2011 FSOC Annual Report
Transcript of 2011 FSOC Annual Report
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Financial Stability
Oversight Council
2011 Annual Report
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Financial Stability Oversight Council
The Financial Stability Oversight Council (Council) was established by the Dodd-Frank WallStreet Reorm and Consumer Protection Act (Dodd-Frank Act) and is charged with three primarypurposes:
1. To identiy risks to the nancial stability o the United States that could arise rom thematerial nancial distress or ailure, or ongoing activities, o large, interconnected bankholding companies or nonbank nancial companies, or that could arise outside thenancial services marketplace.
2. To promote market discipline, by eliminating expectations on the part o shareholders,creditors, and counterparties o such companies that the U.S. government will shield them
rom losses in the event o ailure.3. To respond to emerging threats to the stability o the U.S. nancial system.
Pursuant to the Dodd-Frank Act, the Council consists o 10 voting members and 5 nonvotingmembers and brings together the expertise o ederal nancial regulators, state regulators, andan insurance expert appointed by the President.
The voting members are:
the Secretary o the Treasury, who serves as the Chairperson o the Council;
the Chairman o the Board o Governors o the Federal Reserve System;
the Comptroller o the Currency;
the Director o the Bureau o Consumer Financial Protection; the Chairman o the Securities and Exchange Commission;
the Chairperson o the Federal Deposit Insurance Corporation;
the Chairperson o the Commodity Futures Trading Commission;
the Director o the Federal Housing Finance Agency;
the Chairman o the National Credit Union Administration Board; and
an independent member with insurance expertise who is appointed by the President andconrmed by the Senate or a six-year term.
The nonvoting members, who serve in an advisory capacity, are:
the Director o the Oce o Financial Research; the Director o the Federal Insurance Oce;
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 ocer perorming like unctions) designated by thestate securities commissioners.
The state insurance commissioner, state banking supervisor, and state securities commissionerserve two-year terms.
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Statutory Requirements for the Annual Report
Section 112(a)(2)(N) o the Dodd-Frank Act requires that the Annual Report address theollowing:
(i) the activities o the Council;
(ii) signicant nancial market and regulatory developments, including insurance andaccounting regulations and standards, along with assessment o those developments onthe stability o the nancial system;
(iii) potential emerging threats to the nancial stability o the United States;
(iv) all determinations made under 113 or title VIII, and the basis or such determinations;
(v) all recommendations made under 119 and the result o such recommendations; and
(vi) recommendations
(I) to enhance the integrity, eciency, competitiveness, and stability o United Statesnancial markets;
(II) to promote market discipline; and
(III) to maintain investor condence.
Approval of the Annual Report
This Annual Report was approved unanimously by the voting members o the Council on July
22, 2011.
Abbreviations for Federal Member Agencies of the Council
Department o the Treasury (Treasury)
Board o Governors o the Federal Reserve System (Federal Reserve)
Comptroller o the Currency (OCC)
Bureau o 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 Board (NCUA)
Oce o Financial Research (OFR)
Federal Insurance Oce (FIO)
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Letter rom the Chair i
The institutions, markets, and inrastructure that make up the U.S. nancial system provide
essential services to the U.S. and global economieshelping to allocate unds rom savers to
borrowers, allowing households and businesses to plan or the uture and manage their risks
over time, and acilitating the enormous volume o nancial transactions necessary to support
real economic activity and employment on a daily basis.
Three years ater the worst nancial crisis in generations, our nancial system is now on more
solid ground, less prone to excessive leverage and risk-taking, more transparent to investors,
creditors, and regulators, and more resilient to unexpected adverse events. Financial institutions
hold substantially more capital relative to risk than they did beore the crisis and und themselves
more conservatively. We have withdrawn most o the emergency actions we took to resolve thecrisis and recovered most o the investments we made to stabilize the nancial system.
The Dodd-Frank Wall Street Reorm and Consumer Protection Act (Dodd-Frank Act) made
important and undamental changes to the structure o the U.S. nancial system to strengthen
saeguards or consumers and investors and to provide better tools or limiting risk in the major
nancial institutions and the nancial markets. The core elements o the law were designed
to build a stronger, more resilient nancial systemless vulnerable to crisis, more ecient in
allocating nancial resources, and less vulnerable to raud and abuse.
Tougher constraints on excessive risk taking and leverage across the fnancial
system.To lower the risk o ailure o large nancial institutions and reduce the damage
to the broader economy o such ailures, the Dodd-Frank Act provided authority orregulators to impose more conservative limits on risk that could threaten the stability o the
nancial system.
Stronger consumer protection. The Dodd-Frank Act created the Bureau o Consumer
Financial Protection to concentrate authority and accountability or consumer protection
in a single ederal agency, with the ability to enorce protections on banks as well as other
types o rms involved in the business o consumer nance.
Comprehensive oversight o derivatives.The Dodd-Frank Act created a new regulatory
ramework or the over-the-counter derivatives market to increase oversight, transparency,
and stability in this previously unregulated area.
Transparency and market integrity.The Dodd-Frank Act included a number o measures
that increase disclosure and transparency o nancial markets, including new reportingrules or hedge unds, trade repositories to collect inormation on derivatives markets, and
improved disclosures on asset-backed securities.
Orderly liquidation authority.The Dodd-Frank Act created a new orderly liquidation
authority to break up and wind down a ailing nancial rm in a manner that protects
taxpayers and the economy.
Letter from the Chair
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ii 2011 FSOC Annual Report
Accountability or stability and oversight across the fnancial system. The Dodd-Frank
Act established the Financial Stability Oversight Council (Council) to coordinate across
agencies in monitoring risks and emerging threats to U.S. nancial stability, and the Oce
o Financial Research to improve data quality and acilitate access to and analysis o data
or the Council and its member agencies.
The Council will play an important role in implementing and overseeing these reorms andmitigating current and potential uture threats to nancial stability.
In our regulatory ramework, a signicant number o independent agencies are responsible or
specic aspects o the challenge o promoting nancial stability, including overseeing the saety
and soundness o banking organizations, saeguarding the stability o nancial inrastructure,
promoting disclosure and market integrity, and protecting investors and consumers against
abuse. Each o these individual responsibilities is critical to a stable and well-unctioning nancial
system, but as the crisis demonstrated, threats to nancial stability are oten maniested across
a range o markets and institutions and may not always be eectively mitigated by any one
agency alone.
The Dodd-Frank Act established the Council to create joint accountability or identiying and
mitigating potential threats to the stability o the nancial system. By creating the Council,
Congress recognized that nancial stability will require the collective engagement o the entire
nancial regulatory community.
This is an inherently dicult exercise. No nancial crisis emerges in exactly the same way as its
predecessors, and the most signicant uture threats will oten be the ones that are hardest to
diagnose and preempt. Aspects o the nancial system that appear to make markets more liquid
and nancial institutions more prosperous in normal times may be the same ones that make the
world more dangerous in crisis. Actions taken to preemptively mitigate threats may appear at
the time to be more dangerous than the problems they are designed to address.
We cannot predict the precise threats that may ace the nancial system. The best way to
prepare or this uncertainty is to continue to build the shock absorbers and saeguards thatimprove the resilience o the nancial system. We need to recognize that policy and regulation
will oten be behind the curve o innovation, and we must meet assumptions o ongoing stability
with a heavy dose o skepticism. Our best plan is to plan or constant change and the potential
or instability, and to recognize that the threats will constantly be changing in ways we cannot
predict or ully understand.
Reducing threats to nancial stability will require persistence, creativity, and a willingness
to adapt more quickly to changes in markets. We must work to ensure that the regulatory
ramework keeps pace with the evolving global nancial system. We cannot wait until we have
passed the point o no return to strengthen saeguards against the type o race to the bottom in
credit terms or underwriting standards that oten characterizes periods o nancial expansion.
We need to be willing to act prudently and preemptively in the ace o emerging vulnerabilities orimbalances.
