersal of both
electronic systems and personnel sufficient to enable
an organization to operate despite the occurrence
of a wide-scale disruption affecting the metropolitan
or geographic area of the organization’s primary
operations, including communities economically
integrated with, adjacent to, or within normal
commuting distance of the primary operations
area. Organizations, including major financial firms,
need to continuously and rigorously analyze their
routine positioning and emergency repositioning
of key management and staff. This is an ongoing
requirement as technology, market structure, and
institutions evolve rapidly. Developed business
continuity plans should be implemented, and key
staff should be sent to disaster recovery sites when
there is advance notice of events.
• 	 Dependencies: Cross-industry interdependencies
require constant review, reassessment, and
improvement by organizations to mitigate the impact
of energy, power, transport, and communications
failures during severe incidents, and to help ensure
reliable redundancy.

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settlements with Barclays, UBS, and the Royal Bank
of Scotland included measures requiring those
three banks to take specified steps concerning
their LIBOR and other benchmark interest
rate submissions and to improve related
internal controls.23

Financial Stability Concerns
Council members believe that in the absence of both
an explicit and transparent link between LIBOR
and market transactions and strong governance
of reference rates, price signals for capital and
risk allocation and risk measurement may become
distorted, possibly leading to misallocation of capital
and risk and a mis-measurement of risk. Identifying
alternatives anchored in observable transactions
with appropriate governance structures, and
determining how to achieve a smooth transition to
them, would mitigate the risk of a significant threat
to U.S. financial stability.
Possible Distortions in Capital Markets by Continued Use
of LIBOR
The continued publishing of LIBOR implicitly
suggests that there is a liquid underlying market
when, in fact, trading volumes are thin, and at
times nonexistent, particularly in longer tenors.
Referencing LIBOR and similar rates diminishes
market integrity and will be unsustainable in the
long run, inasmuch as these rates are not anchored
in observable transactions. Furthermore, significant
incentives for misconduct exist when a vast array of
financial instruments reference a given benchmark
based on a small or possibly nonexistent market.
These incentives were noted by a recent Bank
for International Settlements’ (BIS) Economic
Consultative Committee report: “Cases of market
manipulation have raised concerns about the
appropriateness of the processes and methodologies
used in formulating reference interest rates. These
cases reflect both the incentives to manipulate
submissions—e.g. the potential to profit in a large
derivatives market that relies on reference rates and
the desire during the financial crisis to avoid the
stigma associated with relatively high submissions—
and a relatively weak governance structure.”

Banks Withdraw from LIBOR Panels
In light of the litigation and reputational risk, there
is a chance that banks currently participating in
LIBOR panels may choose not to submit rates.24
According to media reports, banks have considered
withdrawing from LIBOR and other panels. To date,
six banks have withdrawn from EURIBOR, and a
number of banks, including Barclays, have pulled
out of lesser-used LIBOR panels, such as LIBOR
for the Australian dollar and the Canadian dollar.
All 18 banks continue to report to the U.S. dollar
LIBOR panel, but absent a smooth and orderly
transition, if banks were to pull out of the U.S.
dollar LIBOR panel, preventing LIBOR from being
published, it could prove difficult to settle contracts
or write new contracts. While some contracts
contain language that allows for a backup rate in
the event of temporary problems with LIBOR, it is
not clear how an event would be treated if LIBOR
ceased to exist.25
A Rapid and Precipitous Move by Market Participants to
Divest Contracts Tied to LIBOR
Another concern is if market participants were to
rapidly and precipitously move to divest investments
and contracts linked to LIBOR. While such an
event is currently not expected, such an event
could destabilize markets. If such a shift occurred
gradually, it could be seen as market participants
effectively solving their own problem. However, if
appetite for LIBOR-linked investments and contracts
was severely reduced and led investors to rapidly
and precipitously shift out of these instruments,
the normal functioning of a variety of markets,
including business and consumer lending, could
be impaired.

Reform Efforts
In the wake of the investigations and settlements
described above, multiple international regulatory
bodies and supervisory agencies responded to
concerns about reference rates and financial
benchmarks by initiating reviews of various global
benchmark activities and developing best practices
to improve the governance of these benchmarks.
The U.K. government requested that the Financial
Services Authority (FSA) review LIBOR and provide
recommendations for its revision or replacement.

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The resulting Wheatley Review published a final
report on September 28, 2012, which included a
number of major and minor revisions to the thencurrent system of governance, calculation, and
oversight. As examples, the Review recommended
an explicit and clear use of transaction data to
corroborate LIBOR submissions and a phasing
out of all but 37 of the current 150 published
rates.26 The Review recommended, for instance,
that Canadian dollar LIBOR and Australian dollar
LIBOR cease to exist. The Review concluded
that transaction data should be explicitly used to
support LIBOR submissions. It also emphasized
the importance of sound governance in the
determination of reference rates and, along the
lines of the Review, recommended that both
the administration and submission processes
be regulated by the FSA. The Wheatley Review
recommendations were incorporated in final
legislation by the U.K. Parliament in December
of 2012. On March 25, 2013, the U.K. FSA issued
proposals for the regulation and supervision of
LIBOR-related activities.27 LIBOR-related activities
fall under regulation by the new Financial Conduct
Authority (FCA) as of April 2, 2013. Benchmark
administrators are required to corroborate
submissions and monitor them for suspicious
activities. Banks must put in place conflicts of
interest policies, and benchmark administrators
and submitters must be considered FSA-approved
persons.
The CFTC and the U.K. FCA are co-chairing
the International Organization of Securities
Commissions (IOSCO) Task Force on financial
market benchmarks. In January 2013, the task force
published its Consultation Report on Financial
Benchmarks, with a final report scheduled to be
published in mid-June.28 The consultation requested
public input on a possible framework of principles
to support the quality and credibility of benchmark
administration and the resilience of benchmarks. In
the report, the Task Force said, among other things,
that in order to be credible, benchmarks should be
anchored in observable transactions and be subject
to clear governance and accountability mechanisms.
The consultation report stated, “The Task Force
is of the view that a benchmark should as a matter
of priority be anchored by observable transactions

entered into at arm’s length between buyers and
sellers in order for it to function as a credible
indicator of prices, rates or index values.” It went
on to say, “However, at some point, an insufficient
level of actual transaction data raises concerns as to
whether the benchmark continues to reflect prices
or rates that have been formed by the competitive
forces of supply and demand.” The consultation
report also discussed the need for benchmarks,
as well as contracts and financial instruments
that reference benchmarks, to have contingency
provisions to address the possible cessation of a
benchmark and the transition to alternatives.
The March 2013, the BIS Economic Consultative
Committee report noted that greater use of
transaction data combined with the transparent
and appropriate use of expert judgment in the
rate setting process would enhance the resilience
of reference rates, and that steps should be taken
to ensure that contracts have robust fallback
arrangements for use in the event that the main
reference rate is not produced.29 In addition, the
report notes both the incentives to manipulate
and a relatively weak governance structure. The
report also discussed a range of options that central
banks could use to promote additional benchmark
choices, including a rebalancing away from current
unsecured, interbank lending reference rates.
Significantly, the report stressed that given the
“public-good” nature of reference rates, it is “entirely
appropriate that the official sector should play a
role in ensuring the reliability and robustness of
reference rates and facilitating a range of private
sector solutions.”
International regulators and markets participants
have begun to consider alternatives and possible
arrangements to transition to alternative rates. For
example, the BIS working group report lists the
overnight swaps rate and short-term collateralized
financing rates, such as general collateral repo rates,
as possible alternatives.
Regulators around the globe have taken steps
toward reviewing their own local benchmarks. The
European Securities and Markets Administration
(ESMA) and European Banking Authority (EBA)
published a joint consultation report in January
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141

2013, which focused on EURIBOR and other
European benchmarks, detailing similar highlevel principles for benchmark administrators,
calculation agents, and submitters. On the
legislative front, the European Commission has
started to revise current legislative authority
over these widely used market instruments.
All of these entities aim to establish systems of
governance and administration, especially in
the case of benchmarks with widespread use,
that will perform robustly through
a wide range of market conditions.

7.4
Financial System Vulnerability to
Sudden Spikes in Fixed Income Yields

12

Treasury yields are at the lowest levels seen since
the 1940s (Chart 7.4.1). Yields across the credit
spectrum are also low by historical standards.
The primary drivers for these exceptionally low
levels are threefold: expectations of continued
low short-term interest rates, compressed
pricing of interest rate risk, and contained
solvency risk for credit markets.

8

8

•	

4

4

Chart 7.4.1 		 Historical Bond Yields
7.4.1 Historical Bond Yields
Percent
20
16
12

As Of: Feb-2013

Percent
20

Moody's Seasoned Baa
Moody's Seasoned Aaa
10-Year Constant Maturity Treasury
3-Month Treasury Bills, Secondary
Market

16

0
0
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Source: Federal Reserve, Haver Analytics

Chart 7.4.2 		 Federal Funds Rate
7.4.2 Federal Funds Rate

•	

As Of: 25-Mar-2013

Percent

Percent

Effective Rate

Implied Rate

Source: Federal Reserve,
Haver Analytics

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2 0 1 3 F S O C / / Annual Report

Note: Implied Federal Funds
Rate derived from OIS quotes.

Market expectations of low short-term rates
can be gauged from federal funds futures,
which are at very low levels relative to recent
years (Chart 7.4.2). Expectations for low
future interest rates primarily reflect the
stance of monetary policy, including the
Federal Open Market Committee’s (FOMC)
rate guidance. That policy stance, in turn,
reflects the depth of the post-crisis recession
and the moderate recovery since that time.
The pricing of interest rate risk can be
measured by term premia, or the excess
compensation to investors of holding
long-term Treasury securities compared
to reinvesting in short-term securities
periodically over time. Current estimates of
term premia are quite compressed relative to
historical averages (Chart 7.4.3).30 The 1-year
rate 9 years forward—another measure of
the risk premium embedded in Treasury
securities—is also very low. The pricing
of risk is driven by the composition of
investors and by risk appetite. An important
factor in the composition of buyers is the

•	

presence of the Federal Reserve’s large-scale
asset purchase programs (LSAPs) as well
as pension funds’ demand for long-term
Treasury securities, both of which tend to
compress term premia. The low rate volatility
environment relaxes risk management
constraints, resulting in higher risk appetite.
The pricing of credit risk is measured by
credit spreads, which are the difference
in yields between corporate bonds and
Treasury securities of the same duration
for given credit qualities. Credit spreads
have declined, but are not unusually low
by historical standards (Chart 7.4.4). Highyield, or speculative grade, corporate
credit spreads have also compressed. The
compression in spreads can be attributed
to a decline in the credit risk premium
in response to robust demand for higheryielding assets, healthy corporate balance
sheets, and a sanguine outlook for defaults.

