## _cr10247

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---

### Executive summary — key findings
- The United States experienced "one of the most devastating financial crises in a century," but "now seems to be slowly recovering."
- Costs of the crisis were "massive," including job and output losses, significant deterioration in public debt, and "enormously damaging spillovers to the rest of the world."
- U.S. policy response was "bold and aggressive"; "most emergency liquidity and guarantee facilities have been wound down."
- Drivers of the crisis:
  - Unsustainable lending boom fueled by low interest rates and capital inflows.
  - A housing bubble.
  - Rapid rise of a "shadow banking system".
  - Decline in underwriting standards.
  - Weaknesses in risk management, governance, and compensation.
  - Growing use of complex derivative and structured credit instruments with poorly understood risk properties.
- Persistent vulnerabilities: "insufficient market discipline" and "critical shortcomings and gaps in the supervisory and regulatory framework, both at a micro- and macro-prudential level."
- Remaining risks:
  - "Bank balance sheets remain fragile and capital buffers may still be inadequate."
  - Vulnerability to weakening demand, CRE credit quality, and housing prices.
  - Heightened risks of "a sharp deterioration in market perceptions of sovereign risk."
- Stress test headline:
  - "Thanks to substantial public and private capital injections, equity buffers now appear adequate from a systemic perspective."
  - Some institutions—especially regional and smaller banks—could still face further difficulties under modestly adverse scenarios.

### Crisis management and liquidity provision — analysis
- Crisis management framework was "severely tested"; need for a "more systematic and forward-looking framework" with clear responsibilities.
- New systemic oversight council and strengthened Fed role are appropriate; critical to ensure inter-agency coordination, accountability, and capacity to act.
- Liquidity backstops:
  - "Decisive action was taken to expand official liquidity backstops."
  - "Most of the crisis support facilities have expired without noticeable market impact" but scope for broad liquidity provision should be retained.
  - As the Fed articulates principles for future lending to nonbank financial intermediaries, important to "strengthen risk monitoring."

### Failures of regulatory and supervisory framework — analysis
- Shortcomings left the system ill-placed to stem systemic risk buildup.
- Critical focus areas:
  - Strengthen supervision of risk management across regulated and systemic entities.
  - Reinforce consolidated supervision and attendant capital/liquidity rules; address BHC oversight constraints.
  - Broaden perimeter for oversight of securities and derivatives (OTC derivatives, unregistered structured finance securities, off-exchange trading platforms).
  - Strengthen oversight of payment, clearing, and settlement infrastructures; provide Fed authority over systemic infrastructure providers.
  - Address supervisory gaps in the shadow banking sector to "level the playing field."

### Fragmentation of U.S. supervision — analysis
- Complexity and diffusion of powers across agencies "undermined [supervisory] efficiency, effectiveness, transparency, and accountability."
- Crisis highlighted weaknesses in systemic oversight, inter-agency communication, and consolidated supervision.
- Reform legislation sought to address issues but "bolder action would have been preferable." Number of oversight agencies "has been increased rather than shrunk."

### Too‑big‑to‑fail and systemic firm measures — recommendations
- FSOC/new council should have authority to access information, mandate coordinated cross‑firm supervisory reviews, and require actions to head off systemic threats.
- Fed should be defined as lead agent for systemic risk oversight.
- Measures to reverse "too‑big‑to‑fail" perceptions:
  - Stricter enterprise-wide standards for capital, liquidity, and risk management for systemic firms.
  - Require "living wills" and enable pre-emptive group-structure changes.
  - Introduce a special resolution framework for early intervention and non-disruptive wind-down.
  - Implement compensation and governance rules to discourage excessive risk taking.

### Housing GSEs — findings and policy direction
- Housing GSEs "have helped both underpin and unhinge the U.S. financial system" and require "fundamental reform."
- Recommended direction: move toward a public–private model, privatize retained portfolios, and reassign social objectives/guarantee functions to an explicitly public utility.