This task will be made easier i we are able to better marshal the power o market discipline.
Financial market participants and investors should no longer operate with the expectation that
government assistance will be available to save the stakeholders in nancial institutions rom
the consequences o their own mistakes. And the regulatory community needs to continue to
work hard to improve the inormation available to investors and the public about the nature and
magnitude o the risks individual institutions are taking.
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Letter rom the Chair iii
The challenge o maintaining a stable nancial system is exacerbated by the diculty o
balancing the benets o regulation against the costs o excessively restraining prudent risk-
taking behavior. I we were to set the overall combination o margin, liquidity, and capital
requirements too high, we could handicap the ability o the nancial system to support
economic growth. Further, nancial activity would inevitably move more quickly to rms,
markets, and countries where the intensity o regulation is weaker. So we need to continue
to strive or a careul balance between the imperatives o creating a more stable system andpromoting a level o innovation and dynamism.
Measures o risk in the nancial system beore the crisis provided little warning o the orce o
the storm to come. Many o the standard observable measures o risk were very low; indeed the
real warning sign was that neither credit ratings nor the pricing o a range o nancial products
showed any expectation o the ragility o the global nancial system to a all in U.S. house prices.
This should make us all humble about our ability to make judgments about the uture, even as
we strive to acquire better data and quantitative metrics. Nonetheless, there is a strong case
or improving the quality o inormation available to the public, supervisors, and regulators about
risks in nancial institutions and markets. With our new authorities, we are working to build a
broader set o quantitative metrics to assess not just what is happening in individual institutions
and markets, but throughout the whole system.
The inormation we collect and the analysis we undertake will allow us to measure more
accurately the nature o risk in individual rms and across the system, but it must be
complemented with a orward-looking perspective that analyzes evolving market practices
and activities and tests the resilience o the nancial system to a wide set o uture events.
This perspective requires careul assessments o the relative likelihood o a range o potential
outcomes, including assessing the potential impact on the unctioning o the nancial system
and understanding where reorms to markets, rms, and inrastructure may mitigate threats.
And it requires an ongoing ocus on incentives within the nancial system that might create or
exacerbate vulnerabilities.
Working through the Council, we will ocus our eorts in our distinct areas:
The ongoing interaction between the fnancial system and the economy. We need
to continue to strengthen our analysis o the interactions between the nancial system
and the economy, including the impact that nancial sector decisions have on the
economy. We also need to better assess how potential external shocks could be amplied
by structural weaknesses and imbalances in the nancial system. Stress testing is an
important tool in making such assessments. It is also important to develop techniques
that give us the ability to analyze the destabilizing second-round eects o shocks across
nancial institutions and markets. While it is impossible or stress tests to capture all
potential threats, the discipline o repeatedly stressing institutions and networks against
low-likelihood adverse scenarios will help temper overly optimistic assumptions that might
otherwise lead to harmul behaviors and outcomes. The buildup o systemwide leverage and unding mismatches. It is crucial to
complement the evaluation o the saety and soundness o individual institutions with
an assessment o leverage in the nancial system and imbalances between unding and
assets across the nancial industry. It is hard to detect vulnerabilities that can build in the
interconnections between rms and markets. Thus, we need to work to ensure that the
capital buers and liquidity saeguards available to the system are sucient.
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iv 2011 FSOC Annual Report
The ongoing evolution o fnancial market activity and practices. We will need to
be attentive to the implications o very rapid growth in types o nancial activity and
new products. This is true in consumer product innovation, but also in the institutional
markets where large institutions and rms interact. Innovation is an essential element o a
healthy system, but rapid growth in products and activities untested by time and adversity
necessarily entails challenges and requires more care and attention.
The potential opportunities or regulatory arbitrage. Where the opportunity and
incentive exist to avoid regulation and supervision, nancial activity will migrate to areas o
the system where there are gaps in authority or inconsistencies in regulatory standards. A
substantial buildup in risk and leverage outside the regulated core o the nancial system
can increase threats to the system as a whole. We must also work to eliminate meaningul
opportunities or arbitrage between countries, particularly in the key areas o capital and
liquidity, derivatives, and resolution authority.
A stable nancial system cannot be maintained by regulation and oversight alone. Those in
positions o leadership in the nancial sector will need to establish and maintain much higher
standards or integrity and a more sophisticated understanding o the risk inherent in the
business o nance than prevailed beore and during this crisis.
This will require continued improvements in management structure and corporate governance
practices. Compensation must be structured to create better incentives or robust risk
management. Risk management ocers in nancial rms need to have a strong voice in
decision making. Boards o directors need to actively engage with management and represent
stakeholder interests by ensuring an appropriately long horizon and a broad perspective in
making strategic choices. With improved disclosure and transparency, rms that take this long-
term perspective should prosper in the long run, while those that do not will ace higher unding
costs and less indulgent investors.
In this rst annual report, we describe the current state o the U.S. nancial system and some
o the major orces that will shape its development going orward. The Council and its members
will continue to implement the Dodd-Frank Act on a coordinated basis to enhance the integrity,eciency, transparency, competitiveness, and stability o U.S. nancial markets. The report
also includes recommendations or additional steps that should be taken to complement these
eorts and urther strengthen the nancial system.
Timothy F. Geithner
Secretary o the Treasury
Chairperson, Financial Stability Oversight Council
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Table of Contents
1 Member Statement .............................................................................. 1
2 Executive Summary ............................................................................. 3
3 Annual Report Recommendations .................................................... 11
4 Macroeconomic Environment ........................................................... 17
Box A: U.S. Dollar as the International Reserve Asset ..................................................34
Box B: Municipal Debt Market ....................................................................................38
Box C: Country Support Developments in Europe .......................................................42
5 Financial Developments .................................................................... 45
Box D: Money Market Funds ......................................................................................50
Box E: Exchange Traded Funds ..................................................................................66
Box F: Improvements in Regulatory Capital and Accounting Measures o Assets ..........72
Box G: Analytical Basis or Basel III Capital Standards .................................................84
Box H: Improving Capital Planning ..............................................................................88
Box I: Addressing Issues Related to Large Complex Financial Institutions ...................112
6 Progress in the Implementation o the Dodd-Frank Act;
Council Activities ............................................................................ 115
7 Potential Emerging Threats to U.S. Financial Stability ................... 131
Box J: Measuring Systemic Risk ...............................................................................132
Box K: Stress Testing as a Forward-Looking Risk Mitigation Tool ...............................134
Box L: Improvements in the Monitoring o Risks to Financial Stability .........................139
Glossary ........................................................................................................................151
Abbreviations .................................................................................................................165
Notes on the Data ..........................................................................................................171
List o Charts .................................................................................................................173
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Member Statement 1
1 Member Statement
In accordance with Section 112(b)(2) o the Dodd-Frank Wall Street Reorm and Consumer Protection Act,or the reasons outlined in the annual report, I believe that additional actions, as described below, shouldbe taken to ensure that the Council, the Government, and the private sector are taking all reasonable stepsto help ensure nancial stability and to mitigate systemic risk that would negatively aect the economy: theissues and recommendations set orth in the Councils annual report should be ully addressed; the Councilshould continue to build its systems and processes or monitoring and responding to emerging threats tothe stability o the United States nancial system, including those described in the Councils annual report;the Council and its member agencies should continue to implement the laws they administer, includingthose established by, and as amended by, the Dodd-Frank Act through ecient and eective measures; andthe Council and its member agencies should exercise their respective authorities or oversight o nancialrms and markets so that the private sector employs sound nancial risk management practices to mitigatepotential risks to the nancial stability o the United States.