The low level of interest rates provides
incentives for institutions to reach for yield
by extending their duration risk, investing in
lower-quality credit, or increasing their degree
of leverage. Pension funds, insurers, and asset
managers face challenges in meeting targets
for future obligations. Reaching for yield is
supported by the low measured volatility across
asset markets. Low term premia provide an
incentive to move down the credit spectrum
and earn higher spread. On the other hand, low
term premia may be offsetting those incentives
to some extent by reducing the profitability
of maturity transformation and encouraging
financial institutions to increase their longerterm funding.

Chart 7.4.3 		 Interest Rate Risk Premium Indicators
7.4.3 Interest Rate Risk Indicators
As Of: 1-Mar-2013

Percent

Percent

1-Year Rate 9
Years Forward
(right axis)

10-Year Treasury
Term Premium
(left axis)

Source: FRBNY calculations, Blue
Chip Consensus, Federal Reserve

Chart 7.4.4 		 Historical Credit Spreads
7.4.4 Historical Credit Spreads
Basis Points
1900
1500

As Of: Feb-2013

Basis Points
1900

BAML High-Yield Spread
Moody’s Seasoned Baa Spread
Moody’s Seasoned Aaa Spread

1500

1100

1100

700

700

300

300

-100
1954

1964

1974

1984

Source: Bank of America Merrill Lynch,
Federal Reserve, Haver Analytics

1994

2004

-100

Note: Spread to 10-Year CMT.

There is some evidence that investors are
exhibiting reach for yield behavior. In primary
markets, new issuance set highs in leveraged
loans, high-yield bonds, and investment
grade bonds. However, there is currently
little evidence that high-yield bonds are
being purchased by levered investors, or that
they are being issued by excessively levered
borrowers. Still, there is some evidence of
deteriorating underwriting standards for highP o te n t i a l E m e r g i n g T h r e a t s

143

yield bonds and leveraged loans. Collateralized loan
obligations (CLOs) offer leveraged exposure to
high-yield corporate credit. Additionally, increased
competition among underwriters and limited
volumes of merger and acquisition activity have led
to an erosion of margins and other protections for
lenders.
The high volume of CLO issuance is indicative
of broader issuance trends in the leveraged loan
market, where financial conditions are getting less
tight. Increased issuance of leveraged loans has
historically served as an early warning indicator.
However, since the financial crisis, rating agencies
have revised criteria to require higher credit
enhancements for rated CLO tranches, which
provide additional protection for senior note
investors. Today, CLO structures are generally less
complex than they were before the crisis.31 While
leverage and illiquidity were key vulnerabilities for
structured products during the crisis, CLOs today
are primarily funded either by non-levered investors
or commercial banks, which tend to buy senior
tranches. There is little evidence that CLOs are
funded by leveraged, short-term funded investors
outside of depository institutions. Besides banks,
CLO investors are often long-term, fully capitalized
entities whose holding periods are less sensitive
to short-term funding conditions. Furthermore,
many CLOs are floating rate, and as a result protect
investors against interest rate risk.
Yields and risk premia are likely to rise from their
current low levels. The speed of this adjustment is
important to financial stability. While a transition
to a more normal yield environment might occur
gradually over years, there is a risk of a sudden
spike in yields. A yield spike could be induced by
changed views about the economic outlook, an
adverse external shock, or a sudden change in risk
appetite. Spikes in the pricing of risk occur when
the risk appetite of institutions, or their ability to
take risk, drops suddenly, triggering an adverse
feedback loop of investor losses, forced asset sales,
lower asset prices, higher market volatility, and
further decreases in risk appetite. The vulnerability
of the financial system to such shifts in risk
appetite depends on the degree of leverage in the
financial system, maturity transformation, and
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2 0 1 3 F S O C / / Annual Report

interconnectedness among financial institutions.
In addition, a sharp increase in yields can be
triggered by duration hedging of investors in the
MBS market (see Box C: Convexity Event Risk).
These vulnerabilities have been mitigated in recent
years. The degree of leverage is generally lower
due to tighter regulatory requirements and more
stringent market discipline, maturity transformation
in wholesale funding markets has been reduced due
to the decline in shadow banking activity since the
crisis, and vulnerabilities from interconnectedness
of financial institutions have been reduced due to
improvements in counterparty risk management.
The combination of low returns and increasing
appetite for risk warrants continued vigilance by
regulators, investors, and lenders to the potential
build-up of risks. Although counterparty risk
management in many markets has improved,
particularly in the swaps market, concerns remain
that funding markets have not taken the necessary
steps to appropriately reduce counterparty risk.
Opaque chains of intermediation remain possible
risk transmission channels, such as in short-term
funding markets, securities lending, and
derivative markets.

7.5
Foreign Economic and Financial
Developments
Though external threats appear to have decreased
over the past year, they remain a risk to U.S.
financial stability and economic activity. The
euro area and Japan grapple with ways to reduce
public debt burdens and promote growth. China
has avoided an abrupt slowdown, but concerns
persist about its ability to transition away from its
investment-driven growth model.
Policy actions undertaken by euro area governments
and the European Central Bank (ECB) have
improved stability in the euro area and eased
severe market pressures, providing additional time
for adjustments at the country and regional level
(see Section 4.4.1). However, recent developments
in Italy and Cyprus serve as a reminder that the
euro area continues to be a source of shocks and
vulnerabilities. Renewed stress could arise due
to missed fiscal or structural reform targets and

adverse political developments. Delays in financial,
economic, and fiscal integration could make it
difficult to reverse large intra-euro area economic
disparities and leave the region vulnerable to new
shocks over an extended period of time. Sustained
economic weakness is also a possible source of
renewed stress. The restoration of growth in the
euro area remains essential, and will support
a reduction of heavy debt burdens, lower high
unemployment rates, and help maintain political
support for the adjustment process within the
core and periphery. In January, the International
Monetary Fund (IMF) forecasted a sequential
strengthening of growth over 2013, by 0.5 percent
on a Q4/Q4 basis; however, headwinds to growth
include substantial fiscal drag, private sector
deleveraging, and a weak external environment.
Medium-term growth prospects remain uncertain,
given mixed progress with reforms to address
challenges to competiveness and productivity.
Financial fragmentation within the euro area
continues to be a challenge. Private sector capital
has started to return to the periphery, but remains
sharply lower compared to pre-crisis levels.
Meanwhile, despite the reduction in sovereign
debt yields, there has been limited feed through
to improved credit conditions for private sector
borrowers in the periphery countries. European
bank lending capacity continues to be constrained
by balance sheet deleveraging, rising credit costs,
and ongoing efforts to bolster capital buffers.

growing share of Japanese government bond (JGB)
holdings remain vulnerabilities.
China has significant influence on financial market
sentiment due to its large size and sustained rapid
growth. A sharp deceleration of domestic demand
could impact macroeconomic, trade, and financial
activity among its trading partners, including
the United States and other Group of 20 (G-20)
countries. Recent Chinese economic data suggests
that activity has stabilized, mitigating concerns that
prevailed last year over an abrupt slowdown (see
Section 4.4.2). However, concerns persist about the
sustainability of China’s growth model, in which
exports and fixed investment have played key roles,
and about the prospects for gradually rebalancing
the economy toward domestic consumption.
Challenges include implementing a host of
structural reforms, such as interest rate and capital
account liberalization, and addressing banking and
other financial sector risks, including the nonbank
credit sector. China’s strong external position and
demonstrated capacity for forceful policy actions
may enable it to address these risks.

The Japanese economy is marked by sluggish
economic growth, persistent deflation, and high
public sector indebtedness. Consistent with Prime
Minister Abe’s campaign calls, in January, the Bank
of Japan (BOJ) adopted a 2 percent inflation target
as part of a joint statement with the government.
The BOJ’s new policy framework, approved in
April, shifted the policy operating target from
the overnight call money rate to the quantity
of the monetary base, with a target of ¥60-70
trillion annual growth. The BOJ has committed to
maintaining the new policy as long as necessary to
maintain 2 percent inflation “in a stable manner.”
The new government is seeking to establish a policy
mix that boosts growth and ends deflation. A high
public debt burden (gross public sector debt totals
235 percent of GDP) and Japanese banks’ large and
P o te n t i a l E m e r g i n g T h r e a t s

145

Chart 7.6.1 		 Moody’s BHC Systemic Support Uplift
7.6.1 MoodyĀs BHC Systemic Support Uplift
Notches

As Of: 27-Mar-2013

Notches

Financial institutions have incentives to take
on excessive risk if they perceive a public sector
guarantee. Risk-taking incentives can be further
supported if the market perceives financial
institutions as being too big, too complex,
or too interconnected to fail. Such market
perceptions of government support diminish
market discipline by allowing institutions to
take on more leverage at lower cost. In fact,
some credit rating agencies continue to factor a
systemic support uplift into the long-term credit
ratings of the largest U.S. financial institutions
(Chart 7.6.1).

BAC
WFC

MS

C

GS

JPM

Source: MoodyĀs, FRBNY calculations

Chart 7.6.2 		
Number and Distribution of Subsidiaries:
Selected Top 50 BHCs

7.6.2 Number and Distribution of Subsidiaries: Selected Top 50 BHCs
BHC
Rank

% of Assets
Outside Domestic Consolidated
Commercial
Count
Total Assets
(Billions of US$)
Banks
Total Foreign

Name

1.. JPMorgan Chase

3,409

449...

14.1%...........

2,359.1…...

2.. Bank of America

1,838

429...

25.1%...........

2,212.0…...

3.. Citigroup

1,642

682...

29.5%...........

1,864.7…...

4.. Wells Fargo

1,331

90...

6.4%...........

1,423.0…...

5.. Goldman Sachs Group

3,124

1,683...

87.4%...........

938.8…...

6.. Morgan Stanley

3,093

1,398...

87.6%...........

781.0…...

115

14...

0.0%...........

313.0…...
121.3…...

10.. Capital One Financial
20.. Regions Financial

39

4...

0.8%...........

30.. BBVA USA Bancshares

44

0...

0.0%...........

69.1…...

40.. BOK Financial

35

0...

0.7%...........

28.1…...

