The Financial Stability Oversight Council issued its "2011 Annual Report" yesterday, saying, "On the heels of the first anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Financial Stability Oversight Council released its 2011 Annual Report. The report -- the first of its kind issued by the U.S. government -– was produced collaboratively by the members of the Council and their staff, and unanimously approved by the Council. Under the Dodd-Frank Act, the Council must report annually to Congress on a range of issues, including the activities of the Council; significant financial market and regulatory developments; and potential emerging threats to the financial stability of the United States. The report must also make recommendations for promoting market discipline; maintaining investor confidence; and enhancing the integrity, efficiency, competitiveness, and stability of U.S. financial markets."
FSOC Chairman and Treasury Secretary Tim Geithner comments, "The most important thing we can do right now to safeguard financial stability is lift the cloud of default hanging over our economy. As we move forward, however, we must also work to ensure that our regulatory framework keeps pace with the evolving global financial system. This report provides key recommendations that will build on the progress we've made through the Dodd-Frank Act and further strengthen the resilience of the financial markets and our economy."
Under the section "Financial Developments," the report says, "Assets have grown at insured depository institutions relative to other financial institutions since the crisis, following a long period in which financial activities moved from banks to markets. In particular, money market fund assets declined as investors transferred significant funds into insured bank deposits during the crisis. At the same time, the crisis reinforced the trend toward concentration and globalization in the banking industry, and foreign banking organizations have expanded their activities in the United States in recent years."
Regarding "Potential Emerging Threats to U.S. Financial Stability," the FSOC writes, "There is significant market uncertainty in Europe, notably associated with the sovereign credit risk of Greece, Ireland, and Portugal. U.S. financial institutions have very limited net direct exposure to these three countries. They have larger exposure and important ties to major financial institutions elsewhere in Europe that in turn have large exposures to Greece, Ireland, and Portugal. Some major European banks obtain substantial short-term wholesale U.S. dollar funding from U.S. money market funds. Further, money market funds remain an important supplier of cash to the tri-party repo market. Structural vulnerabilities in money market funds and tri-party repo amplified a number of shocks in the financial crisis. Reforms undertaken since the crisis have improved resilience, and money market funds report de minimis exposure to Greece, Ireland, and Portugal; however, amplification of a shock through these channels is still possible."
The report adds, "The Council recommends reforms to address structural vulnerabilities in the tri-party repo market, for money market mutual funds, and in mortgage servicing: Elimination of most intraday credit exposure and reform of collateral practices in the tri-party repo market to strengthen the market. Given the vital importance and size of tri-party repo financing and the broad array of financial institutions active in this market, the regulatory community should exert its supervisory authority over the industry's reform efforts to ensure that the Tri-Party Repo Infrastructure Reform Task Force meets its commitments as promptly as possible. The Task Force's efforts should ultimately improve market functioning, but several important structural reform issues require coordinated supervisory and regulatory attention. Chief among these priorities are enhancing dealer liquidity risk management practices, alleviating the propensity of cash investors to withdraw funding and exit the market when risk surfaces, and implementing mechanisms to manage a potential dealer default. The fragility of broader market liquidity facilities and the constraints on the types of collateral that certain investors are prepared to take (particularly money market funds) heightens the risk of contagion in the market. Reform efforts should practically eliminate intraday credit exposures of clearing banks to borrowers and strengthen collateral management practices to improve the stability of this critical short term funding market."
The Council also recommends, "[I]mplement[ing] structural reforms to mitigate run risk in money market funds. When the SEC adopted new rules for money market funds (MMFs) in February 2010, it noted that a number of features still make MMFs susceptible to runs and should be addressed to mitigate vulnerabilities in this market. To increase stability, market discipline, and investor confidence in the MMF market by improving the market's functioning and resilience, the Council should examine, and the SEC should continue to pursue, further reform alternatives to reduce MMFs' susceptibility to runs, with a particular emphasis on (1) a mandatory floating net asset value (NAV), (2) capital buffers to absorb fund losses to sustain a stable NAV, and (3) deterrents to redemption, paired with capital buffers, to mitigate investor runs."
FSOC also writes, "While there have been a number of bank, thrift, and credit union failures -- including several high-profile failures or near-failures of large complex financial institutions -- the FDIC and the NCUA were able to prevent any disruptions in retail payments and transaction services as a result of the failure, or fear of failure, of an insured depository institution. In contrast, certain parts of the financial system, such as prime money market funds, experienced the equivalent of a bank run in late 2008 [see report for chart]. The Transaction Account Guarantee Program (TAGP) brought stability and confidence to deposit accounts that are commonly used for payroll and other business transaction purposes. Through the TAGP, the FDIC guaranteed, for a fee, noninterest-bearing transaction accounts held at participating insured depository institutions.... The Dodd-Frank Act replaced TAGP with a provision mandating unlimited deposit insurance coverage without a separate fee through December 2012 for certain noninterest-bearing accounts at all insured depository institutions."