The honorable John a. boehner
Speakerofthe houSe
United StateS HoUSeof RepReSentativeS
The honorable nancy Pelosi
Democratic LeaDer
United StateS HoUSeof RepReSentativeS
The honorable MiTch Mcconnell
repubLican LeaDer
United StateS Senate
The honorable JosePh r. biden, Jr.
preSiDentofthe Senate
United StateS Senate
The honorable harry reid
majority LeaDer
United StateS Senate
ben s. bernankechairman
BoaRdof GoveRnoRSoftHe fedeRal ReSeRve SyStem
Mary l. schaPiro
chairman
SecURitieS & excHanGe commiSSion
Gary Gensler
chairman
commodity fUtUReS tRadinG commiSSion
debbie MaTz
chairman
national cRedit Union adminiStRation
edward J. deMarco
acting Director
fedeRal HoUSinG finance aGency
TiMoThy F. GeiThnerSecretaryofthe treaSury
cHaiRpeRSon, financial StaBility oveRSiGHt coUncil
John walsh
acting comptroLLerofthe currency
officeoftHe comptRolleRoftHe cURRency
MarTin J. GruenberG
acting chairman
fedeRal depoSit inSURance coRpoRation
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2 Executive Summary
The ecient provision o nancial services is critical to the nations economic growth and
prosperity. A stable nancial system can continue to provide nancial services while absorbing
a range o shocks. A stable nancial system should not be the source o, nor ampliy the impact
o, shocks.
The Financial Stability Oversight Council is charged with identiying risks to the nancial
stability o the United States, promoting market discipline, and responding to emerging threats.
Council members have many tools at their disposal to accomplish these goals, owing to their
involvement in supervision and regulation, consumer and investor protection, and market and
inrastructure oversight.
The U.S. economy continues to heal rom the 200709 recession (the
longest since the Great Depression). Consumer spending and business
investment have increased, but housing markets remain depressed
and the unemployment rate is elevated. The global economy is also
recovering, albeit at varying rates across advanced and emerging
economies.
The nancial crisis produced great upheaval in the U.S. nancial
sector, but the impact on the economy was even more devastating.At the height o the crisis, credit conditions tightened or households
and businesses, as well as or nancial rms o all sizes, refecting
severe disruptions to a range o nancial markets that proved ar more
damaging than the disruptions rom the initial credit losses themselves.
Credit conditions have improved signicantly rom the depths o
the crisis. Recently, credit fows have shown signs o recovery, with
large corporate borrowers acing avorable nancing conditions and
households experiencing an increase in credit. Corporate balance
sheets deteriorated signicantly during the crisis, primarily as a result o
alling asset values, but they have recovered since mid-2009 as cash
fows and prots have increased. Corporate bond markets have also
recovered or both investment-grade and non investment-grade issuers.
The outlook is more challenging or small businesses, which tend to
borrow against real estate assets. They report weak demand or their
products and services, as well as borrowing constraints, although the
number o small businesses reporting diculties obtaining credit has
declined since the crisis.
Macroeconomic Environment
Executive Summary 3
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Nonmortgage lending to consumers has grown recently ater declining
or several years. Household balance sheets are recovering, partly
because o the rebound in stock prices, but they remain challenged
by the weak labor market, slow income growth, and declines in real
estate values. As a result o the all in home values, a signicant number
o homeowners now have low or negative equity in their properties,
and record numbers o homes have entered the oreclosure process.However, low interest rates have helped mitigate some o the costs o
mortgage debt and, in the aggregate, households ability to meet debt
payments has improved since 2007.
Government budgets, both ederal and nonederal, have been strained
by the cyclical response o revenues and expenditures to a weak
economy as well as the scal actions taken to ease the recession
and aid the recovery. The ederal government decit grew rom 1.2
percent o GDP in 2007 to 8.9 percent in 2010, and net publicly held
ederal debt outstanding rose rom $5 trillion to $9 trillion. This public
borrowing largely replaced private borrowing in the credit markets,
and global nancial markets readily accommodated the increase inederal debt. Even ater economic conditions return to normal, the
ederal government aces a long-run imbalance between revenues and
expenditures. This need or long-run scal sustainability has been a
ocus o recent attention rom credit rating agencies. Achieving long-
run sustainability o the national budget is crucial to maintaining global
market condence in U.S. Treasury securities and the nancial stability
o the United States.
State and local government revenues were severely aected by the
economic downturn. While state nances started to improve in the
second hal o 2010, several quarters into the economic recovery, local
governments remain challenged. The municipal debt market exhibitedevidence o considerable stress last year.
Sovereign and banking sector strains are evident among a number o
advanced economies. Three countries in the European Monetary Union
have required nancial assistance as markets have priced elevated
sovereign credit risk into their debt. The relatively new phenomenon
o dierentiated compensation or sovereign credit risk in advanced
countries has added to volatility in global markets. It has also exposed
tensions within the European Monetary Union and limitations in the
pre-crisis set o tools available to European policymakers to respond to
economic and nancial stress.
In contrast, most emerging economies have recovered relatively quicklyrom the crisis, partly because o their lack o nancial imbalances
beore the nancial crisis. However, emerging economies ace
challenges rom robust capital infows and the potential or overheating.
Recent instability in North Arica and the Middle East and the natural
disaster in Japan have added to uncertainty in the international
environment.
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Executive Summary 5
At the peak o the nancial crisis, the U.S. government introduced
unprecedented support or nancial markets, injecting hundreds o
billions o dollars o capital and liquidity into the nancial sector. As
market condence has returned, private unding has gradually replaced
those support programs: many nancial institutions have returned
the governments capital; the Federal Reserve is no longer oering
extraordinary liquidity support to nancial markets; and the FDIC
guarantees or bank senior debt will expire in 2012.
Funding has not returned to the private securitized mortgage market,
which nanced a signicant portion o household borrowing in the rst
decade o the 2000s. In the past, the governments role encouraged
housing purchases and real estate investment over other sectors
and ultimately let taxpayers responsible or much o the risk incurred
by a poorly supervised housing market. This led to the two large
government-sponsored enterprises, Fannie Mae and Freddie Mac, being
placed into ederal conservatorship. These entities and the FederalHousing Administration now dominate mortgage lending, guaranteeing
or insuring over 90 percent o mortgage loan originations. This is not a
viable long-term solution, but, given the current ragility o the real estate
market, the transition back to more private involvement will require time
and care.
Protability has returned in the banking sector and or many other
nancial institutions. Investors purchased large amounts o new
equity in the largest bank holding companies in 2009 and 2010, partly
responding to the results o the 2009 supervisory-run stress test. U.S.
banking institutions now have substantially stronger capital and liquidity
buers than beore the crisis. However, smaller banks, particularly thosewith large commercial real estate exposures, have not recovered as
quickly as larger banks and have continued to ail at elevated rates. At
the same time, in taking prudent measures to conserve their capital
and liquidity, many banks have been slow to expand their direct lending
activity since the nancial crisis.
Assets have grown at insured depository institutions relative to other
nancial institutions since the crisis, ollowing a long period in which
nancial activities moved rom banks to markets. In particular, money
market und assets declined as investors transerred signicant unds
into insured bank deposits during the crisis. At the same time, the
crisis reinorced the trend toward concentration and globalization in thebanking industry, and oreign banking organizations have expanded
their activities in the United States in recent years.
The nancial system is less leveraged than it was beore the crisis. Four
o the ve largest independent investment banks, all highly leveraged
institutions, were acquired by or converted their charters to become
bank holding companies in 2008, and the th ailed. The specialty
nance sector, which also relied heavily on market nancing, is now
Financial Developments
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6 2011 FSOC Annual Report
smaller and more stable. Several o the largest companies in the
specialty nance sector also became bank holding companies
during the crisis to expand their unding options. These and other
companies have reduced their leverage signicantly below the levels
beore the crisis.
Short-term wholesale unding markets provide liquidity or nancialinstitutions to support their activities, but the nancial crisis showed
that these markets can be ragile and subject to runs by risk-averse
investors. In response to unprecedented strains in these markets,
the Federal Reserve, the FDIC, and the Treasury took extraordinary
steps to support market unctioning. The crisis also revealed, in
particular ater the reezing o Lehman Brothers prime brokerage
assets in London, that dierences in international bankruptcy
regimes can accelerate runs on short-term wholesale unding
markets. Activity in several o these markets remains signicantly
below pre-crisis levels, as investors and supervisors have a new
sensitivity to potential liquidity risks and other risks.