50.. Webster Financial
Total

Source: National Information
Center, FR Y-9C, FR Y-6,
FR Y-10, FFIEC 031, FFIEC 041

19

0...

0.2%...........

20.2…...

19,743

5,859...

24.9%...........

14,274.0…...

Note: Subsidiary data are as of 2-Apr-2013. Financial data are as of
2012 Q4. Capital One % of assets set to zero; raw figure is negative
due to netting of related party transactions. Excludes data on SLHCs.

Chart 7.6.3 		 BHC Subsidiaries by Industry
7.6.3 BHC Subsidiaries by Industry
Number of Subsidiaries

As Of: 2-Apr-2013

7.6
Risk-Taking Incentives
of Large, Complex, Interconnected
Financial Institutions

Number of Subsidiaries

Remaining Top 50 BHCs
Morgan Stanley
Goldman Sachs
Wells Fargo
Citigroup
JPMorgan Chase
Bank of America

While the systemic uplift by credit rating
agencies generally declined since the financial
crisis due to improving credit assessments of
the underlying company and a perception of
decreased government support, the uplift has
not disappeared completely. The justification
by the credit rating agencies for the systemic
support uplift is the perception that the actions
of government authorities during the recent
crisis imply a guarantee to large, complex,
interconnected financial institutions. The
uplifts for long-term credit ratings also tend to
be reflected in 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 solely on the
intrinsic strength of the institution and
its portfolio.
The Dodd-Frank Act explicitly addresses the
incentives and abilities of large, complex,
interconnected institutions to engage in risk
taking through a combination of policies.
•	

Source: National Information Center, FR Y-6, FR Y-10

146

2 0 1 3 F S O C / / Annual Report

The Act limits the ability of the government
to provide extraordinary support to
shareholders and creditors of large, complex
financial institutions. Thus, by law, the

•	

•	

government is constrained in its ability to provide
support after a crisis event.
The Act institutes enhanced prudential standards
for the largest BHCs and designated nonbank
financial companies (see Section 6.1.1). The
enhanced prudential standards include riskbased capital and leverage requirements, liquidity
standards, risk management and risk committee
requirements, single-counterparty credit limits,
and stress test requirements. The stringency of
these requirements tends to increase with the
size and complexity of the firm. In addition
to these enhanced prudential standards, the
Dodd-Frank Act provides the Council authority
to impose a debt-to-equity limit for companies
that it has determined pose a grave threat to
financial stability. Together, these provisions put
limits on certain types of risk taking by financial
institutions, and thus reduce the probability of
failure, though the provisions do not directly
reduce perceptions of public guarantees.
The Act authorizes the FDIC to resolve certain
failing financial companies deemed to pose a risk
to the financial system. The FDIC is developing
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 and culpable management to be replaced.
In addition, covered companies are required to
develop their own resolution plans, which are
jointly reviewed by the Federal Reserve and the
FDIC (see Section 6.1.3). If the Federal Reserve
and the FDIC jointly determine that a resolution
plan is not credible or would not facilitate orderly
resolution under the Bankruptcy Code, then the
company must resubmit the plan with revisions,
including, if necessary, proposed changes in
business operations or corporate structure,
that demonstrate that the plan is credible and
would result in orderly resolution under the
Bankruptcy Code.

For the six largest BHCs by total assets, the share
of assets outside of domestic commercial bank
subsidiaries ranges from 6.4 percent to 87.6 percent,
illustrating that traditional banking is in some
cases only a small fraction of BHCs’ activities. The
largest share by industry of nonbank subsidiaries is
accounted for by funds, trusts, and other financial
vehicles (Chart 7.6.3). Many of these funds,
trusts, and financial vehicles conduct credit
intermediation via securitization outside of the
commercial bank. For the largest BHCs, the biggest
nonbank subsidiaries by asset size include securities
broker-dealers.
Market participants may continue to perceive that
some institutions receive special treatment by virtue
of their size. Such beliefs could be exacerbated by
the degree of concentration in the financial services
industry. While the approval process for bank
consolidations now take into account the systemic
risk footprint of the resulting firm (see Box G:
Bank Consolidation and Financial Stability Policy),
increased concentration can still be achieved via
organic growth. However, in the past two years,
the asset share of the 10 largest U.S. financial
institutions has decreased, while the asset share of
smaller institutions has increased (Chart G.1).

The complexity and international reach of BHCs
is illustrated in Chart 7.6.2, which reflects the
diverse business lines and locations in which
these firms operate.32 BHC legal structures spread
over hundreds, and in some cases thousands, of
subsidiaries, many of which are domiciled abroad.
P o te n t i a l E m e r g i n g T h r e a t s

147

BOX G:

BANK CONSOLIDATION AND FINANCIAL STABILITY POLICY

Banking concentration in the United States has remained
relatively stable in the years since the financial crisis. As
is shown in Chart G.1, acquisitions by the largest firms in
the years preceding the crisis had caused a substantial
fraction of assets at the top 50 banking organizations to
become consolidated among the 10 largest institutions.
The crisis-related acquisitions that occurred during 2007
to 2008 further raised the asset share of the 10 largest
institutions to above 50 percent.33 In the past two years,
the asset share of the 10 largest institutions has declined
somewhat, while the share of the banks below the top 50
has increased. Despite the trend towards consolidation
prior to and during the financial crisis, the U.S. banking
system remains relatively unconcentrated compared
with that of many other advanced economies. The size
distribution of banking firms is relatively broad, with
regional or smaller banks conducting a substantial share
of retail banking activity.

For several years, the federal banking agencies have
been prohibited from approving an interstate acquisition
or merger in which a banking organization’s post-merger
share of U.S. deposits would exceed 10 percent upon
consummation.34 In addition to this limitation, prior to
the financial crisis, federal banking agencies focused
primarily on competitive, microprudential supervisory, and
community and consumer considerations when reviewing
bank and BHC mergers and applications, without specific
regard to financial stability. For the competitive analysis—
which is still applied today—federal law prohibits the
appropriate federal banking agencies from approving a
bank merger or acquisition if it would result in a monopoly.
The law also prohibits an agency from approving a
proposal that would substantially lessen competition or
tend to create a monopoly, unless the agency finds that
the anticompetitive effects are clearly outweighed in the
public interest by the probable effects in meeting the
convenience and needs of communities served.

Chart G.1 	 Asset Shares of U.S. Financial Institutions
G.1 Asset Shares of U.S. Financial Institutions

In 2010, the Dodd-Frank Act incorporated additional
provisions regarding banking acquisitions, including
several sections that direct the Federal Reserve to
consider financial stability in its review of banks, BHCs,
and related nonbank acquisitions.35 The Dodd-Frank Act
also requires the appropriate federal banking agency to
consider the risks to U.S. financial stability in its review of
a banking organization merger.36 In addition, the DoddFrank Act prohibits an insured depository institution,
BHC, savings and loan holding company (SLHC), or
nonbank financial company supervised by the Federal
Reserve from merging with or acquiring control of
another company if the total consolidated liabilities of
the acquiring company upon consummation of the
transaction would exceed 10 percent of the liabilities
of all financial companies.

Percent of Total Assets
60

Percent of Total Assets
60

As Of: 2012 Q4

50

50

Top 10

40

40

30

30
Top 11-50

20

20

Below Top 50
10
2005

2006

2007

2008

2009

2010

2011

10
2012

Note: Includes U.S.-chartered independent banks and BHCs, SLHCs, independent thrifts, ILCs, credit card
banks, FBO edge corporations, FBO nonbank affiliates, and FBO branches. Assets are adjusted to account
for acquisitions and charter changes. Assets are as of 2012 Q4 except small-parent BHCs (2012 Q2),
certain FBO nonbank affiliates that file annually (2011 Q4), and all other FBO nonbank affiliates (2012 Q3).

Source: FR Y-9C, FR Y-9SP, SLHC, Call Reports, SEC 10Qs

The new financial stability screens have been applied to
several recent acquisitions, including PNC’s December
2011 acquisition of Royal Bank of Canada’s U.S. banking
subsidiary and the acquisition by Capital One of ING Bank
(the U.S. thrift affiliate of ING Group) in February 2012.
These two acquisitions left the acquiring firms among

148

2 0 1 3 F S O C / / Annual Report

the largest U.S. institutions in terms of deposits, but their
shares of banking organization assets are still substantially
smaller, leaving the two firms out of the top 10 (Chart
G.2). The Federal Reserve stated that it will generally find
a significant adverse effect “if the failure of the resulting
firm, or its inability to conduct regular-course-of-business
transactions, would likely impair financial intermediation
or financial market functioning so as to inflict material
damage on the broader economy.”37

Chart G.2 	 Asset Shares of the Top 10 U.S. Financial Institutions
G.2 Asset Shares of the Top 10 U.S. Financial Institutions
As Of: 2012 Q4
Share of U.S. Assets

Assets

Percent

Billions of US$

2,359

JPMorgan Chase

10.5

Bank of America

9.8

2,212

Citigroup

8.3

1,865

Wells Fargo

6.3

1,423

Goldman Sachs

4.2

939

Morgan Stanley

3.5

781

Credit Suisse (U.S.)

2.6

575

Deutsche Bank (U.S.)

2.3

509

Barclays (U.S.)

2.2

501

BoNY Mellon

1.6

359

Note: Includes U.S.-chartered independent banks and BHCs, SLHCs, independent thrifts, ILCs, credit card
banks, FBO edge corporations, FBO nonbank affiliates, and FBO branches. Assets are adjusted to account
for acquisitions and charter changes. Assets are as of 2012 Q4 except small-parent BHCs (2012 Q2),
certain FBO nonbank affiliates that file annually (2011 Q4), and all other FBO nonbank affiliates (2012 Q3).

Source: FR Y-9C, FR Y-9SP, SLHC, Call Reports, SEC 10Qs

The metrics applied by the Federal Reserve to assess
the effects of the transactions on financial stability
include measures of size, substitutability of critical
services, interconnectedness, complexity, and crossborder activity. These metrics are conceptually similar to
the global metrics applied by the Basel Committee on
Banking Supervision (BCBS) in the designation of global
systemically important banks (G-SIBs).

P o te n t i a l E m e r g i n g T h r e a t s

149

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153

Abbreviations
ABCP

Asset-Backed Commercial Paper

ABS

Asset-Backed Security

AFS

Available-for-Sale

ARM

Adjustable-Rate Mortgage

ATRA

American Taxpayer Relief Act of 2012

AUM

Assets Under Management

BAC

Bank of America

BATS

BATS Global Markets, Inc.