### Key recommendations (timing and priority preserved)
- Institutionalize and strengthen systemic risk oversight:
  - Establish a council with mandate for financial stability and powers to designate potentially systemic firms. — ST, HP
  - Define the Fed as the lead executor and consolidated supervisor of designated potentially systemic firms. — ST, HP
  - Provide the Fed oversight authority over systemically important payment, clearing, and settlement infrastructure. — ST, HP
- Redesign regulatory architecture:
  - Strengthen the Fed’s consolidated role; unify safety-and-soundness regulation of commercial banks/thrifts; unify federal securities and derivative market regulation. — ST/MT, HP/MP
  - Establish independent federal consumer protection agency. — ST, MP
  - Establish federal office to promote regulatory uniformity in insurance. — MT, MP
- Strengthen micro-prudential regulation and supervision across banking, securities, derivatives, and insurance with specified timing/priorities (ST/MT; HP/MP preserved as in source).
- Shadow banking and short-term funding markets:
  - Discourage deposit‑like instruments outside formal banking and set minimum haircuts for repo transactions. — ST, HP
  - Require money market funds to make real-time disclosures of actual NAVs. — MT, MP
- Market infrastructure oversight:
  - Allow systemic payment, clearing, and settlement infrastructures to have Fed accounts and emergency Fed liquidity access. — ST, HP
  - Increase frequency of stress testing from monthly to weekly for clearing/settlement infrastructures. — ST, MP
- Crisis management and resolution:
  - Extend FDIC special powers to enable receivership/conservatorship of BHCs and systemically important firms. — ST, HP
  - Review Deposit Insurance Fund funding and consider removing the ceiling on fund size. — MT, MP
  - Implement "living will" requirements for large, complex groups. — MT, HP
- Too‑big‑to‑fail and GSEs:
  - Subject systemic institutions to more stringent prudential requirements and grant regulators pre-emptive authority. — ST, HP
  - Reform housing GSEs (privatize retained portfolios; reassign guarantees to a public utility). — MT, HP

### Causes of vulnerability (maturity and risk transformation)
- "Originate‑to‑distribute" model led to complex structured securities, credit derivatives, and funding chains with embedded leverage and poorly understood risk.
- A shadow banking sector funded longer‑maturity structured credit with short‑term wholesale funding.
- Drivers: regulatory gaps/arbitrage, information asymmetries, diluted underwriting standards.

### Trigger and crisis dynamics
- Collapse of subprime mortgages triggered downgrades of structured debt, impairing investor confidence and causing markets to seize.
- Consequences: jump in repo "haircuts", run on wholesale funding, and major failures.

### Policy response and interventions (selected numeric facts preserved)
- Fed actions: discount window, Term Auction Facility, funding mechanisms for primary dealers and the tri‑party repo market, support for money market mutual funds and ABCP, Large Scale Asset Purchase program.
- Treasury TARP authority: $700 billion to purchase assets, make equity investments and loans, and provide guarantees.
  - So far, some $310 billion of capital provided to around 400 financial institutions.
  - CPP effectively closed, earning $19 billion and representing a 17 percent return on investment on the top‑25 institutions that fully repaid.
  - TARP extended until October 3, 2010.
- Other measures:
  - Treasury guaranteed over $3 trillion in assets to prevent MMF runs.
  - FDIC extended coverage to $250,000 and provided unlimited transactions deposit guarantee.
- Fiscal outcomes:
  - By end‑FY2009, fiscal cost of stabilizing the financial system estimated at less than $120 billion.
  - Treasury ended Temporary Guarantee Program for money market funds in September 2009 with no losses and $1.2 billion in fees collected.
  - FDIC Debt Guarantee Program issuances ended October 2009, with over $10 billion in fees collected.
  - Fed crisis programs expired progressively except foreign exchange swap lines (re‑opened May 2010).