The credit risk transer markets that contributed to the nancial
crisisspecically, those or credit deault swaps and collateralized
debt obligationsare now signicantly smaller, partly owing to new
regulatory and accounting rules. Derivatives markets generally will be
subject to greater supervisory oversight under the Dodd-Frank Act.
Supervisors and market participants are more aware o the potential
or extreme market fuctuations in the uture and the need to
maintain a stronger set o shock absorbers in individual institutions
and in markets to absorb the impact o such events. These issues
are particularly relevant when market participants are highly
leveraged or when derivatives or other complex instruments areinvolved.
In general, the pricing o risk in important markets appears to be
in line with historical averages. For example, the price-to-earnings
ratios or corporate equities are well within historical ranges, and
the credit risk premium on high-yield corporate debt is in the
lower part o its long-run historical range. Prices or commodities
and agricultural land have risen strongly but do not appear to be
associated with high debt levels.
Compensation practices that incented nancial institution
employees to take excessive risks are widely acknowledged to have
been a contributing actor in the nancial crisis. Under pressure romregulators and investors, nancial institutions are reorming their
compensation practices to better align the interests o managers,
traders, and other employees with the long-term health o the rm,
although more needs to be done.
Following the rebound in equity markets, aggregate assets in mutual
unds and hedge unds have recovered to pre-crisis levels. Assets
in dened contribution plans have also recovered, although many
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Executive Summary 7
pension plans or state and local government employees appear to ace
unding shortalls over the long run. Investors have increasingly turned
to exchange traded unds, which oer low ees and intraday liquidity.
Regulatory reorms and advances in technology have altered the
landscape or nancial inrastructure, providing nancial markets with
advances in eciency and transparency. While this inrastructure andthe markets that it supports have generally perormed their primary
unctions in an orderly ashion during and since the crisis, there were
exceptions. One was the so-called fash crash o May 2010, when
equities and equity utures markets plunged more than 5 percent and
then rebounded in a matter o minutes. This incident illustrates some o
the risks associated with increasingly complex and connected nancial
markets interacting with ever-aster automated trading systems. Poor
unctioning in mortgage servicing and the tri-party repo market were
also identied during the crisis, and regulators are taking steps to
address them.
Progress of Regulatory Reform
In the period ater the nancial crisis, the legal, regulatory, and
accounting ramework o our nancial system has changed signicantly.
The Dodd-Frank Act, which created the Council, closed gaps in the
nancial regulatory ramework and strengthened supervisory, risk
management, and disclosure standards in important ways. The new
Basel III international standards or banks, negotiated with major input
rom U.S. regulators, will require banks globally to hold more capital,
particularly when they take market risk, and will subject banks to a
liquidity standard or the rst time, and new accounting rules will serve
to limit nancial institutions o-balance-sheet activities.
For the rst time, inormation on trading in swaps will be available
through trade repositories. In addition, standardized derivatives will
have to be traded on regulated trading platorms and centrally cleared,
improving price transparency and reducing counterparty credit risk or
market participants. Once regulators complete the implementation o
the Dodd-Frank Act, the mix o complex structured credit products,
derivatives, and short-term wholesale unding that helped produce the
nancial crisis is unlikely to reappear in its previous orm.
U.S. regulators continue to work out the details o several important
initiatives, including those mandated by the Dodd-Frank Act and those
agreed to with their international counterparts. For example, the Councilhas dened the characteristics under which it will designate systemically
important nancial market utilities or enhanced supervision. The Council
is also in the process o dening the characteristics under which it will
designate nonbank nancial institutions or Federal Reserve supervision,
and the Federal Reserve, in consultation with other Council member
agencies, is establishing tougher supervisory guidelines or large
nancial institutions. Regulators are also developing new reporting and
disclosure requirements or designated nonbank nancial companies.
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The Dodd-Frank Act also established a new ramework or resolving
large complex nancial institutions, limiting the expectation that the
government will bail out such institutions in a crisis. As part o the
enhanced supervisory standards, designated nonbank companies and
large bank holding companies will be required to maintain detailed
resolution plans. Until the Dodd-Frank Act is ully implemented, the
public will not receive the ull set o protections provided by theimproved regulatory system. In addition, to maximize all the benets o
the new regulatory ramework, it is imperative that relevant regulatory
agencies be unded at levels consistent with their expanded missions.
Regulators are also working with their international counterparts to
promote consistency in global regulatory reorm, particularly with
regard to implementing the new Basel III capital and liquidity standards;
strengthening the supervision o, designing capital surcharges or,
and developing a ramework or the resolution o large, globally active
nancial institutions; promoting harmonization or the oversight o
derivatives markets; and regulating global nancial inrastructures.
Potential Emerging Threats to U.S. Financial Stability
Assessing uture threats to nancial stability will require attention to
the broad orces driving the evolution o the nancial system, which
determine the prot opportunities available to market participants
and nancial institutions along with the risks they take. In addition to
these long-run challenges to maintaining nancial stability, a number
o possible shocks and vulnerabilities could produce more immediate
threats to U.S. nancial stability.
Globalization and technological innovation are among the most
important orces that could aect uture nancial stability. While the riseo international banking and the important role o oreign banks in U.S.
nancial markets allow risks to be transerred more broadly across the
global economy, they also increase the links across economies and add
to the complexity o the nancial system. Global interconnectedness
is heightened by the role o the U.S. dollar as the international reserve
currency and the unding needs o large oreign rms that hold U.S.
dollar-denominated assets.
Financial product innovation and growth is crucial to support a vibrant
economy, but at times it can result in dramatic changes in business
models and can introduce increased complexity, thereby altering the
evolution o linkages among rms. Three such products examined in thereport are exchange traded unds, structured notes, and collateralized
commercial paper. While the level o activity in these products in the
United States is not high enough to represent a threat, the level o
activity abroad and the links to derivatives have led regulators in other
countries to ocus special attention on them.
The unctioning o the U.S. nancial system has proven resilient to the
impact o a number o recent shocks, such as the natural disaster in
Japan and the fuctuating concerns over European sovereign debt.
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Executive Summary 9
Further, increases in trading volumes and enhanced market liquidity
have been ostered, in part, by the increasing use o electronic trading.
This liquidity can evaporate in stressed environments, as the fash crash
demonstrated. New technology has helped strengthen the resilience o
payment systems, data repositories, and other nancial inrastructure.
This has given rms the tools to handle increasingly intricate
transactions, including transactions in short-term wholesale undingmarkets that can provide hundreds o billions o dollars overnight to
cover daily unding needs. Operational risk events, along with recent
high-prole cyberattacks, are important reminders that both regulators
and rms need to continuously upgrade the resilience o their electronic
systems and networks.
There is signicant market uncertainty in Europe, notably associated
with the sovereign credit risk o Greece, Ireland, and Portugal. U.S.
nancial institutions have very limited net direct exposure to these
three countries. They have larger exposure and important ties to
major nancial 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 unding rom U.S. money market unds. Further, money
market unds remain an important supplier o cash to the tri-party repo
market. Structural vulnerabilities in money market unds and tri-party
repo amplied a number o shocks in the nancial crisis. Reorms
undertaken since the crisis have improved resilience, and money market
unds report de minimis exposure to Greece, Ireland, and Portugal;
however, amplication o a shock through these channels is still
possible.
The impact on the U.S. nancial system o events in Europe dependson how the peripheral European sovereign debt crisis evolves and on
the resilience o U.S. nancial institutions and markets. I the crisis, now
aecting Greece, Ireland, and Portugal, were to intensiy signicantly
or spread more broadly across the euro area, then the impact on the
U.S. nancial system would be greater. Supervisors have or some time
been working with U.S. nancial institutions to improve their ability to
withstand a variety o possible nancial contagion stress scenarios
emanating rom Europe. The Council and its member agencies will
continue to careully monitor the potential risks that could emerge rom
the peripheral European sovereign debt crisis.