BBA

British Bankers’ Association

BCBS

Basel Committee on Banking Supervision

BEA

Bureau of Economic Analysis

BFI

Business Fixed Investment

BHC

Bank Holding Company

BIS

Bank for International Settlements

BLS

Bureau of Labor Statistics

BNYM

Bank of New York Mellon

BOE

Bank of England

BOJ

Bank of Japan

C

Citigroup

C&I

Commercial and Industrial

CapPR

Capital Plan Review

CBO

Congressional Budget Office
Abbreviations

155

CCAR
CCP

Central Counterparty

CD

Certificate of Deposit

CDS

Credit Default Swap

CEA

Commodity Exchange Act

CFPB

Bureau of Consumer Financial Protection

CFTC

Commodity Futures Trading Commission

CGFS

Committee on the Global Financial System

CLO

Collateralized Loan Obligation

CLS

CLS Bank International

CMBS

Commercial Mortgage-Backed Security

CME

Chicago Mercantile Exchange

CMO

Collateralized Mortgage Obligation

COU

Central Operating Unit

CoVaR

Conditional Value-at-Risk

CP

Commercial Paper

CPPI

Commercial Property Price Index

CPSS

Committee on Payment and Settlement Systems

CRE

Commercial Real Estate

CU

Credit Union

DB

Defined Benefit

DC

Defined Contribution

DDoS

Distributed Denial-of-Service

DFAST

156

Comprehensive Capital Analysis and Review

Dodd-Frank Act Stress Tests

2 0 1 3 F S O C / / Annual Report

DIP

Distress Insurance Premium

DOJ

U.S. Department of Justice

DTC

Depository Trust Company

DTI

Debt-to-Income

DTCC

Depository Trust & Clearing Corporation

E&S

Equipment and Software

EBA

European Banking Authority

ECB

European Central Bank

ECOA

Equal Credit Opportunity Act

EFSF

European Financial Stability Facility

EM

Emerging Market

EMBI+

Emerging Markets Bond Index Plus

EME

Emerging Market Economy

ERISA

Employee Retirement Income Security Act

ESM

European Stability Mechanism

ESMA

European Securities and Markets Administration

ETF

Exchange-Traded Fund

ETN

Exchange-Traded Note

ETP

Exchange-Traded Product

ETV

Exchange-Traded Vehicle

EU

European Union

EURIBOR

Euro Interbank Offered Rate

FASB

Financial Accounting Standards Board

FBO

Foreign Banking Organization

Abbreviations

157

FCA
FDIC

Federal Deposit Insurance Corporation

Federal Reserve

Board of Governors of the Federal Reserve System

FFIEC

Federal Financial Institutions Examination Council

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

FMI

Financial Market Infrastructure

FMU

Financial Market Utility

FOIA

Freedom of Information Act

FOMC

Federal Open Market Committee

FRBNY

Federal Reserve Bank of New York

FSA

Financial Services Authority

FSB

Financial Stability Board

FSC

Financial Stability Committee (IAIS)

FSOC

Financial Stability Oversight Council

FX

Foreign Exchange

G-20

The Group of Twenty Finance Ministers and Central Bank Governors

G-SIB

Global Systemically Important Bank

G-SIFI

Global Systemically Important Financial Institution

G-SII

158

Farm Credit Administration

Global Systemically Important Insurer

2 0 1 3 F S O C / / Annual Report

GAAP

Generally Accepted Accounting Principles

GASB

Governmental Accounting Standards Board

GCF

General Collateral Finance

GDP

Gross Domestic Product

GS

Goldman Sachs

GSE

Government-Sponsored Enterprise

HAMP

Home Affordable Modification Program

HARP

Home Affordable Refinance Program

HHF

Hardest Hit Fund

HOEPA

Home Ownership and Equity Protection Act

HPML

Higher-Priced Mortgage Loan

HQLA

High-Quality Liquid Asset

HTM

Held-to-Maturity

HUD

U.S. Department of Housing and Urban Development

IAIG

Internationally Active Insurance Group

IAIS

International Association of Insurance Supervisors

ICE

IntercontinentalExchange

ICI

Investment Company Institute

IHC

Intermediate Holding Company

IMF

International Monetary Fund

IOSCO

International Organization of Securities Commissions

IPO

Initial Public Offering

IRD

Interest Rate Derivative

ISDA

International Swaps and Derivatives Association

Abbreviations

159

JGB
JPM

JPMorgan Chase

KBW

Keefe, Bruyette & Woods

LCR

Liquidity Coverage Ratio

LEI

Legal Entity Identifier

LIBOR

London Interbank Offered Rate

LISCC

Large Institution Supervision Coordinating Committee

LOU

Local Operating Unit

LSAPs

Large-Scale Asset Purchases

LTV

Loan-to-Value Ratio

MBR

Minimum Balance at Risk

MBS

Mortgage-Backed Security

MBSD

Mortgage-Backed Securities Division

MHA

Making Home Affordable Program

MMF

Money Market Mutual Fund

MOVE

Merrill Lynch Option Volatility Estimate

MS

Morgan Stanley

MSP

Major Swap Participant

NAIC

National Association of Insurance Commissioners

NASDAQ

NASDAQ Stock Market

NAV

Net Asset Value

NBER

National Bureau of Economic Research

NCUA

National Credit Union Administration

NFIB

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Japanese Government Bond

National Federation of Independent Business

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NIM

Net Interest Margin

NMDB

National Mortgage Database

NPR

Notice of Proposed Rulemaking

NYSE

New York Stock Exchange

OAS

Option-Adjusted Spread

OCC

Office of the Comptroller of the Currency

OFR

Office of Financial Research

OIS

Overnight Index Swap

OLA

Orderly Liquidation Authority

OMB

Office of Management and Budget

OMO

Open Market Operation

OMT

Outright Monetary Transactions

OPEC

Organization of Petroleum Exporting Countries

OptionsCC

Options Clearing Corporation

ORSA

Own Risk and Solvency Assessment

OTC

Over-the-Counter

OTS

Office of Thrift Supervision

P/B

Price-to-Book

P/E

Price-to-Earnings

PBGC

Pension Benefit Guaranty Corporation

PCE

Personal Consumption Expenditures

PFMI

Principles for Financial Market Infrastructures

PIK

Payment-In-Kind

PSPAs

Preferred Stock Purchase Agreements

Abbreviations

161

PVP
Q4/Q4

Fourth Quarter over Fourth Quarter

QFC

Qualified Financial Contract

QIS

Quantitative Impact Study

QM

Qualified Mortgage

QRM

Qualified Residential Mortgage

REIT

Real Estate Investment Trust

Repo

Repurchase Agreement

RMBS

Residential Mortgage-Backed Security

ROA

Return on Assets

ROC

Regulatory Oversight Committee

RWA

Risk-Weighted Assets

S&P

Standard & Poor’s

SCAP

Supervisory Capital Assessment Program

SCOOS

Senior Credit Officer Opinion Survey on Dealer Financing Terms

SDR

Swap Data Repository

SEC

Securities and Exchange Commission

SES

Systemic Expected Shortfall

SIFI

Systemically Important Financial Institution

SIFMA

Securities Industry and Financial Markets Association

SLHC

Savings and Loan Holding Company

SLOOS

Senior Loan Officer Opinion Survey on Bank Lending Practices

SMOVE

Merrill Lynch Swaption Volatility Estimate

SRC

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Payment-versus-Payment

Systemic Risk Committee

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SSM

Single Supervisory Mechanism

STIF

Short-Term Investment Fund

STRIPS

Separate Trading of Registered Interest and Principal Securities

TAG

Transaction Account Guarantee

TALF

Term Asset-Backed Securities Loan Facility

TBA

To Be Announced

TIBOR

Tokyo Interbank Offered Rate

TLGP

Temporary Liquidity Guarantee Program

USD

U.S. Dollar

USDA

U.S. Department of Agriculture

UPI

Universal Product Identifier

USI

Unique Swap Identifier

VA

U.S. Department of Veterans Affairs

WAL

Weighted Average Life

WAM

Weighted Average Maturity

WFC

Wells Fargo Company

WGMR

Working Group on Margin Requirements

WTI

West Texas Intermediate

Abbreviations

163

Glossary
Adjustable-Rate Mortgage (ARM)

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 Paper

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

(ABCP)

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

Asset-Backed Security (ABS)

A fixed income or other security that is collateralized by any type
of self-liquidating financial asset that allows the holder of the
security to receive payments that depend primarily on cash flows
from the assets.

Available-for-Sale (AFS)

An accounting term for debt and equity securities that are
accounted for at fair value on firms’ balance sheets and are not
classified as trading securities or as held-to-maturity securities.
Changes in fair value for AFS securities are recognized
in stockholders’ equity as part of accumulated other
comprehensive income.

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.

Bank for International

An international financial organization that serves central banks

Settlements (BIS)

in their pursuit of monetary and financial stability, to foster
international cooperation in those areas, and that acts as a bank
for central banks. The BIS hosts the secretariat of the Basel
Committeee on Banking Supervision (BCBS), the Committee on
the Global Financial System (CGFS), the Committee on Payment
and Settlement Systems (CPSS), the Markets Committee, the
Central Bank Governance Group, and the Irving Fisher Committee
on Central Bank Statistics. Other secretariats operating out
of the BIS, but not reporting directly to the BIS or its member
central banks, are those of the Financial Stability Board (FSB),
the International Association of Deposit Insurers, and the
International Association of Insurance Supervisors (IAIS).

Glossary

165

Basel Committee on Banking

An international forum for the cooperation of bank supervisors

Supervision (BCBS)

that aims to improve banking supervision worldwide. The
BCBS develops guidelines and supervisory standards, such as
standards on capital adequacy, the core principles for effective
banking supervision, and the Concordat on cross-border banking
supervision. Following the financial crisis, the BCBS developed
new global capital and liquidity standards for the banking system
that are collectively referred to as Basel III.

Broker-Dealer

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

Central Counterparty (CCP)

An entity that interposes itself between counterparties to
contracts traded in one or more financial markets, becoming the
buyer to every seller and the seller to every buyer and thereby
ensuring the performance of open contracts.

Clearing Bank

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

Clearing House

An entity through which financial institutions agree to
exchange payment instructions or other financial obligations
(e.g., securities). The institutions settle for items exchanged
at a designated time based on the rules and procedures of
the clearing house. In some cases, the clearing house may
assume significant counterparty, financial, or risk management
responsibilities for the clearing system. Where a clearing house
interposes itself between the initial participants to a bilateral
transaction, and becomes the buyer to every seller and the seller
to every buyer, it is known as a Central Counterparty (CCP).