### Banking sector conditions and vulnerabilities — key statistics (selected)
- Real estate and loan maturity pressures:
  - About $1.4 trillion of CRE loans will mature in 2010–14; nearly half are seriously delinquent (90 days+) or "underwater."
- Financial soundness indicators (selected series, 2002–March 2010):
  - Total regulatory capital to risk‑weighted assets: 13.0, 13.0, 13.2, 12.9, 13.0, 12.8, 12.8, 14.3, 14.7
  - Tier 1 capital to risk‑weighted assets: 10.4, 10.5, 10.8, 10.6, 10.5, 10.1, 10.0, 11.7, 12.1
  - Core capital (leverage) ratio: 7.9, 7.9, 8.1, 8.3, 8.2, 8.0, 7.5, 8.7, 8.6
  - Nonperforming loan ratio: 1.4, 1.1, 0.8, 0.7, 0.8, 1.4, 2.9, 5.4, 5.5
  - Reserve coverage ratio (allowances to nonperforming loans): 123.7, 140.3, 168.0, 154.8, 134.8, 91.7, 75.3, 58.1, 64.2
  - Net charge‑off rates (consumer loans): 3.0, 3.1, 2.8, 3.2, 2.4, 2.8, 4.2, 5.4, 6.5
  - Annual change in house price index (FHFA national, NSA): 6.9, 7.0, 10.5, 11.2, 4.8, -0.1, -4.4, -4.5, -6.8
  - Number of institutions: 9,354; 9,181; 8,976; 8,833; 8,680; 8,534; 8,305; 8,012; 7,932
  - Household debt‑service ratio: 13.2, 13.2, 13.3, 13.8, 13.9, 13.9, 13.6, 12.7, 12.5

### Remaining macrofinancial fragility and risks
- Stability restored but macrofinancial situation remains fragile; economy and markets still rely on policy support.
- Output gap expected to remain wide for many years; household sector deleveraging significant.
- Key downside risks:
  - Sluggish growth could undermine balance sheet repair.
  - Sharp worsening of real estate conditions could trigger self‑reinforcing dynamics and losses concentrated at small/midsize depositories.
  - Mounting fiscal deficits: Administration’s 2011 budget projected federal debt to rise to over 70 percent of GDP by 2020; erosion of market confidence could raise interest rates and impair balance sheet repair.

### Stability of financial markets and structure (selected shares)
- Financial system composition (selected shares and % GDP entries, 2002–March 2010):
  - Depository institutions: 24.0 (% share) — 88.3 (% GDP) — 22.1 — 97.8 — 25.9 — 109.0 — 25.9 — 112.6 — 26.5 — 113.6
  - GSEs: 14.8 — 54.5 — 12.3 — 54.3 — 13.7 — 57.8 — 13.3 — 58.0 — 12.7 — 54.3
  - "Shadow banking system": 21.4 — 78.5 — 23.5 — 103.9 — 24.5 — 103.3 — 20.9 — 90.8 — 19.3 — 83.1
  - Investment and pension funds: 26.8 — 98.3 — 30.5 — 134.6 — 22.7 — 95.5 — 26.5 — 115.4 — 27.7 — 119.1
- Memorandum:
  - Total financial system = 100.0 (% share) — 367.2 (% GDP) — 100.0 — 441.7 — 100.0 — 420.9 — 100.0 — 435.3 — 100.0 — 429.3

### Opacity of OTC markets, structured credit, and securitization
- Trading in bespoke OTC products fell sharply, undermining price discovery and hedging.
- Critical weaknesses: lack of transparency in pricing, opacity of risk characteristics (e.g., CDOs), inadequate collateralization, weak margining, widespread rehypothecation.
  - Example: Lehman had reused or rehypothecated an estimated $427 billion of securities posted as collateral.
- Securitization markets dysfunction risks impairing banks’ ability to roll over securitized products and new lending—particularly for small‑ and medium‑sized companies.