Real estate-related exposures remain a signicant risk or many U.S.
nancial institutions. However, the improvement in capital across the
nancial system provides an important buer against urther declines
in real estate prices and larger losses; this makes it less likely that
U.S. nancial institutions will have to reduce assets or reduce growth
in lending in response to a more prolonged period o weakness in the
housing market or in the U.S. economy more generally. On the other
hand, the transition path back to a greater role or private capital in the
housing nance system remains uncertain.
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The weakness o the current recovery has delayed monetary policy
normalization and exacerbated the unsustainable scal trajectory in
the United States. Despite the sustained low interest rate environment,
there is limited evidence o major U.S. market participants reaching or
yield. One possible exception has been in some o the activity in the
markets or non investment-grade bonds and loans.
Both monetary policy normalization and scal consolidation will have
important consequences or the business models o many nancial rms
that are currently unding large holdings o government securities and
reserves at the Federal Reserve with low-cost deposits. Uncertainty
over the pace o monetary policy normalization and scal consolidation
has the potential to generate shocks; however, with appropriate
planning and risk diversication, the nancial market impact o such
shocks should be absorbed without aecting the unctions o the
system.
The capital and liquidity o the largest U.S. nancial institutions have
improved substantially. However, many large U.S. nancial institutionscurrently receive the highest credit rating or short-term unding partly
because o a presumption o possible government support in stressed
conditions. Further, the Federal Reserve, in its Comprehensive Capital
Analysis and Review, ound a number o weaknesses in the capital
planning processes at many large banking institutions. These actors
highlight some o the challenges still ahead in building a stronger
nancial system.
The recent nancial crisis provides a stark illustration o how quickly
condence can erode and nancial contagion can spread, as well as
how challenging and expensive it is to repair the damage. This lesson
is important to bear in mind in the current debate over the increase inthe ederal governments debt limit. It is vital to the stability o the U.S.
nancial system and the global nancial system or the debt limit to be
raised in a timely manner to avoid creating any risk o deault on U.S.
obligations.
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Annual Report Recommendations 11
3 Annual Report Recommendations
In the ollowing areas, market participants should employ heightened
risk management, and Council member agencies should enhance
ongoing supervisory attention to determine whether any o these market
dynamics rises to a level that merits a regulatory response.
Construct robust capital, liquidity, and resolution plans.To
support stability in the nancial system, nancial institutions
should ensure that they have in place robust capital, liquidity,
and resolution planning processes. The Federal Reserves
Comprehensive Capital Analysis and Review exercise ound that
all o the largest banking companies need to bolster their capital
planning processes. The largest nancial institutions must also
incorporate within their planning processes contingencies or
resolution that would acilitate resolvability under bankruptcy
without government assistance. In addition, the largest banks
The Dodd-Frank Act requires the Council to make annual recommendations to (1) enhance
the integrity, eciency, competitiveness, and stability o U.S. nancial markets; (2) promote
market discipline; and (3) maintain investor condence. The Council ullls this requirement by
recommending (1) heightened risk management and supervisory attention in specic areas; (2)
urther reorms to address structural vulnerabilities in key markets; (3) steps to address reorm o
the housing nance market; and (4) coordination on nancial regulatory reorm.
The Council recommendations work together to balance the stated requirements o integrity,
eciency, competition, market discipline, and investor condence, while maintaining
nancial stability. For instance, recommendations to improve capital and liquidity planning,address vulnerabilities in the money market und and tri-party repo markets, and coordinate
implementation o the Dodd-Frank Act will improve the stability o the nancial system. To
promote market discipline, the Council recommends responsible credit underwriting standards;
housing nance reorms, including mortgage servicing standards and servicer compensation;
and eective implementation o orderly liquidation authority or the largest nancial rms. To
maintain investor condence, the Council also recommends that market participants keep
pace with inrastructure and technological advances and conduct heightened due diligence on
emerging nancial products. Collectively, the Council recommendations address the identied
vulnerabilities in the system and emerging threats to nancial stability. Regulatory agencies
and market participants should take these steps to enhance the resilience and integrity o the
system. The discussion below outlines the Council recommendations and their ulllment o theCouncils statutory mandate.
I. Heightened Risk Management and Supervisory Attention
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should plan urther improvement in their capital levels and liquidity
risk proles to support unding models without any assumption o
government assistance and their continued smooth transition to
new global standards.
Bolster resilience to unexpected interest rate shits. In
light o a sustained, historically low interest rate environment,
market participants should work to ensure that they have robust
processes or measuring and, where necessary, mitigating their
exposure to a range o interest rate scenarios. Preparedness to
ace unexpected rate changes or yield curve shits will enable
market participants to make a stable transition to a new rate
environment, minimizing potential disruption to the system.
Maintain discipline in credit underwriting standards. Although
it is dicult to make denitive determinations regarding the
appropriateness o risk pricing, there have been some indicators
that credit underwriting standards might have overly eased
in certain products, such as leveraged loans, refecting the
dynamics o competition among arranging bankers. Greatermarket discipline can be supported through robust due diligence
practices and processes or monitoring and responding to
developments in credit underwriting standards, including deal
eatures that may allow borrowers to take on excessive risk.
Sound underwriting standards, which were abandoned in the run-
up to the crisis, will encourage greater investor condence and
stability in the market.
Employ appropriate due diligence or emerging fnancial
products. Council agencies are highly attentive to the emergence
and growth o nancial products, particularly those that may be
designed to arbitrage new capital and accounting standards bymoving nancial activities outside the regulated core. A robust
nancial system should acilitate innovation. Market participants,
as issuers or investors, should work to ensure that they have
an adequate understanding o the risks that products such as
exchange traded unds and structured notes present, including
impacts under strained market conditions.
Keep pace with competitive, technological, and regulatory
market structure developments. Equity trading markets in the
United States have experienced changes in market structure over
the past several years, including an expansion o the number o
trading venues and the rise o electronic trading. The fash crash o
May 6, 2010 demonstrated that regulators and market participantsshould continue to monitor these changes and take action as
necessary to help ensure that the market structure regulatory
ramework and operational policies keep pace with changes
to trading and other market practices. Regulators and market
participants should also continue to oster investor condence by
promoting market integrity, eciency, and competition.
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II. Additional Reforms to Address Structural Vulnerabilities
Financial systems are vulnerable to shocks that can be exacerbated
by weaknesses in the structure o nancial institutions, markets, and
inrastructure.
The Council recommends reorms to address structural vulnerabilitiesin the tri-party repo market, or money market mutual unds, and in
mortgage servicing:
Elimination o most intraday credit exposure and reorm o
collateral practices in the tri-party repo market to strengthen
the market. Given the vital importance and size o tri-party
repo nancing and the broad array o nancial institutions
active in this market, the regulatory community should exert its
supervisory authority over the industrys reorm eorts to ensure
that the Tri-Party Repo Inrastructure Reorm Task Force meets
its commitments as promptly as possible. The Task Forces
eorts should ultimately improve market unctioning, but severalimportant structural reorm issues require coordinated supervisory
and regulatory attention. Chie among these priorities are
enhancing dealer liquidity risk management practices, alleviating
the propensity o cash investors to withdraw unding and exit the
market when risk suraces, and implementing mechanisms to
manage a potential dealer deault. The ragility o broader market
liquidity acilities and the constraints on the types o collateral that
certain investors are prepared to take (particularly money market
unds) heightens the risk o contagion in the market. Reorm
eorts should practically eliminate intraday credit exposures
o clearing banks to borrowers and strengthen collateral
management practices to improve the stability o this critical short-term unding market.