Collateralized Mortgage

An obligation of a bankruptcy remote special purpose vehicle with

Obligation (CMO)

claims to specific cash flows from a pool of mortgage-backed
securities (MBS). The streams of principal and interest payments
on the MBS underlying loans are distributed to the different
classes of CMO interests, known as tranches, according to a deal
structure. Each tranche may have different principal balances,
coupon rates, prepayment risks, and maturity dates.

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.

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Commercial Mortgage-Backed

A security that is collateralized by a pool of commercial mortgage

Security (CMBS)

loans and makes payments derived from the interest and principal
payments on the underlying mortgage loans.

Commercial Paper (CP)

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

Committee on the Global

A committee comprised of senior officials of participating central

Financial System (CGFS)

banks that monitors developments in global financial markets
to identify and assess potential sources of stress, to further
the understanding of the structural underpinnings of financial
markets, and to promote improvements to the functioning and
stability of these markets. The CGFS fulfills this mandate by way
of regular monitoring discussions among CGFS members, through
coordinated longer-term efforts, including working groups
involving central bank staff, and through the various reports that
the CGFS publishes. The CGFS also oversees the collection of the
Bank for International Settlements’ (BIS) international banking
and financial statistics.

Committee on Payment and

A standard-setting body for payment, clearing and securities

Settlement Systems (CPSS)

settlement systems. The CPSS also serves as a forum for central
banks to monitor and analyze developments in domestic payment,
clearing, and settlement systems as well as in cross-border and
multicurrency settlement schemes.

Comprehensive Capital Analysis

An annual exercise by the Federal Reserve to ensure that

and Review (CCAR)

institutions have robust, forward-looking capital planning
processes that account for their unique risks and sufficient
capital to continue operations throughout times of economic and
financial stress.

Convexity Event Risk

Risk that an initial increase in long-term interest rates can be
significantly amplified by many MBS investors actively hedging
the duration of their MBS. Convexity events can result in rapid
changes in long-term interest rates, sharp increases in interest
rate volatility, and reduced liquidity in fixed income markets. See
Duration Hedging

Core Deposits

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

Credit Default Swap (CDS)

A financial 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.

Glossary

167

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 (NRSROs),
the largest of which are Fitch Ratings, Moody’s Investors Service,
and Standard & Poor’s.

Credit Union (CU)

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.

Deed-in-Lieu-of-Foreclosure

A document that transfers the right of ownership in a property
from a borrower-in-default to the mortgage lender in order to
avoid foreclosure proceedings.

Defined Benefit (DB) Plan

A retirement plan in which the cost to the employer is based on a
predetermined formula to calculate the amount of a participant’s
future benefit. In DB plans, the investment risk is borne by the
plan sponsor.

Defined Contribution (DC) Plan

A retirement plan in which the cost to the employer is limited to
the specified annual contribution. In DC plans, the investment risk
is borne by the plan participant.

Depository Institution

A financial institution that is legally permitted to accept deposits.
Examples of 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.

Duration

The sensitivity of the prices of bonds and other fixed income
securities to changes in the level of interest rates.

Duration Hedging

A process of dynamically changing portfolio allocation to fixed
income instruments—such as Treasury securities or futures, or
interest rate swaps or swaptions—so as to limit fluctuation of the
portfolio interest rate duration.

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European Financial Stability

A European intergovernmental crisis-financing facility that was

Facility (EFSF)

activated in May 2010. The EFSF’s mandate is to safeguard
financial stability in Europe by providing financial assistance
to euro area member states by issuing bonds or other debt
instruments and lending the proceeds to countries within the
framework of a macroeconomic adjustment program. Since the
creation of the European Stability Mechanism (ESM), the EFSF
is no longer the main mechanism for financing new programs,
though it continues operating ongoing programs for Greece,
Portugal, and Ireland.

European Stability Mechanism

A European intergovernmental crisis-financing facility that was

(ESM)

activated in October 2012, following ratification of an amendment
to the EU treaties. The ESM is authorized to provide assistance
through: direct lending to sovereigns (including on a precautionary
basis); purchases in the secondary government debt markets;
and (once the EU’s Single Supervisory Mechanism (SSM) has
been established) direct lending to financial institutions. All
lending decisions must be approved by unanimous agreement by
creditor states, and borrowers must be under a macroeconomic
adjustment program or policy conditionality program approved by
creditors and (in some cases) the IMF.

Federal Financial Institutions

An interagency body that prescribes uniform principles,

Examination Council (FFIEC)

standards, and reporting forms for the federal examination of
financial institutions. The FFIEC makes recommendations to
promote uniformity in the supervision of financial institutions.
Members include the Federal Reserve, FDIC, NCUA, OCC, CFPB,
and a representative of state financial supervisors.

Federal Funds Rate

The interest rate at which depository institutions lend balances
to each other overnight. The Federal Open Market Committee
(FOMC) sets a target level for the overnight federal funds rate,
and the Federal Reserve Bank of New York then uses open
market operations to influence the overnight federal funds rate to
trade around the policy target rate or within the target rate range.

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.

Glossary

169

Financial Market Infrastructure

A multilateral system among participating financial institutions,

(FMI)

including the operator of the system, used for the purposes of
recording, clearing, or settling payments, securities, derivatives,
or other financial transactions. Under the Dodd-Frank Act, certain
FMIs are recognized as Financial Market Utilities (FMUs).

Financial Market Utility (FMU)

A Dodd-Frank defined entity, which, subject to certain exclusions,
is “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.”

Fire Sale

The disorderly liquidation of assets to meet margin requirements
or other urgent cash needs. Such a sudden sell-off drives down
prices, potentially below their intrinsic value, when the quantities
to be sold are large relative to the typical volume of transactions.
Fire sales can be self-reinforcing and lead to additional forced
selling by some market participants that, subsequent to an initial
fire sale and consequent decline in asset prices, may also need to
meet margin or other urgent cash needs.

Fiscal Consolidation

Changes in government policy pertaining to taxes and
spending intended to reduce deficits and slow 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.

Forward

A contract traded over-the-counter to buy or sell an asset in the
future. Most forwards are standardized contracts, but they can be
customized.

Future

A standardized contract traded over exchanges to buy or sell an
asset in the future.

Government-Sponsored

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

Enterprise (GSE)

but that is a privately owned financial institution. Examples
include the Federal National Mortgage Association (Fannie Mae)
and the Federal Home Loan Mortgage Corporation (Freddie Mac).

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.

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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 and
promote financial stability.

Haircut

The discount, represented as a percentage of par or market value,
at which an asset can be pledged as collateral. For example, a
$1,000,000 bond with a 5 percent haircut would collateralize a
$950,000 loan. The purpose of a haircut is to provide a collateral
margin for a secured lender.

Held-to-Maturity (HTM)

An accounting term for debt securities held in portfolio and
accounted for at cost less any impairment, under the proviso that
the company has no intent to sell and it is more likely than not
that it will hold those securities to maturity.

High-Quality Liquid Asset (HQLA)

Assets such as government bonds that are considered eligible as
liquidity buffers in Basel III’s liquidity coverage ratio (LCR). HQLA
should be liquid in markets during times of stress and, ideally, be
central bank eligible.

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

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

Interest Rate Swap

A derivative contract in which two parties swap interest rate cash
flows on a periodic basis, referencing a specified notional amount
for a fixed term. Typically one party will pay a predetermined fixed
rate while the other party will pay a short-term variable reference
rate that resets at specified intervals.

Glossary

171

International Organization of

An international organization that develops, implements, and

Securities Commissions (IOSCO)

promotes adherence to internationally recognized standards
for securities regulation. The member agencies currently
assembled have resolved, through IOSCO’s permanent
structures, to cooperate in developing, implementing, and
promoting adherence to internationally recognized and consistent
standards of regulation, oversight and enforcement in order
to protect investors, maintain fair, efficient, and transparent
markets, and seek to address systemic risks; to enhance
investor protection and promote investor confidence in the
integrity of securities markets, through strengthened information
exchange and cooperation in enforcement against misconduct
and in supervision of markets and market intermediaries; and
to exchange information at both global and regional levels on
their respective experiences in order to assist the development
of markets, strengthen market infrastructure and implement
appropriate regulation.

Large Bank Holding Company

Any bank holding company (BHC) that files the FR Y-9C
Consolidated Financial Statements for Bank Holding Companies.
All BHCs with total consolidated assets of $500 million or more
are required to file. BHCs meeting certain additional criteria
determined by the Federal Reserve may also be required to file
regardless of size.

Large-Scale Asset Purchases

Purchases by the Federal Reserve of securities issued by the U.S.

(LSAPs)

government or securities issued or guaranteed by governmentsponsored agencies (including Fannie Mae, Freddie Mac, Ginnie
Mae, and the Federal Home Loan Banks) in the implementation of
monetary policy.

Legal Entity Identifier (LEI)

A 20-digit alpha-numeric code that connects to key reference
information that enables clear and unique identification of
companies participating in global financial markets. The LEI
system is designed to facilitate many financial stability objectives,
including: improved risk management in firms; better assessment
of microprudential and macroprudential risks; expedition of
orderly resolution; containment of market abuse and financial
fraud; and provision of higher-quality and more accurate financial
data.

Leveraged Buyout

An acquisition of a company financed by a private equity
contribution combined with borrowed funds, with debt comprising
a significant portion of the purchase price.

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Loan-to-Value Ratio (LTV)

The ratio of the amount of a loan to the value of the asset that
the loan funds, typically expressed as a percentage. This is a
key metric when considering the level of collateralization of a
mortgage.

Major Security-Based Swap

A person that is not a security-based swap dealer and maintains

Participant

a substantial position in security-based swaps, creates
substantial counterparty exposure, or is a financial entity that is
highly leveraged and not subject to federal banking capital rules.

Major Swap Participant (MSP)

A person that is not a swap dealer and maintains a substantial
position in swaps, holds outstanding swaps that create
substantial counterparty exposure, or is a highly leveraged
financial entity which is not otherwise subject to capital
requirements.

Mark-to-Market

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

Maturity Gap

The weighted-average time to maturity of financial assets less
the weighted-average time to maturity of liabilities.

Maturity Transformation

An activity 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 model risk can be due to programming
errors, technical errors, data issues, calibration errors, or
conceptual mistakes.