### Regulatory responses for credit rating agencies
- Legislative and other initiatives to strengthen SEC oversight and avoid "ratings shopping" and conflicts of interest at rating agencies.

### Stress testing vulnerabilities and scenarios
- Authorities’ SCAP (2009) stressed 19 largest BHCs; SCAP-19 raised about $205 billion of private capital, 54 percent in common equity, and redeemed 86 percent of $221 billion of preferred shares previously issued under CPP.
- FSAP team stress tests covered 53 largest BHCs (85 percent of aggregate BHC assets) using three approaches; limited by public data availability, especially on funding risk.
- Scenario descriptions (Box 2):
  - Baseline: IMF April 2010 WEO; inflation stabilizes at about 2¼ percent; government bond yields rise moderately; government debt‑to‑GDP ratio increases.
  - Adverse: four combined shocks leading to faltering growth, rising inflation and yields; government debt‑to‑GDP ratio climbs almost 10 percentage points above baseline by 2013.
  - Alternative: further deterioration in real estate sectors; CRE prices fall by another 8 percent by end‑2012 (vs. 3.3 percent in adverse scenario); CRE losses peak at 5.1 percent at end‑2011.
- Selected peak net loss timing entries:
  - Residential real estate loans: 2.7 (2009 Q4), 3.4 (2011 Q4), 3.5 (2012 Q1)
  - Consumer loans: 6.5 (2010 Q1)
  - CRE loans: 3.4 (2011 Q2), 4.6 (2011 Q3), 5.1 (2011 Q4)

### Key stress‑test findings and capital needs (selected figures)
- Baseline:
  - Capital adequate for most banks.
  - Four largest BHCs and former investment banking groups expected to maintain a 6 percent tier 1 common equity ratio over 2010–14.
  - Four regional banks and seven smaller institutions (assets below $60 billion) would require a total of $8 billion in additional capital owing to CRE exposure.
  - Subsidiaries of foreign banks would require up to $26 billion.
- Adverse:
  - Around one‑third of U.S. BHCs would experience some capital shortfall.
  - Total of $32 billion needed to maintain a 4 percent tier 1 common equity ratio until end‑2014, including $15 billion for three SCAP banks.
  - Four regional banks would require $8 billion and ten smaller institutions another $15 billion; foreign BHCs would need $22 billion.
  - Adverse scenario assumes 2010–11 cumulative loan loss rate of 7.7 percent (8.7 percent including securities write‑downs), below the 9.1 percent 2009–10 cumulative rate assumed under authorities’ SCAP tests.

### Liquidity, rollover risk, and interdependencies
- Market liquidity risks for systemic firms appear to have declined, but rollover risk requires monitoring given loan maturities bunching in 2011–13.
- Distress‑dependency analysis indicates substantial cumulative losses under baseline and adverse scenarios; about 20 percent of systemic losses attributable to housing GSEs.
- Cross‑border linkages: as of June 2010, if all U.S. (or all European) banks in the sample were to fall into distress, there would be roughly a 40 percent chance of spillover to European (U.S.) banks.

### CCA (contingent claims analysis) findings on public support efficacy (selected table)
- Table 7 (95th percentile, US$ billions):
  - Full period Apr 1, 2007–Jan 29, 2011:
    - Assuming no capital injection: 2382
    - Actual: 1419
    - Assuming 2x actual capital injection: 197
  - Pre‑crisis Jul 1, 2007–Sep 14, 2009:
    - Assuming no capital injection: 991
    - Actual: 919
    - Assuming 2x actual capital injection: 191
  - Crisis period 1 Sep 15–Dec 31, 2009:
    - Assuming no capital injection: 4844
    - Actual: 779
    - Assuming 2x actual capital injection: 469
  - Crisis period 2 Jan 1–May 8, 2010:
    - Assuming no capital injection: 4143
    - Actual: 593
    - Assuming 2x actual capital injection: 353
  - Crisis period 3 May 11, 2009–Dec 31, 2010:
    - Assuming no capital injection: 3562
    - Actual: 2722
    - Assuming 2x actual capital injection: 226