Implement structural reorms to mitigate run risk in money
market unds. When the SEC adopted new rules or money
market unds (MMFs) in February 2010, it noted that a number
o eatures still make MMFs susceptible to runs and should be
addressed to mitigate vulnerabilities in this market. To increase
stability, market discipline, and investor condence in the MMF
market by improving the markets unctioning and resilience, the
Council should examine, and the SEC should continue to pursue,
urther reorm alternatives to reduce MMFs susceptibility to runs,
with a particular emphasis on (1) a mandatory foating net assetvalue (NAV), (2) capital buers to absorb und losses to sustain a
stable NAV, and (3) deterrents to redemption, paired with capital
buers, to mitigate investor runs.
Improve the overall quality o mortgage servicing by
establishing national mortgage servicing standards and
servicer compensation reorm.The mortgage servicing
industry was unprepared and poorly structured to address the
rapid increase in deaults and oreclosures. To address this
Annual Report Recommendations 13
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structural vulnerability, regulators should establish national
mortgage servicing standards and promote alternative servicer
compensation models.
National mortgage servicing standards should provide clarityto borrowers and investors, and servicers should be held tothe same quality and responsiveness standards regardless o
whether the loans being serviced are held on the originatorsbooks, have been sold, or have been securitized. Nationalstandards would align incentives and provide clarity andconsistency to borrowers and investors, especially in the caseo delinquency. These standards will enhance the integrity andeciency o mortgage servicing and help reestablish investorcondence in the housing nance market.
Today, the structure o servicing compensation generallydoes not adjust to refect the amount o servicing eortand expense required. This fat-ee structure does notappropriately incent servicers to invest the time and eort towork with borrowers to avoid deault or oreclosure. The FHFA
and the Department o Housing and Urban Developmentshould continue to coordinate a review o the structural fawsin the current mortgage servicing compensation model and
should consider alternatives.
III. Housing Finance
The U.S. housing nance system required extraordinary ederal
government support during the crisis. Over 90 percent o the market
continues to unction on the basis o this government support
and without sucient return o private capital. This dynamic is not
sustainable over the long term. The Council member agencies and
the Department o Housing and Urban Development should continuetheir work to strengthen the housing nance system, which includes
developing a ramework or the return o private capital to the system.
The ramework should include regulatory activities that set orth
standards and guidelines or participants in the housing nance system,
and other actions that strengthen mortgage underwriting. To give urther
condence to the market and provide long-term stability to the U.S.
nancial system, the Council believes Congress must pass responsible
legislation to reorm the housing nance system. The reorm eorts
should not urther destabilize the ragile housing market.
IV. Financial Regulatory Reform
Council member agencies are committed to implementation o nancial
regulatory reorm. While important steps have been taken, both
domestically and in the international policy arena, much work remains
to be done. The agencies are approaching reorm careully, mindul
o the need or sucient public comment and the risks o unintended
consequences.
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Coordinated implementation o regulatory reorm will enhance the
integrity, eciency, competitiveness, and stability o U.S. nancial
markets; promote market discipline; and maintain investor condence by
closing regulatory gaps that contributed to the crisis and previous market
dislocations.
Dodd-Frank Act
The Dodd-Frank Act provides comprehensive reorms and protections
across the nancial regulatory system. These reorms include the creation
o a regulatory ramework or the over-the-counter derivatives market;
investor protection measures that increase disclosure, transparency,
and condence; reporting or managers o hedge unds and other
private unds; and the establishment o a single agency dedicated to
ensuring consumer nancial protection and the integrity o the market
or consumer nancial products and services. The Dodd-Frank Act also
requires regulators to impose heightened prudential standards on certain
large nancial rms to help oster market discipline and stability, and
to make clear that no rm will be considered too big to ail, by creatinga new authority to break up and wind down a ailing nancial rm in a
manner that protects taxpayers and the economy. In addition, the Dodd-
Frank Act created the Council to monitor risks that could build across
the system in a way that threatens the stability o the nancial markets in
the United States, and the OFR to collect data on the Councils behal,
working closely with supervisors.
The Council member agencies have made signicant progress in
implementing the many reorms that the Dodd-Frank Act requires.
The Council and its member agencies recognize that successul
implementation o reorm across complex areas o the nancial system
requires independent agencies to coordinate their eorts, even i
such consultation is not statutorily required. Coordination is critical to
implementing reorms that not only work together in a sensible, coherent
way, but also appropriately balance market eciencies, competitiveness,
and stability while providing or innovation. To meet the challenges
o designing and enorcing these new rules, the quality and scale o
resources dedicated to nancial oversight must increase. Agencies must
have sucient resources to attract and retain talented individuals and
invest in systems to monitor market activity and enorce the new rules.
International Coordination
At the September 2009 summit in Pittsburgh, the G-20 heads o state
agreed that reorms were needed to build high-quality capital andmitigate pro-cyclicality in the nancial system; improve compensation
practices to support nancial stability; reorm the over-the-counter
derivatives markets or greater transparency and risk management; and
address cross-border resolutions and systemically important nancial
institutions. The implementation o the Dodd-Frank Act will accomplish
many o these goals within the United States, but international
coordination is required to ensure that similar reorms are applied
consistently across the global nancial system to mitigate regulatory gaps
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and level the playing eld. Council member agencies are committed to
working with their international counterparts to implement these reorms
in a timely manner. Key reorms include the ollowing:
Capital and liquidity standards. In 2010, central banks and
supervisors reached agreement on the core elements o new
global capital and liquidity standards, Basel III. As a result othis agreement, internationally active banks will have to hold
substantially more capital in the orm o common equity against
the risks they take. This agreement was the oundation o a
comprehensive new capital ramework to urther stabilize global
markets, but it let open several areas or urther analysis, including
the size and composition o additional capital requirements to
impose on the largest global institutions, how to implement the new
liquidity standards, and how to bring more consistency to the risk
weighting o assets across countries.
Globally active systemically important banks. The Financial
Stability Board, a global body o nance ministers, central bankers,
and supervisors, has been working to develop guidelines orcooperation in the supervision o large, globally active nancial
institutions, and to develop a consistent international ramework
or the orderly resolution o such companies. These initiatives
complement Dodd-Frank Act requirements, and Council members
are actively supporting eorts to promote international consistency
on resolution rameworks.
Derivatives markets. A core element o the international
ramework or reorm o the over-the-counter derivatives market is
a requirement or standardized derivatives to be centrally cleared.
While there will continue to be bilaterally executed derivatives
transactions that are not cleared, there is international agreement
that non-centrally cleared derivatives should be subject to higher
capital requirements. In addition, Council member agencies
are committed to working with international counterparts to
develop global standards or central counterparties and margin
requirements or swaps and security-based swaps that are not
centrally cleared. Other key elements o reorm are the reporting
o over-the-counter derivatives to trade data repositories and the
trading o standardized over-the-counter derivatives on exchanges
or electronic trading platorms. In each o these areas, Council
member agencies are committed to working with international
counterparts to harmonize requirements.
Inrastructure. International authorities have released revisedstandards or nancial market inrastructures that provide a single
set o principles (CPSS-IOSCO Principles or nancial market
inrastructures) or greater consistency in the oversight and
regulation o nancial inrastructures worldwide, including enhanced
requirements or governance and risk management practices, and
new standards on transparency and general business practices.
These principles should provide greater consistency in the oversight
and regulation o nancial inrastructures worldwide and thus
enhance the integrity o markets and global investor condence.
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Macroeconomic Environment 17
4 Macroeconomic Environment
The U.S. economy expanded at a moderate pace in 2010 and early 2011. The economy is
healing slowly rom the lingering eects o the extraordinary fnancial market dislocations
in 200809 and the severe declines in employment and output (Chart 4.0.1). Businesses
have increased investment, and consumers have increased spending (Chart 4.0.2).
However, construction and housing demand remain depressed, the unemployment
rate is elevated, and the gains in total employment have been insufcient to raise the
employment-population ratio.