Money Market Mutual Fund

A type of mutual fund that invests in short-term, liquid securities

(MMF)

such as government bills, certificates of deposit, commercial
paper, or repurchase agreements.

Mortgage Servicer

A company that acts as an agent for mortgage holders by
collecting and distributing mortgage cash flows. Mortgage
servicers also manage defaults, modifications, settlements,
foreclosure proceedings, and various notifications of borrowers
and investors.

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.
This term typically applies to mortgage-backed securities issued
or guaranteed by the GSEs; these securities can also be called
“agency MBS.”

Glossary

173

Municipal Bond

A bond issued by states, cities, counties, local governmental
agencies, or certain nongovernment issuers to finance certain
general or project-related activities.

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.

Novation

A process through which one of the original parties in a swap
contract transfers its respective position or liability to another,
unrelated party.

Option

A financial contract granting the holder the right but not the
obligation to engage in a future transaction on an underlying
security or real asset. The most basic examples are an equity
call option, which provides the right but not the obligation to
buy a block of shares at a fixed price for a fixed period, and an
equity put option, which similarly grants the right to sell a block
of shares.

Outright Monetary Transactions

An ECB program under which secondary market purchases of

(OMT)

sovereign bonds can be made, with the aim of safeguarding
appropriate monetary policy transmission and the singleness of
the monetary policy. A necessary condition for OMT is a support
agreement under which the EFSF or ESM program can make
primary market purchases of sovereign debt. Such an agreement
would include a range of policy conditions.

Over-the-Counter (OTC)

A method of trading that does not involve an organized
exchange. In over-the-counter markets, participants trade
directly on a bilateral basis, typically through voice or
computer communication and often with certain standardized
documentation with counterparty-dependent terms.

Prudential Regulation

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

Public Debt

All debt issued by Treasury and the Federal Financing Bank,
including both debt held by the public and debt held in
intergovernmental accounts such as the Social Security Trust
Funds. Not included is debt issued by government agencies other
than the Department of the Treasury.

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Qualified Mortgage (QM)

A mortgage loan that meets certain underwriting criteria
announced by the CFPB. An originator of a Qualified Mortgage is
provided with certain protections from borrower lawsuits alleging
that the originator failed to fulfill its duty under the Dodd-Frank
Act to make a good faith and reasonable determination of the
borrower’s ability to repay the loan.

Qualified Residential Mortgage

A mortgage loan that is exempt from the Dodd-Frank Act’s

(QRM)

securitization risk retention rule requiring securitization issuers to
retain a portion of securitized risk exposure in transactions that
they issue.

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 a higher credit rating assigned
by the same credit rating agency that includes the possibility of
government support.

Real Estate Investment Trust

An operating company that manages income-producing real

(REIT)

estate or real estate-related assets. Certain REITs also operate
real estate properties in which they invest. To qualify as a REIT, a
company must have three-fourths of its assets and gross income
connected to real estate investment and must distribute at least
90 percent of its taxable income to shareholders annually in the
form of dividends.

Receiver

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

Rehypothecation

The reuse of collateral posted by clients of banks or brokerdealers. The collateral is used for securities lending, repurchase
agreements, or as collateral for the bank’s or broker-dealer’s own
borrowing.

Repurchase Agreement (Repo)

The sale of a security combined with an agreement to repurchase
the security, or a similar security, on a specified future date at a
prearranged price. A repo is a secured lending arrangement.

Reserves

Balances held by depository institutions at the central bank plus
vault cash.

Residential Mortgage-Backed

A security that is collateralized by a pool of residential mortgage

Security (RMBS)

loans and makes payments derived from the interest and principal
payments on the underlying mortgage loans.

Glossary

175

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 draw funds 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-weighting of various
asset categories, that a financial institution is required to hold to
protect against unexpected losses.

Risk-Weighted Assets (RWA)

A risk-based concept used as the denominator of risk-based
capital ratios with respect to Basel capital guidelines for banking
organizations. The RWA is a weighted total asset value developed
from assigned risk categories or modeled analysis. Broadly,
total RWA are determined by calculating RWA for market risk
and operational risk and adding the sum of RWA for on-balance
sheet, off-balance sheet, counterparty, and other credit risks.
Details vary, in part, depending upon the version of Basel capital
guidelines to which the banking organization is subject.

Rollover Risk

The risk that as an institution’s debt nears maturity, the
institution may not be able to refinance the existing debt or may
have to refinance at less favorable terms.

Run Risk

The risk that investors lose confidence in an institution—due to
concerns about counterparties, collateral, solvency, or related
issues—and respond by pulling back their funding.

Securities Lending/Borrowing

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, securities representing interests in the pool are
issued, and proceeds from the underlying pooled assets are used
to service and repay securities issued via the securitization.

Security-Based Swap Dealer

A person that holds itself out as a dealer in security-based
swaps, makes a market in security-based swaps, regularly enters
into security-based swaps with counterparties, or engages in
any activity causing it to be known as a dealer or market maker
in security-based swaps; does not include a person entering into
security-based swaps for such person’s own account.

Shadow Banking

Maturity, credit, or liquidity transformation activities conducted by
entities that are not regulated as banks and that unlike banks do
not have access to a lender of last resort or to forms of
liability guarantees.

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Short-Term Wholesale Funding

Short-term funding instruments not covered by deposit insurance
that are typically issued to institutional investors. Examples
include large checkable and time deposits, brokered CDs,
commercial paper, Federal Home Loan Bank borrowings, and
repurchase agreements.

Single Supervisory Mechanism

A proposed European bank supervision framework, under which

(SSM)

the ECB will assume supervisory responsibility for euro area
banks, working in cooperation with national authorities.

Supervisory Capital Assessment

A stress test, conducted from February-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; SCAP was administered by the Federal Reserve, the
OCC, and the FDIC.

Supervisory Information

Generally refers to information consisting of 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 the course of any investigation
or enforcement action. Supervisory information is exempt from
public disclosure.

Swap

An exchange of cash flows with defined terms and over a fixed
period, agreed upon by two parties. A swap contract may
reference underlying financial products across various asset
classes including interest rates, credit, equity, commodity, and
foreign exchange.

Swap Data Repository (SDR)

A person that collects and maintains information or records
with respect to transactions or positions in, or the terms
and conditions of, swaps entered into by third parties for the
purpose of providing a centralized recordkeeping facility for
swaps. In certain jurisdictions, SDRs are referred to as trade
repositories. CPSS-IOSCO describes a trade repository as “an
entity that maintains a centralized electronic record (database) of
transaction data”.

Swap Dealer

A person that holds itself out as a dealer in swaps, makes a
market in swaps, regularly enters into swaps with counterparties,
or engages in any activity causing it to be known as a dealer or
market maker in swaps; does not include a person entering into
swaps for such person’s own account.

Swaption

An option granting the right to enter into a swap. See Option
and Swap.

Glossary

177

TARGET2

The real-time gross settlement system owned and operated
by the Eurosystem. TARGET2 must be used for all payments
involving the Eurosystem, as well as for the settlement of
operations of all large-value net settlement systems and
securities settlement systems handling the euro. Payment
transactions are settled one by one on a continuous basis in
central bank money with immediate finality.

Temporary Liquidity Guarantee

A program implemented in October 2008 (and which expired

Program (TLGP)

in December 2012) by the FDIC through a 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 ABS. TALF was intended
to assist 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 market conditions for ABS more
generally. The program was announced in November 2008. The
facility ceased making loans collateralized by newly issued CMBS
on June 30, 2010, and loans collateralized by all other types of
TALF-eligible newly issued and legacy ABS on March 31, 2010.

Term Premium

The excess compensation to investors for owning long-term
Treasury securities compared to reinvesting short-term securities
continually over time.

Term Spread

The excess yield an investor must receive in order to purchase a
longer-maturity bond over a shorter-maturity bond of the same
issuer.

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

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To-Be-Announced (TBA)

A forward transaction involving a purchase or sale of MBS

Transaction

with settlement occurring in the future, generally a period of
up to three months from the purchase date. TBA transactions
include solely agency-issued or agency-guaranteed MBS. MBS
transacted in the TBA market use a few standardized contracts,
which are grouped based on key characteristics such as the
agency, term, coupon, or settlement date of the MBS security
that will be delivered. At the settlement date, TBA sellers have
the option to deliver any agency MBS that meet the contract
requirements.

Transaction Account Guarantee

The Dodd-Frank Act-provided temporary, unlimited deposit

(TAG) Program

insurance coverage for noninterest-bearing transaction
accounts and IOLTAs (but not low-interest NOW accounts) from
December 31, 2010 through December 31, 2012, regardless of
the balance in the account and the ownership capacity of the
funds. This coverage essentially replaced TAGP, which expired on
December 31, 2010, and was available to all depositors, including
consumers, businesses, and government entities. The coverage
was separate from, and in addition to, the standard insurance
coverage provided for a depositor’s other accounts held at an
FDIC-insured bank.

Tri-Party Repo

A repurchase agreement in which a clearing bank acts as thirdparty agent to provide collateral management services and to
facilitate the exchange of cash against collateral between the two
counterparties.

Underwater Mortgage

A mortgage loan with a higher unpaid principal balance than the
value of the home.

Underwriting Standards

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

Yield Curve

A graphical representation of the relationship between bond
yields and their respective maturities.