Under a section on "Guarantee Support," the report explains, "Temporary programs to guarantee deposits, unsecured bank debt, and investor assets in money market mutual funds helped stabilize investor confidence. In October 2008, at the peak of the financial crisis, the FDIC introduced the Temporary Liquidity Guarantee Program (TLGP). In addition to the Transaction Account Guarantee Program, the TLGP guaranteed, for a fee, unsecured debt with a term of up to three years issued by financial entities participating in its Debt Guarantee Program (DGP). The issuance of new guaranteed debt expired on October 31, 2009, and the guarantee on outstanding debt expires on December 31, 2012.... At the peak of the TLGP, the FDIC guaranteed almost $350 billion of debt outstanding. As of June 30, 2011, the total amount of remaining FDIC-guaranteed debt outstanding was $236.9 billion, of which $70.7 billion will mature in 2011 and the remaining $166.2 billion will mature in 2012. The majority of the debt exposure resides within the largest financial entities."
It adds, "The Treasury Department announced its temporary money market fund guarantee program on September 19, 2008, to stop the run on money market funds (MMFs) [chart in PDF]. Certain structural features of MMFs can produce incentives for investors to cash in shares if they fear that a fund will suffer a loss (see Box D: Money Market Funds). The temporary guarantee program provided coverage to shareholders for amounts they held in participating MMFs at the close of business on September 19, 2008. The guarantee would have been triggered if a participating fund's net asset value fell below $0.995 per share. The temporary guarantee, along with Federal Reserve facilities aimed at stabilizing markets linked to MMFs, was successful in restoring investor confidence; it expired in September 2009 without any claims."
The FSOC Report contains a sidebar, "Box D: Money Market Funds," which explains, "The run on money market funds (MMFs) added considerably to market stress during the financial crisis. Some of the key features of MMFs that make them susceptible to runs remain today.... MMFs generally invest in the highest rated (A1/P1-rated) short-term collateral. SEC Rule 2a-7 places stringent limitations on MMF holdings of lower rated securities. MMFs must comply with the rule, which permits these funds to maintain a stable net asset value (NAV) per share, typically $1, through the use of amortized cost accounting and rounding. However, if the mark-to-market per share value of a fund's assets falls more than one-half of 1 percent, or below $0.995, the fund must reprice its shares, an event known as "breaking the buck." MMF investors benefit from the implicity and convenience of the stable NAV feature and from the risk management, monitoring, and diversification services that MMFs provide. However, several of these MMF features contribute to their fragility."
It says, "Given the unprecedented government support of MMFs during the crisis in 2008 and 2009, even sophisticated institutional investors and fund managers may have the impression that the government would be ready to support the industry again with the same tools. This expectation may give fund managers incentives to take greater risks than are prudent and may reduce sponsors' incentives to support funds in times of stress. Such expectations may be particularly misaligned given that Congress has since prohibited the Treasury from using the fund that it used to support the MMFs for this purpose."
FSOC also writes, "In February 2010, the SEC adopted new rules for MMFs to make these funds more resilient to market volatility and to credit and liquidity risk. First, the SEC introduced new risk-limiting restrictions, including increased liquidity requirements, restrictions on the ability of MMFs to purchase lower quality securities, and maturity restrictions that reduce the maximum allowable weighted average maturity of funds' portfolios.... Finally, the new rules impose requirements to disclose portfolio holdings and mark-to-market (shadow) NAV, which gives the SEC a window on MMF activity and helps investors impose strong market discipline. Although these new rules are a positive first step, the SEC recognizes that they address only some of the features that make MMFs susceptible to runs, and that more should be done to address systemic risks posed by MMFs and their structural vulnerabilities.... The MMF sector has grown significantly in recent decades and now plays a dominant role in some short-term credit markets. While total assets under management have declined since their peak in 2009, MMFs continue to purchase a large share of private short-term debt issuance."
Finally, the FSOC Annual Report says, "One of the key factors that contributed to the financial crisis was insufficient analysis and management of liquidity risk by participants in short-term money markets. During the crisis, weaknesses in the liquidity risk profiles of financial institutions became evident and required a significant expansion of government support that went well beyond the traditional safety net extended to regulated depository institutions. Exposure of these weaknesses has given financial institutions and market participants a better understanding of the vulnerabilities in these markets and, in particular, of the importance of liquidity risk management. Liquidity risk in the U.S. financial sector has fallen since the crisis, as financial institutions have more liquid assets and more stable liabilities on their balance sheets.... Since the crisis, assets managed by MMFs have declined. Council members have been tracking the exposures that domestic MMFs have to Europe [see chart in PDF]. Their direct exposure to the countries that have been most affected by the sovereign debt crisis is minimal, although some major European banks obtain substantial short-term wholesale U.S. dollar funding from U.S. money market funds."