### Insurance sector: resilience, vulnerabilities, and stress testing (selected)
- Stress tests of 30 largest life insurers:
  - Aggregate RBC ratio would decline from 843 percent at end‑2008 to 459 percent after the combined shocks.
  - Six out of 30 companies would have RBC ratios below 200 percent.
  - No company would have a negative RBC ratio under the scenario.
- Insurance sector indicators (2004–09, selected):
  - Life insurance total adjusted capital ($ billion): 340, 344, 364, 383, 338, 385 (2004–2009)
  - Life insurance aggregate RBC ratio (percent): 775, 814, 811, 802, 758, 835 (2004–2009)
  - Property & casualty total adjusted capital ($ billion): 485, 524, 599, 641, 579, 644 (2004–2009)
  - Health insurance total adjusted capital ($ billion): 47, 62, 72, 80, 75, 82 (2004–2009)
- U.S. insurance market: 7,948 licensed insurance companies at end‑2008; total premium volume in 2008: $1.24 trillion (29 percent of global market).

### Systemic liquidity arrangements, Fed balance sheet, and OMO considerations (selected)
- As of end‑May 2010:
  - Conventional discount window borrowing fell below $5 billion; peak was $112 billion at end‑October 2008.
  - Term Auction Facility borrowing peaked at nearly $500 billion and was fully repaid by mid‑April 2010.
  - Fed holdings of GSE bonds and MBSs totaled $1.3 trillion, with excess bank reserves over $1 trillion.
- Operational tools to manage large excess reserves: reverse repos, term deposit auctions, adjustments to IOER.
- Potential OMO amendments: expand regular OMO counterparties beyond primary dealers; consider widening eligible collateral for OMO with caution.

### Strengthening financial sector oversight — weaknesses and actions
- Key shortcomings:
  - Multiplicity of regulators; no single body with clear financial stability mandate.
  - Consolidated regulation and supervision insufficient for systemic groups.
  - Weaknesses in risk management oversight and funding arrangements for supervisors.
- Recommended banking supervision enhancements:
  - Strengthen group‑wide oversight, regular inter‑agency horizontal assessments, and domestic supervisory "colleges."
  - Boost timeliness and forcefulness of interventions and invest in staff skills and data systems.
- Basel II: U.S. preparations advanced for large internationally active banks; no final view on regime for small and midsize banks.

### OTC derivatives, securitized instruments, and market infrastructure reforms
- OTC derivatives reforms in new legislation (selected provisions):
  - Registration for dealers and "major swap participants."
  - Powers for SEC/CFTC to determine clearing and trading venues.
  - Reporting requirements for all derivative transactions.
  - Enhanced prudential and collateral requirements for non‑centrally cleared trades.
- Securitized credit reforms:
  - Improve issuer disclosure (including computer coding of waterfalls) and credit rating quality.
  - Caution against unintended consequences from accounting rule changes (FAS 166 and 167) and "skin in the game" rules.
- Payment and settlement systems:
  - Fed intraday liquidity policy to facilitate collateralization of daylight credit (implementation late 2010/early 2011).
  - Concentration risks in government securities settlement require monitoring; recommendations include increased stress testing, external validation, separate collateral pools, and access to liquidity outside repo markets.
- New oversight powers:
  - Fed may authorize designated financial market utilities to open deposit accounts at the Fed and, in unusual/exigent circumstances and after consultation with Treasury, access the discount window.