Glossary

179

List of Charts
Chart 4.1.1 	

Change in Real Gross Domestic Product....................................................................21

Chart 4.1.2 	 Change in Real Personal Consumption Expenditures...................................................21
Chart 4.1.3 	 Private Housing Starts.............................................................................................22
Chart 4.1.4 	 Net Change in Nonfarm Payroll Employment...............................................................23
Chart 4.1.5 	 Civilian Unemployment Rate.....................................................................................23
Chart 4.1.6 	 Long-Term Unemployment.......................................................................................23
Chart 4.1.7 	 Labor Force Participation Rate.................................................................................24
Chart 4.2.1 	 Financial Ratios for Nonfinancial Corporations.............................................................24
Chart 4.2.2 	 Bank Business Lending Standards and Demand.........................................................24
Chart 4.2.3 	 Nonfinancial Corporate Bond Default Rate..................................................................25
Chart 4.2.4 	 Noncurrent Commercial and Industrial Loans..............................................................25
Chart 4.2.5 	 Noncorporate Assets..............................................................................................25
Chart 4.2.6 	 Net Borrowing by Nonfinancial Noncorporate Businesses.............................................26
Chart 4.2.7 	 Bank Business Lending Standards and Demand.........................................................26
Chart 4.2.8 	 Small Businesses’ Difficulty Obtaining Credit..............................................................26
Chart 4.2.9 	 Household Debt as a Percent of Disposable Personal Income.......................................27
Chart 4.2.10 	 Private Nonfinancial Debt.........................................................................................27
Chart 4.2.11 	 Household Debt Service Ratio..................................................................................27
Chart 4.2.12 	 Share of Household Debt by Delinquency Status.........................................................28
Chart 4.2.13 	 Household and Nonprofit Balance Sheets..................................................................28
Chart 4.2.14 	 Share of Owners’ Equity in Household Real Estate......................................................28
Chart 4.2.15 	 Components of Consumer Credit..............................................................................29
Chart 4.2.16 	 Applications for Credit.............................................................................................29
Chart 4.2.17 	 90+ Day Delinquency Rate by Loan Type..................................................................29
Chart 4.3.1 	 Federal Unified Budget Surplus/Deficit.......................................................................30
Chart 4.3.2 	 Federal Debt Held by the Public as a Percent of GDP..................................................30
Chart 4.3.3 	 Interest Outlays and Average Maturity of U.S. Public Debt............................................31
Chart A.1 	

10-Year Treasury Yield and Corporate Bond Spreads..................................................32

Chart A.2 	

10-Year Treasury Yield and Market Volatility...............................................................33

Chart 4.3.4 	 State and Local Government Tax Revenues...............................................................34
Chart 4.3.5 	 Long-Term Mutual Fund Flows: Municipal Bonds........................................................34
Chart 4.3.6 	 Federal Grants-in-Aid to State and Local Governments................................................34
Chart 4.3.7 	 Total Public Construction Spending...........................................................................35
Chart 4.3.8 	 Municipal Bond Issuance.........................................................................................35
Chart 4.3.9 	 Municipal Tax-Exempt Bond Yield Ratios....................................................................35
Chart 4.4.1 	 Real GDP Growth...................................................................................................36
List of Char ts

181

Chart 4.4.2 	 Advanced Economies Real GDP Growth....................................................................36
Chart 4.4.3 	 Euro Area Real GDP Growth.....................................................................................37
Chart 4.4.4 	 Peripheral Europe: Gross Public Debt........................................................................37
Chart 4.4.5 	 Emerging Market Economies Real GDP Growth..........................................................39
Chart 4.4.6 	 Contribution to World GDP Growth............................................................................39
Chart 4.4.7 	 BRIC and U.S. Inflation Rates...................................................................................39
Chart 4.4.8 	 Inflows to EMEs......................................................................................................40
Chart 4.4.9 	 China Real GDP Growth...........................................................................................41
Chart 4.4.10 	 China: Annual Increases in Credit and GDP................................................................41
Chart 5.1.1 	

Treasury Yields.......................................................................................................43

Chart 5.1.2 	 Slope of the Treasury Yield Curve.............................................................................43
Chart 5.1.3 	 Realized and Implied Interest Rate Volatility............................................................... 44
Chart 5.1.4 	 Implied Volatility..................................................................................................... 44
Chart 5.1.5 	 U.S. Corporate Bond Spreads – Investment Grade..................................................... 44
Chart 5.1.6 	 U.S. Corporate Bond Issuance.................................................................................45
Chart 5.1.7 	 High-Yield Bonds: Issuance and Market Size..............................................................45
Chart 5.1.8 	 Institutional Loans: Issuance and Market Size.............................................................45
Chart 5.1.9 	 CLOs: Issuance and Market Size...............................................................................46
Chart 5.1.10 	 Agency MBS Spreads to Treasuries..........................................................................46
Chart 5.1.11 	 Publically Held Federal Debt Outstanding...................................................................47
Chart 5.1.12 	 Foreign Holders of U.S. Federal Debt........................................................................47
Chart 5.1.13 	 Euro Area 10-Year Yield Spreads to German Debt.......................................................50
Chart 5.1.14 	 Emerging Market Bond Spreads...............................................................................51
Chart 5.1.15 	 Dollar Index Volatility...............................................................................................52
Chart 5.1.16 	 Currency Implied Volatility........................................................................................52
Chart 5.1.17 	 U.S. Dollar Exchange Rates......................................................................................52
Chart 5.1.18 	 Returns in Selected Equities Indices..........................................................................53
Chart 5.1.19 	 S&P 500 Key Ratios...............................................................................................53
Chart 5.1.20 	 Selected Equities Indices.........................................................................................53
Chart 5.1.21 	 Market Volatility......................................................................................................54
Chart 5.1.22 	 VIX Term Premium..................................................................................................54
Chart 5.1.23 	 Oil Production........................................................................................................54
Chart 5.1.24	 S&P GSCI Unleaded Gasoline Index..........................................................................55
Chart 5.1.25 	Commodities..........................................................................................................55
Chart 5.1.26 	 Gold Prices............................................................................................................55
Chart 5.1.27 	 Farmland Prices and Value of Crop Yield....................................................................56
Chart 5.1.28 	 Agricultural Prices...................................................................................................56
Chart 5.1.29 	 Agricultural Real Estate Debt Outstanding..................................................................56
Chart 5.1.30 	 National Repeat Sales Home Price Indices.................................................................57
Chart 5.1.31 	 Mortgages with Negative Equity................................................................................57

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Chart 5.1.32 	 Mortgage Delinquency and Foreclosure.....................................................................57
Chart 5.1.33 	 Mortgage Originations by Program............................................................................58
Chart 5.1.34 	 Mortgage Servicing Rights at U.S. Commercial Banks and Thrifts.................................58
Chart 5.1.35 	 Mortgage Originations by Type.................................................................................58
Chart 5.1.36 	 Origination Volume by Credit Score...........................................................................59
Chart 5.1.37 	 Average Debt-to-Income Ratio at Origination..............................................................59
Chart 5.1.38 	 Minimum Eligibility Standards for Government Purchase Loans.....................................59
Chart 5.1.39 	 GSE Net Income.....................................................................................................61
Chart 5.1.40	 Issuance of RMBS..................................................................................................61
Chart 5.1.41 	 CMBS New Issuance...............................................................................................63
Chart 5.1.42 	 CMBS Senior Debt Spreads.....................................................................................63
Chart 5.1.43 	 CRE Refinancing.....................................................................................................63
Chart 5.1.44 	 Commercial Property Price Indices...........................................................................64
Chart 5.2.1 	 Large Bank Holding Company Liability Structure.........................................................64
Chart 5.2.2 	 Wholesale Cash Investors........................................................................................64
Chart 5.2.3 	 Composition of Bank Short-Term Funding..................................................................65
Chart 5.2.4 	 Premium for Borrowing Dollars for 1 Year..................................................................65
Chart 5.2.5 	 Commercial Paper Outstanding................................................................................65
Chart 5.2.6 	 Value of the Repo Market........................................................................................66
Chart 5.2.7 	 Primary Dealer Repo Agreements.............................................................................66
Chart 5.2.8 	 Tri-Party Repo Collateral Distribution.........................................................................66
Chart 5.2.9 	 Securities Lending Loans by Industry........................................................................67
Chart 5.2.10 	 Value of Securities on Loan......................................................................................67
Chart 5.2.11 	 Securities Lending Cash Reinvestment......................................................................67
Chart 5.3.1 	 Aggregate BHC Pre-Tax Income...............................................................................69
Chart 5.3.2 	 Return on Average Assets for BHCs > $10B..............................................................69
Chart 5.3.3 	 Net Interest Margins for BHCs > $10B......................................................................69
Chart 5.3.4 	 Maturity Gap at Large Banks....................................................................................70
Chart 5.3.5 	 Maturity Gap at Small Banks....................................................................................70
Chart 5.3.6 	 KBW Bank Index and Implied Volatility.......................................................................72
Chart 5.3.7 	 Average P/B and P/E Ratios of 6 Large Complex BHCs...............................................72
Chart 5.3.8 	 CDS Spreads of 6 Large Complex BHCs...................................................................72
Chart 5.3.9 	 Systemic Risk Measures..........................................................................................73
Chart 5.3.10 	 Change in Tier 1 Common Ratios for Aggregate U.S. BHCs.........................................73
Chart 5.3.11 	 Consolidated Liquidity Ratio* for Top 50 BHCs...........................................................73
Chart 5.3.12 	 Non-Core Funding* Relative to Liquid Assets**...........................................................74
Chart 5.3.13 	 Nonperforming Loans (30-89 Days)..........................................................................74
Chart 5.3.14 	 Nonperforming Loans (90+ Days and Nonaccrual).....................................................74
Chart 5.3.15 	 Allowance for Loan/Lease Losses as a Multiple of Charge-offs.....................................75
Chart 5.3.16 	 U.S. Unemployment Rate: Actual vs. Stress Scenarios................................................75

List of Char ts

183

Chart 5.3.17 	 Initial and Stressed Tier 1 Common Capital Ratios......................................................76
Chart 5.3.18 	 FDIC-Insured Failed Institutions.................................................................................76
Chart 5.3.19 	 Commercial Bank and Thrift Pre-Tax Income..............................................................77
Chart 5.3.20 	 Net Charge-offs and Noncurrent Loans.....................................................................77
Chart 5.3.21 	 Risk-Weighted Assets and Return on Assets..............................................................77
Chart 5.3.22 	 Concentration of Credit Union Assets........................................................................78
Chart 5.3.23 	 Federally Insured Credit Union Income.......................................................................78
Chart 5.3.24 	 Credit Union Deposits..............................................................................................79
Chart 5.3.25 	 U.S. Branches and Agencies of Foreign Banks: Assets................................................79
Chart 5.3.26 	 U.S. Branches and Agencies of Foreign Banks: Liabilities.............................................80
Chart 5.4.1 	 Broker-Dealer Revenues..........................................................................................82
Chart 5.4.2 	 Broker-Dealer Assets and Leverage..........................................................................82
Chart 5.4.3 	 Primary Dealer Securities........................................................................................82
Chart 5.4.4 	 Life and Other Insurance: Capital and Net Income.......................................................83
Chart 5.4.5 	 Life Insurers: Impact of Low Rate Environment............................................................83
Chart 5.4.6 	 Property and Casualty Insurance: Capital and Net Income............................................85
Chart 5.4.7 	 Consumer Loans Outstanding..................................................................................87
Chart 5.4.8 	 Business Loans Outstanding....................................................................................87
Chart 5.4.9 	 ABS Issuance........................................................................................................87
Chart C.1 	

Convexity Risk........................................................................................................88

Chart C.2 	

Outstanding Agency MBS by Holders........................................................................89