Most oreign economies also continue torecover rom the most severe global downturn
since the Great Depression, albeit at diering
paces. Emerging economies, which suered
ewer nancial disruptions rom the crisis, have
been able to recover more quickly, and many o
those economies have returned to or exceeded
their previous trend growth rate. Recovery in
the advanced economies has been slowed
by the weakness o the nancial sector, and
many have not yet reached their pre-crisis
level o economic activity. With interest rates in
advanced economies at historically low levels tosupport economic growth, unds have fowed to
emerging markets, where returns are relatively
higher. Political tensions in North Arica and the
Middle East, and the natural disaster in Japan
added to uncertainty in the rst hal o 2011.
The recession depressed tax revenues and
required additional public sector spending,
leading to substantial increases in government
debt in many advanced economies
(Charts 4.0.3 and 4.0.4). For the most
part, nancial markets have been able tosmoothly accommodate elevated government
borrowing, as private savers have increased
their demand or government debt. However,
certain governments and nancial institutions
in peripheral Europe have encountered
severe diculties in maintaining access to
private nancial market unding. As the global
economy continues to recover, governments
Chart 4.0.1 Real GDP Growth and the Unemployment Rate
-8
-4
0
4
8
12
1995 1999 2003 2007 2011
2
4
6
8
10
12
Percent Change Annual Rate Percent
Source: BLS and BEA
GDP Growth(left axis)
Unemployment Rate
(right axis)
Chart 4.0.2 Real GDP Growth and Its Components
-12
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
2007:Q1 2008:Q1 2009:Q1 2010:Q1 2011:Q1
-12
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
Percent Contribution Percent Change Annual Rate
Source: BEA
Personal Consumption ExpendituresResidential Investment + StructuresGovernment Consumption and Investment
Net Exports
GDP Growth(right axis)
left axis
Equipment and Software
left axisChange in Inventories
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ace the challenge o rebalancing revenue and
expenditures.
4.1 Provision o Financial
Services to the Real Economy
Functions o the Financial System
The nancial system has three primary
unctions: (1) credit fow acilitation, (2) risk
transer, and (3) transaction and payment
services.
Credit ows: A primary unction o the nancial
system is to acilitate the fow o unds rom
savers to borrowers at prices that appropriately
compensate all parties or the inherent riskiness
o lending; hence, nancial markets and their
participants play a key role in price discovery.
Risk transer: Another key unction o the
nancial system is to acilitate the ecient
allocation o risk across households and
businesses.
Transaction and payment services:The
nancial system is also responsible or providing
reliable and robust transaction and payment
services to the real economy.
4.1.1 Credit Flows
The reduction in credit ows to households
and businesses during the crisis reected both
a decline in demand or credit and a reduction
in the supply o available credit. Combined
credit ows to businesses and households
have started to increase. However, persistent
weakness in real estate markets continues to
restrain demand or and supply o mortgage
credit.
Beore the nancial crisis, many households
and nancial market participants increased
their debt loads. Some o this credit fowedto borrowers with limited ability, and at times
limited incentives, to repay their loans. Further,
some companies that originated mortgages and
sold them or securitization were compensated
on the basis o volume and did not always
retain a stake in the mortgages. This meant
that they had less incentive than traditional
Chart 4.0.3 United States Nonfnancial Net Debt Flows
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Trillions of US$ Trillions of US$
Private Nonfinancial SectorGeneral Government
Source: Flow of Funds Note: At a quarterly rate.
Chart 4.0.4 Euro Area Nonfnancial Net Debt Flows
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Trillions of Euros Trillions of Euros
Private Nonfinancial SectorGeneral Government
Source: Eurostat Note: At a quarterly rate.
Chart 4.1.1 Net Debt Outstanding as a Percent o GDP
40
50
60
70
80
90
100
110
120
130
2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1
40
50
60
70
80
90
100
110
120
130
Percent Percent
Source: Flow of Funds, BEA
NonfinancialCorporate
Financial Institutions
U.S. GeneralGovernment
Household
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Macroeconomic Environment 19
originate-to-hold lenders to underwrite loans to
high standards.
The crisis triggered signicant reductions
in the fow o credit and an unprecedented
deleveraging by consumers, businesses, and,
most dramatically, the nancial sector itsel.Even as the recession stressed government
budgets, public borrowing largely replaced
private borrowing in the credit markets
(Chart 4.1.1). These trends have begun to
moderate, and net fows o credit to the private
nonnancial sector have turned marginally
positive owing to increases in both demand or
and supply o credit.
Credit Flows to the Corporate Sector
The nonnancial corporate sector continues
to recover as increased demand and low laborcosts contribute to protability. In the aggregate,
corporate borrowers are experiencing more
avorable nancing conditions rom banks,
bond markets, and syndicated loan markets,
which allow large corporate rms to nance
their activities on better terms. For instance,
bank underwriting standards have eased rom
the extremely tight conditions at the peak o the
crisis (Chart 4.1.2).
Credit intermediation or large corporations
in the United States is characterized by ahigh degree o unding through debt capital
markets rather than through banks. Debt
capital markets, somewhat impaired during the
crisis, are again unctioning well. Corporate
bond markets have recovered, and issuance
o investment-grade and speculative-grade
bonds has been robust in recent months (Chart
4.1.3). Spreads between yields on corporate
bonds and comparable-maturity U.S. Treasury
securities have narrowed, although they remain
above the very low pre-crisis levels (Chart
4.1.4). In addition, new equity issuance hasbeen robust lately and M&A activity has picked
up, indicating that credit has become more
available.
Corporate leveraged buyouts (LBOs) remain
well below the elevated levels seen during the
last credit cycle, although they have increased
somewhat as credit conditions have improved
Chart 4.1.2 Bank Business Lending Standards and Demand
-80
-60
-40
-20
0
20
40
60
80
100
2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1
-80
-60
-40
-20
0
20
40
60
80
100
Net Percent Net Percent
Source: SLOOS
ReportingIncreasedDemand
ReportingHigher Spreads
ReportingTightenedStandards
Note: For C&I loans to medium and large firms.
Chart 4.1.3 Corporate Bond Market Issuance
0
20
40
60
80
100
2005 2006 2007 2008 2009 2010 2011
0
20
40
60
80
100
Billions of US$ Billions of US$
Source: Dealogic
Investment-Grade
High-Yield
Note: U.S. marketed issuance only.
Chart 4.1.4 Corporate Bond Spreads
Source: Bloomberg
0
400
800
1200
1600
2000
2400
2005 2006 2007 2008 2009 2010 2011
0
400
800
1200
1600
2000
2400
Basis Points Basis Points
Investment-Grade
High-Yield
Note: Spreads to Treasuries.
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20 2011 FSOC Annual Report
(Chart 4.1.5). Private equity rms continue to
hold high levels o committed but uninvested
capital available or LBO activity.
Credit Flows to the Small Business Sector
Banks are a large source o credit or small
businesses: banks provide these businesseswith term loans, credit cards, credit lines,
commercial mortgages, and capital leases.
Regulatory data on business loans less than
$1 million and agricultural loans less than
$500,000 suggest that small business lending
had increased solidly in the years leading up to
2008, beore declining by more than 10 percent
through 2010 (Chart 4.1.6). A number o
related actors explain the decline, including the
general dislocation o credit during the crisis,
the adverse eect o the crisis on borrowers
balance sheets and on the value o theiravailable collateral, and the reduced demand
or credit in light o lower inventory investment
and cuts in investment and payrolls as these
businesses have experienced weak demand
and stagnant prospective sales.
In the National Federation o Independent
Business (NFIB) June 2011 Small Business
Survey, the number o small businesses
reporting that credit is harder to obtain has
declined to mid-2008 levels. Small businesses
continue to cite weak demand or their productsor services as the main actor limiting growth.
Additionally, with more than hal o credit to
small businesses secured by some orm o real
estate, borrowing capacity is limited by the
ongoing stress in real estate.
