Front Matter Page

IMF Country Report No. 15/172

UNITED STATES

FINANCIAL SECTOR ASSESSMENT PROGRAM

SYSTEMIC RISK OVERSIGHT AND MANAGEMENT—TECHNICAL NOTE

July 2015

This Technical Note on Systemic Risk Oversight and Management on the United States was prepared by a staff team of the International Monetary Fund. It is based on the information available at the time it was completed in June 2015.

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Front Matter Page

UNITED STATES: FINANCIAL SECTOR ASSESSMENT PROGRAM

TECHNICAL NOTE: SYSTEMIC RISK OVERSIGHT AND MANAGEMENT

June 2015

Prepared By

Monetary and Capital Markets Department

Contents

• GLOSSARY

• EXECUTIVE SUMMARY

• SYSTEMIC RISK OVERSIGHT AND MANAGEMENT OVERVIEW

• A. Overview

• B. Remit, Responsibilities and Organization of FSOC

• C. Strengthening Systemic Risk Identification in the United States

• D. Addressing Identified Threats to Financial Stability

• E. Systemic Risks—A Closer Look at Some Key Concerns

• SYSTEMIC LIQUIDITY AND LIQUIDITY BACKSTOPS

• A. Introduction

• B. Tri-party Repo Infrastructure

• C. Repo Safe Harbors

• D. Broker-dealers

• E. Money Market Mutual Funds

• F. Fed Exit and Financial Stability

• G. Data Gaps

• H. Liquidity Backstops

• INVESTMENT FUNDS AND SYSTEMIC RISK

• A. Asset Managers and Market Liquidity Risks

• B. Securities Lending by Mutual Funds

• SYSTEMIC RISK OVERSIGHT OF FINANCIAL MARKET INFRASTRUCTURES

• A. Overview of FMIs in the United States

• B. Regulation and Supervision of FMIs

• C. System-Wide Risks Identification and Management

• D. Crisis Management Arrangements

• HOUSING FINANCE

• BOXES

• 1. Summary of Major Authorities and Tasks of FSOC

• 2. Normalizing Monetary Policy, Reverse Repos and Financial Stability

• FIGURES

• 1. Intraday Credit as of May 2014

• 2. MMMFs Funds by Type

• 3. ONRRP and Selected Interest Rates

• 4. TPR Collateral

• 5. TPR Haircuts January 2015

• 6. Corporate Bonds Inventory

• 7. Sold Assets under Stress and Dealers Inventories

• 8. Private Nonfinancial Sector Debt

• 9. Mortgage Debt by Holder

• 10. Residential Mortgage-Backed Security Issuance

• TABLES

• 1. Organization, Role and Powers of FSOC and other Macroprudential Oversight Bodies

• 2. Primary Supervisory Agency and Application of Enhanced Risk Management Standards for U.S. FMIs

• APPENDICES

• 1. Remit and Organization of the Financial Stability Oversight Council

• 2. The Office of Financial Research

• 3. Macroprudential Policy Tools in the United States

• 4. Risks and Interconnectedness In and Around TPR

• 5. Statistics on Financial Market Infrastructures

• 6. FMI Landscape

• 7. Cross-Margining Arrangements and CSD Links

• 8. Dependencies of Designated FMUs on Commercial Bank Services

• APPENDIX TABLES

• 1. Statistics on FMIs, 2013

• 2. CCPs Offering OTC Derivatives Clearing

• 3. CCP Size of Financial Resources, December 2013

Glossary

Executive Summary¹

The importance of enhancing systemic risk oversight and building effective macroprudential tools is widely recognized. In the United States, where the financial markets display a greater degree of heterogeneity than elsewhere, and supervision and regulation are split amongst a range of specialist agencies, the need to build structures that ensure interagency sharing of information, avoid regulatory gaps, obtain a good overview of systemic risks, and develop an effective, cooperative framework to address identified threats to financial stability is particularly evident. This paper reviews those processes in the United States, as well as examining progress to address several important areas of risk which have been identified, particularly in the non-banking sector.

The establishment of the Financial Stability Oversight Council (FSOC) in 2010 filled a major gap in the U.S. financial stability framework, and it is central to the regulatory response to the problems which hit the financial sector in 2007–2009.² The Dodd Frank Act (DFA) gives the Council a range of powers that enable it to respond to emerging threats to financial stability (see Box 1).³ In practice the Council works primarily through enhanced communication, consultation, and coordination of the work of the U.S. financial regulatory agencies; the effectiveness of FSOC relies extensively on the Council’s success in building and delivering a collective, common, purpose across the U.S. financial regulatory agencies to identify and address systemic risks and to work together to promote financial stability. The work which the FSOC has undertaken is welcome. However:

• The collective purpose and accountability of FSOC would be strengthened by providing to each member agency and member an explicit mandate to promote financial stability and thus to support the work of FSOC (subject to the mission and objectives of the member agencies and members). ⁴

• Further actions are needed to: address data gaps; resolve remaining impediments to data sharing; support coordination and consultation on prudential standards and regulations; enhance risk monitoring frameworks; provide additional clarity on the nature and scale of identified emerging systemic threats; and strengthen the transparency and collective ownership of the actions needed to address identified risks by clarifying and publishing more specific follow-up actions, and outlining where responsibility for delivery lies, including the expected timeline for implementation and reporting of results.