Chart C.3 	

2003 Convexity Event.............................................................................................89

Chart 5.4.10 	 Selected ABS Spreads............................................................................................90
Chart 5.4.11 	 Total Agency REIT Assets........................................................................................90
Chart 5.4.12 	 Agency REITs: Return on Assets...............................................................................90
Chart 5.5.1 	 MMF Assets by Fund Type.......................................................................................91
Chart 5.5.2 	 Prime Funds Liquidity..............................................................................................92
Chart 5.5.3 	 MMF Weighted Average Life*...................................................................................92
Chart 5.5.4 	 Total Assets of Mutual Funds....................................................................................94
Chart 5.5.5 	 Mutual Fund Flows by Asset Class (Mar-2012 to Feb-2013).........................................94
Chart 5.5.6 	 Mutual Fund Taxable Bond Flows (Mar-2012 to Feb-2013)..........................................94
Chart 5.5.7 	 Annual Net Worldwide Fund Flows............................................................................95
Chart 5.5.8 	 Mutual Fund Holdings.............................................................................................95
Chart 5.5.9 	 Retirement Fund Assets by Plan Type........................................................................95
Chart 5.5.10 	 Public and Private Pension Funding Level...................................................................96
Chart 5.5.11 	 U.S. Private Equity AUM..........................................................................................96
Chart 5.5.12 	 U.S. Private Equity AUM by Strategy.........................................................................96
Chart 5.5.13 	 Change in Hedge Fund AUM....................................................................................97
Chart 5.5.14 	 Hedge Fund Assets and Net Asset Flows...................................................................97
Chart 5.5.15 	 Hedge Fund Net Asset Flows by AUM.......................................................................97

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Chart 5.5.16 	 Hedge Fund Performance by Strategy.......................................................................98
Chart 5.5.17 	 ETP Net Assets by Product Type...............................................................................98
Chart 5.5.18 	 ETP Net Flows by Product Type................................................................................98
Chart 5.6.1 	 Global OTC Derivatives Market...............................................................................101
Chart 5.6.2 	 Global Exchange-Traded Derivatives........................................................................101
Chart 5.6.3 	 Global OTC and Exchange-Traded Derivatives Growth................................................102
Chart 5.6.4 	 Exchange-Traded Derivatives Globalization...............................................................102
Chart 5.6.5 	 Credit Derivatives Market.......................................................................................103
Chart 5.6.6 	 Interest Rate Derivatives Market..............................................................................103
Chart 5.6.7 	 Notional Amounts Outstanding on CCPs by Asset Class.............................................104
Chart 5.6.8 	 SwapClear Volume................................................................................................105
Chart 5.6.9 	 ICE Clear Credit....................................................................................................105
Chart 5.6.10 	 ICE Clear Europe..................................................................................................105
Chart D.1 	

Outstanding Amounts of Marketable Potentially Safe Assets.......................................108

Chart D.2 	

Compilation of Potential Impact on Global Eligible Collateral........................................108

Chart 7.1.1 	

Total MMF Repo Holdings......................................................................................134

Chart 7.1.2 	

Repo Funding by MMFs.........................................................................................134

Chart 7.4.1 	

Historical Bond Yields............................................................................................142

Chart 7.4.2 	 Federal Fund Rate................................................................................................142
Chart 7.4.3 	 Interest Rate Risk Premium Indicators......................................................................143
Chart 7.4.4 	 Historical Credit Spreads........................................................................................143
Chart 7.6.1 	

Moody’s BHC Systemic Support Uplift.....................................................................146

Chart 7.6.2 	 Number and Distribution of Subsidiaries: Selected Top 50 BHCs................................146
Chart 7.6.3 	 BHC Subsidiaries by Industry.................................................................................146
Chart G.1 	

Asset Shares of U.S. Financial Institutions................................................................148

Chart G.2 	

Asset Shares of the Top 10 U.S. Financial Institutions................................................149

List of Char ts

185

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Endnotes
1

See FSOC (2012).

2

See SEC (2012).

3

See FSB (2013).

4

See, Daly, Hobijn, Sahin, and Valletta (2012).

5
The extraordinary measures available were (1) suspending sales of State and Local Government
Series Treasury securities; (2) redeeming existing, and suspending new, investments of the Civil
Service Retirement and Disability Fund and the Postal Service Retirees health Benefit Fund; (3) suspending reinvestment of the Government Securities Investment Fund and (4) suspending reinvestment of the Exchange Stabilization fund. In total, these measures would have freed up about $200
billion in headroom under the debt ceiling.
6
Tri-party transactions are used to enable cash transactions against general collateral, and activity
in this market is reported to the Federal Reserve Bank of New York. GCF repo is administered by
the Fixed Income Clearing Corporation, which also provides aggregate data on outstandings. Data
on bilateral repo transactions, which are typically used to obtain specific collateral, negotiate certain
non-price terms, or enable firms to transact with counterparties who are not in the tri-party market,
are not systematically collected. However, bilateral repo transactions conducted by primary dealers
are reported in the aggregate with GCF and tri-party repo in the Federal Reserve Bank of New York’s
FR2004 Primary Dealer survey.
7
See the Federal Reserve’s December 2012 Senior Credit Officer Opinion Survey on Dealer
Financing Terms for additional evidence at http://www.federalreserve.gov/econresdata/releases/
SCOOS_201212.htm.
8
The estimation methodology is based on that described in English, Van den Heuvel, and Zakrajšek
(2012).
9
The figure represents the evolution of three normalized systemic risk measures averaged across
JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley.
Conditional Value-at-Risk (CoVaR) measures the contribution of each institution to overall systemic risk from the market value of total assets. The Distress Insurance premium (DIP) measures a
hypothetical CDS implied insurance premium to protect institutions from a systemic event. Systemic
Expected Shortfall (SES) is the equity shortfall contingent on market stress. CoVaR is by Adrian and
Brunnermeier (2011); DIP is by Huang, Zhu, and Zhou (2009); and SES is by Acharya, Pedersen,
Philippon, Richardson (2010).
10
The federal government’s response to the financial crisis included the FDIC’s Temporary Liquidity Guarantee Program (TLGP). The Transaction Account Guarantee (TAG) portion of the TLGP
guaranteed deposits in noninterest-bearing transaction accounts of participating insured depository institutions. The TAG expired on December 31, 2010. Under the other portion of the TLGP, the
Debt Guarantee Program, the FDIC guaranteed newly issued senior unsecured debt of participating
insured depository institutions, their holding companies, and certain affiliates. This guarantee expired
on December 31, 2012. Section 343 of the Dodd-Frank Act, which provided unlimited deposit and
share insurance coverage for noninterest-bearing transaction accounts for all insured depository
institutions beginning December 31, 2010, expired on December 31, 2012.
11

See BCBS/CPSS (2013).

12

See ISDA (2012a).

13

See CPSS/IOSCO (2012a).

14

See CPSS/IOSCO (2012b).

15

See Payment Risk Committee (2013).

16

See ISDA (2012b).

17

See SEC (2013).
E n d n o te s

187

In 2012, the Council met on February 1, April 3, May 22, June 11, July 18, September 28, October 18, October 29, October 30, November 13, December 3, and December 13.

18

19

In 2012, the Council held public sessions on April 3, July 18, and November 13.

20
The Council’s Freedom of Information Act regulation and its transparency policy are available at
www.fsoc.gov.
21

See SEC (2012).

22
LIBOR comprises a set of unsecured lending rates for commercial banks based in London, with
published rates for different currencies and tenors, ranging from overnight through twelve months.
Every business day shortly before 11 a.m. London time, banks on the LIBOR panel submit the rates
at which they could borrow funds “by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.” A trimmed averaging process is used to exclude the top and
bottom quartile of the rates submitted, and the remaining rates are averaged for each tenor. That
average rate becomes the official daily LIBOR.
23
Among other things, the banks were required to (1) make their submissions based on certain
specified factors, with their own transactions given the greatest weight; (2) implement firewalls to
prevent improper communications, including between traders and submitters; (3) prepare and retain
documents concerning submissions, and retain relevant communications; (4) implement auditing,
monitoring and training measures concerning their submissions and related processes; (5) make
regular reports to regulators concerning compliance with the obligations under the respective
orders; and (6) use best efforts to encourage the development of rigorous standards for benchmark
interest rates.
24

See BBA (2012).

25

See FSA (2013).

26

CPSS/IOSCO (2013).

27

BIS (2013).

28
The term premium estimate is computed by the Federal Reserve Bank of New York based on the
methodology of Adrian, Crump, and Moench (2013).
29
The Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS) provides additional
information on underwriting standards in broker-dealer intermediated credit markets and recent
special questions have included CLOs, see http://www.federalreserve.gov/econresdata/releases/
scoos.htm.
30
The underlying data for Charts 7.6.2 and 7.6.3 is described in more detail in Avraham, Selvaggi,
and Vickery (2012).
31
Assets include consolidated assets of U.S.-chartered bank holding companies (BHCs), savings
and loan holding companies (SLHCs); federally insured depository institutions (excluding credit
unions) not held by a BHC or SLHC; and U.S.-domiciled affiliates (including nonbanking affiliates),
branches, and agencies of FBOs. The denominators used for assets are merger-adjusted in the
pre-crisis years to reflect the BHC charters that were granted to former nonbanks during the financial crisis (and thus drew in substantial aggregate assets and deposits to be included in the share
calculations).
32
This restriction is a provision of the Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994.
33
Dodd-Frank Act Section 604(d), which covers acquisitions of banking organizations, requires that
the Federal Reserve “take into consideration the extent to which a proposed acquisition, merger, or
consolidation would result in greater or more concentrated risks to the stability of the United States
banking or financial system.” Dodd-Frank Act Section 604(e), which covers nonbank acquisitions by
bank holding companies, adds “risk to the stability of the United States banking or financial system”
as a factor to be considered in the balancing test that the Federal Reserve is required to conduct.
Dodd-Frank Act Section 163(b), which governs the acquisition of voting shares of a nonbank company with assets over $10 billion or more by a bank holding company with assets over $50 billion or
more, states that the Federal Reserve “shall consider the extent to which the proposed acquisition
would result in greater or more concentrated risks to global or United States financial stability or the
United States economy.”

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34
Dodd-Frank Act Section 604(f), which covers Bank Merger Act transactions, adds “risk to the stability of the United States banking or financial system” as a factor to be considered by the appropriate federal banking agency.
35

See Federal Reserve System (2012).

E n d n o te s

189