Credit Flows to the Household Sector
Consumer spending has risen at a moderate
pace since mid-2009, contributing to overall
economic growth. However, consumer credit
fows, which ell sharply during the crisis, have
only recently begun to recover. The modest
recovery o these fows refects restraints on
the availability o consumer credit as well as
subdued demand as households ace weaker
income prospects. Nonmortgage lending to
consumers, which declined or several years,
began growing in 2010, driven by nonrevolving
credit (Chart 4.1.7). The amount o revolving
credit available to consumers has been
Chart 4.1.5 North American Completed LBOs
0
50
100
150
200
250
2003:Q1 2005:Q1 2007:Q1 2009:Q1 2011:Q1
0
50
100
150
200
250
Billions of US$ Number of Deals
Source: Thomson Reuters
Deal Value Net Debtof Target(left axis)
Number of Deals(right axis)
Chart 4.1.6 Proxy or Small Business Lending
500
550
600
650
700
750
800
2000:Q2 2002:Q2 2004:Q2 2006:Q2 2008:Q2 2010:Q2
500
550
600
650
700
750
800
Billions of US$ Billions of US$
Source: FDICNote: Data from all FDIC-insured institutions; includes C&I and NFNR loans
less than 1MM, agriculture and farm loans less than 500k.
Chart 4.1.7 Nonmortgage Consumer Credit Flows
-4
-3
-2
-1
0
1
2
3
4
5
2000 2002 2004 2006 2008 2010
-4
-3
-2
-1
0
1
2
3
4
5
% Change 3-month % Change 3-month
Source: FR G-19
Nonrevolving
Revolving
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Macroeconomic Environment 21
substantially reduced, although aggregate
borrowing capacity remains considerable
(Chart 4.1.8). Demand or auto nancing
has risen along with the increase in vehicle
purchases rom the lows o the crisis. Student
loan volumes increased during the downturn
in part because o rising enrollments andincreased tuition costs; these volumes have
been increasingly supported by government-
guaranteed loan programs.
Real Estate and Mortgage Markets
The housing sector remains depressed. To
date, real residential investment has allen
nearly 60 percent since its peak in early 2006.
Housing starts and sales o new homes have
remained near record low levels, and distressed
sales have increased, recently comprising 46
percent o all sales (Charts 4.1.9 and 4.1.10).As a result o the pullback in mortgage lending
and an elevated level o charge-os, overall
mortgage debt outstanding contracted or two
years (Chart 4.1.11).
Home prices ace continued downward
pressure rom excess inventory, lackluster
demand, and distressed sales, in part coming
rom oreclosures. Ater stabilizing in late
2009 and early 2010, home prices have
allen urther since the summer o 2010. The
CoreLogic repeat sales home price index,which is representative o conorming and
non-conorming mortgages, is back down to
its mid-2003 levels, about one-third below its
2006 peak (Chart 4.1.12). The Federal Reserve
Boards Senior Loan Ocer Opinion Survey or
April 2011 showed that demand or residential
mortgages at banks continued to decrease.
Some o the housing market undamentals
have shown signs o improvement. Indexes o
aordability based on current interest rates,
median incomes, and median home prices haverisen to historic highs (Chart 4.1.13). The very
low levels o new home construction in recent
years have helped trim the backlog o excess
new homes or sale. In addition, the unusually
low levels o household ormation over the past
several years could reverse once the labor
market improves suciently, suggesting the
possibility o pent-up demand or housing.
Chart 4.1.8 Credit Card Limit and Outstanding Balance
0
1
2
3
4
2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1
-20
-10
0
10
20
30
40
Trillions of US$ % Change Annual Rate
Credit Card Available Credit (left axis)
Credit Card Balance (left axis)
Source: FRBNY Consumer Credit Panel
Growth in Credit Card Balance(right axis)
Chart 4.1.9 Single-Family New Home Starts and Sales
0
400
800
1200
1600
2000
2000 2002 2004 2006 2008 2010
0
400
800
1200
1600
2000
Thousands of Units, Annual Rate Thousands of Units, Annual Rate
Source: Census Bureau
Starts
Sales
Chart 4.1.10 Distressed Sales Share o Total Home Sales
0
10
20
30
40
50
2000 2002 2004 2006 2008 2010
0
10
20
30
40
50
Percent Percent
Source: CoreLogic
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22 2011 FSOC Annual Report
More than osetting the developments in these
undamentals, ongoing operational deciencies
and legal challenges in the processing o
oreclosure lings have signicantly slowed
the oreclosure process, adding to a growing
inventory o distressed properties. Moreover,
the government-sponsored enterprises (GSEs)Fannie Mae and Freddie Mac, as well as the
Federal Housing Administration (FHA) and
the Department o Veterans Aairs (VA)
which together account or the guarantee
and insurance o more than 90 percent o
originationshave tightened their underwriting
standards. Standards have been tightened
across product, credit score, and loan-to-
value (LTV) spectrums, and ewer loans with
low down payments are being guaranteed.
FICO scores on mortgage originations have
risen sharply, refecting the tighter underwritingstandards as well as the characteristics o
borrowers who are applying or credit (Chart
4.1.14).
On the other hand, FHA/VA loans, which
typically have higher LTVs and hence greater
risk compared with GSE loans, have gained a
larger share o the market, rising rom 3 percent
o total market originations in 2005 to more
than 30 percent in mid-2010.
National commercial real estate (CRE)markets also weakened dramatically during
the credit crisis and recession. Moodys/
REAL commercial property price index ell
by about 45 percent rom its 2007 peak
(Chart 4.1.15). Sales activity also decreased
sharply: commercial property transactions
ell 89 percent to $66 billion in 2009 rom a
peak o $579 billion in 2007. A combination o
weaker cash lows, lower collateral values, and
tightened underwriting standards since 2008
has made it more diicult or CRE owners to
reinance their debt, putting urther stress onthe market. Since mid-2008, bank lending to
inance commercial property has allen by 50
percent. One-quarter o recent CRE activity
has involved distressed properties.
Commercial mortgage-backed security (CMBS)
issuers account or nearly 25 percent o the
total CRE debt. Refecting the credit crisis
Chart 4.1.11 Net Consumer Sector Credit Flows
-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1
-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
Trillions of US$ Trillions of US$
Mortgage and Home EquityNonmortgage
Source: FRBNY Consumer Credit Panel
Chart 4.1.12 National Repeat Sales Home Price Indexes
100
120
140
160
180
200
220
2000 2002 2004 2006 2008 2010
100
120
140
160
180
200
220
Index, January 2000 = 100 Index, January 2000 = 100
Source: FHFA and CoreLogic
CoreLogic(including distressed sales)
FHFA
CoreLogic(excluding distressed sales)
Chart 4.1.13 Housing Aordability Index
80
100
120
140
160
180
200
1990 1994 1998 2002 2006 2010
80
100
120
140
160
180
200
Index Index
Source: NAR
Note: At 100 the income of a median family would qualify for an80% LTV mortgage on a median priced single-family home.
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Macroeconomic Environment 23
and economic stress, issuance o CMBS
in the United States was only $2.7 billion in
2009 and $11.6 billion in 2010, well below the
approximately $200 billion issued in both 2006
and 2007 (Chart 4.1.16).
Recently, the commercial property market hasshown tentative signs o recovery, with more
sales activity among higher quality, well-leased
properties in major metropolitan markets, as
well as signs o increased demand or and
supply o commercial property loan nancing.
The Senior Loan Ocer Opinion Survey or
April 2011 showed that about 35 percent o
domestic banks on net had seen increased
demand or CRE loans, and a ew large banks
and oreign banks had eased their lending
standards somewhat, although outstanding
bank commercial property loans have continuedto all.
Securitization Markets
Much o the large increase in credit leading
up to the nancial crisis was driven by an
expansion o securitized credit, particularly in
the mortgage market. During this time, nancial
market participants and regulators tended to
view securitization avorably: it allowed banks
to reduce their exposure to certain types o
loans, redistributing