• The development of the macroprudential toolkit remains a work in progress; FSOC member agencies and members should continue to focus on measures to address the buildup of cyclical and sectoral risks and to strengthen the resilience of financial markets to run risks; as well as clarifying the framework for implementation of macroprudential policies.

Significant steps have been taken by the U.S. authorities to reduce risks in a number of areas, but progress is most advanced in the area of banking sector resilience, and less so in other areas which play a major role in the financial system.

• In the area of Too-Big-to-Fail, progress has been made with FSOC designation, and with heightened prudential standards and enhanced supervision, which together with the development of ‘living wills’ and resolution legislation and procedures reduce the risk that the material financial distress or activities of an individual firm could pose a threat to U.S. financial stability. At the same time, the DFA restricts the authorities’ (and in particular the Fed’s) ability to provide a liquidity backstop to individual institutions. This clearly puts an onus on the effectiveness of strengthened prudential standards and recovery and resolution planning. In the transition, until they are fully embedded, the U.S. Treasury, the Fed and other regulatory agencies need to ensure that adequate plans are in place and legal authorities sufficiently clear, to allow for a timely and sufficient response to any problems that may arise in Systemically-Important Financial Institutions (SIFIs), as well as in systemically-important markets.

• Given their increased systemic importance, all risks related to financial market infrastructures (FMIs), in particular central counterparties (CCPs), need to be carefully addressed. Progress is continuing in this area: agencies have substantially increased staff, and regulatory frameworks governing designated Financial Market Utilities (FMUs)⁵ provide for transparency, governance, and strong risk management. It will be important to promptly finalize implementation of the internationally agreed PFMI, through completion of rules and their implementation by FMIs, and by further addressing the potential threat posed by the concentration of service provision by G-SIBs to FMIs. Providing designated FMUs with an account at a Federal Reserve Bank will be an important element of this. System wide risks related to interdependencies and interconnections in the U.S. FMI landscape could be further identified and managed. Finally, recovery and resolution plans for FMIs are at an early stage and authorities are encouraged to continue their efforts to further develop these in line with international guidance.

In principle, there should be no impediment in designating any entity or identifying an activity as systemically important if the entity’s failure, distress or excesses or the nature of the activity could cause a major disruption in the financial markets, and consequently subjecting it to higher prudential standards of regulation and supervision or enhanced resolution regimes. In practice, the challenge lies in applying this principle to non-banks such as investment funds and to activities such as asset management, which are often managed by agents and where the focus of regulation has mainly been on conduct. The FSOC has been deliberating on this issue, as has the FSB at the international level. It is important that potential risks in these areas are addressed, given the concerns in the present conjuncture about the build-up of systemic risks in non-banks. It should be noted that under Section 112 of the DFA, FSOC can make recommendations in this regard to the primary regulators even in the absence of designation, and it should be prepared to use this authority.

Focusing particularly on the areas of liquidity risks, market based finance, and housing finance, important remaining weaknesses include:⁶

• Reforms to the triparty repo infrastructure have reduced, though not eliminated, a number of risks; and consideration should be given to the use of a central counterparty (CCP) with access to central bank accounts to further reduce risks.

• Money market mutual funds (MMMFs) have been made more resilient, but the use of stable Net Asset Values (NAVs) persists, and even after 2016 may apply to three quarters of the funds managed by MMMFs, allowing both institutional and retail investors to treat these investments as cash-equivalent despite the greater liquidity risks involved than with cash.

• More needs to be done: to strengthen broker-dealer (BD) regulation and supervision (especially since it cannot be assumed the large BDs will remain under Bank Holding Companies (BHCs) forever); to review risk management practices related to securities lending and cash collateral reinvestment (improving data will be a necessary part of this); and to review the impact of coverage of the safe harbor provisions governing repo transactions.

• Expansion of open-ended mutual funds (MF) and exchange traded funds (ETF) in certain products has increased market liquidity risks. These funds’ holdings of high yield (HY) corporate bonds, emerging market (EM) debt and bank loans have increased substantially since 2008 even as common metrics of trading liquidity have declined significantly in these products. Structural factors, including money-like investment shares, lack of balance-sheet capacity to meet investor redemption demand, and incentives for investors to herd give cause for concern.

• Important data gaps remain in some significant areas: there are shortfalls not only in the collection of data, but also in the availability and ease of manipulation of data across FSOC members and financial regulatory agencies. Steps taken to address these are welcome, though it is striking that in some—such as bilateral repo, securities lending and asset management—data gathering is still at very early stages.

• A comprehensive assessment of financial stability risks from MFs’ securities lending and embedded leverage is needed. The FSAP discussions suggest that MFs’ investment of cash collateral received in securities’ lending is increasingly directed by mandates to MMMFs. While this avoids maturity risks in term repo deals increasingly preferred by dealers, it does not eliminate liquidity risk given that redemptions from such MMMFs could be gated at times of stress.

• Not enough has been done to tackle the structural weaknesses in mortgage markets that were uncovered during the GFC. The legislative reforms of Fannie Mae and Freddie Mac have stalled. It is essential to reinvigorate legislative momentum for comprehensive housing finance reform in line with recent proposals.