### Regulatory architecture, FSOC, Dodd‑Frank, and implementation challenges
- Dodd–Frank features (selected):
  - FSOC: statutory systemic risk regulator with Office of Financial Research.
  - Fed: consolidated oversight of designated nonbank firms and enhanced supervision of BHCs/SLHCs.
  - Special resolution authority and "orderly liquidation authority" for systemic firms.
  - Regulation of derivative markets (clearing, exchanges, reporting).
  - Bureau of Consumer Financial Protection (BCFP) created.
  - Federal Insurance Office established to monitor insurance.
- Implementation challenges:
  - Legislation increases the number of agencies rather than streamlining architecture; multiple time‑bound rulemakings required.
  - FSOC must coordinate nine federal bodies and improve inter‑agency data sharing.
  - Dodd‑Frank left housing GSEs largely untouched; GSE reform remains unfinished.
  - Fed’s role strengthened but some exceptions to consolidated supervision persist pending GAO review.

### Macro‑prudential framework, moral hazard, and regulatory perimeter
- FSOC keystone of macro‑prudential framework: gather information, designate systemically important nonbank firms for Fed supervision, recommend actions, report to Congress.
- Addressing moral hazard / too‑big‑to‑fail:
  - Tools include liquidity and capital surcharges, anti‑cyclical provisioning, leverage ratios, contingent capital, resolution fees, and compensation/governance reforms.
  - Living wills critical; require periodic updating and pre‑emptive use to simplify group structures.
- Regulatory perimeter:
  - FSOC role includes monitoring and adjusting the perimeter; address shadow banking via money market fund disclosure, ABCP/ABS requirements, and tri‑party repo restructuring.

### Cross‑border coordination and living wills
- U.S. reforms should catalyze international efforts on resolution of global conglomerates; living wills should identify foreign legal framework inconsistencies and prompt coordinated crisis management frameworks.
- Recommendation: establish more permanent coordinated mechanism for offshore dollar market pressures and extend supervisory colleges to major emerging markets.

### Risk Assessment Matrix — selected threats, likelihoods, and impacts
- Inability to roll over outstanding CRE loans
  - Likelihood: High
  - Key facts: "Around $1.4 trillion of CRE loans are expected to mature by 2014, and almost half of these are underwater or seriously delinquent."
  - Expected impact: Medium
- Further weaknesses in residential real estate prices
  - Likelihood: High
  - Expected impact: Medium
- Double‑dip recession
  - Likelihood: Low
  - Expected impact: Medium
- Loss of credibility of long‑term fiscal consolidation
  - Likelihood: Low (but rising)
  - Key fact: "Under the authorities’ current projections, the federal debt‑to‑GDP ratio is expected to rise to nearly 100 percent by 2020."
  - Expected impact: Medium
- Credit crunch/limited securitization
  - Likelihood: Low
  - Expected impact: Low
- Regulatory uncertainty
  - Likelihood: Low
  - Expected impact: Low
- Failure of systemically important institutions
  - Likelihood: Low
  - Expected impact: Medium

*Source: Executive Summary, _cr10247 - Executive Summary.*

### Executive Summary ......................................................................................................

### _cr10247 - Executive Summary ......................................................................................................

### Executive summary — key findings
- The United States experienced "one of the most devastating financial crises in a century," but "now seems to be slowly recovering."
- Costs of the crisis were "massive," including job and output losses, significant deterioration in public debt, and "enormously damaging spillovers to the rest of the world."
- The U.S. policy response was "bold and aggressive" and helped restore stability; as a result, "most emergency liquidity and guarantee facilities have been wound down," and significant legislative steps were being taken to strengthen supervision and regulation.
- Drivers of the crisis included:
  - An unsustainable lending boom fueled by low interest rates and capital inflows from abroad;
  - A housing bubble;
  - Rapid rise of a "shadow banking system";
  - Decline in underwriting standards;
  - Weaknesses in risk management, governance, and compensation structures;
  - Growing use of complex derivative and structured credit instruments whose risk properties and contribution to systemic fragility were poorly understood.
- These vulnerabilities persisted because of "insufficient market discipline" and "critical shortcomings and gaps in the supervisory and regulatory framework, both at a micro- and macro-prudential level."
- Remaining risks and vulnerabilities:
  - "Bank balance sheets remain fragile and capital buffers may still be inadequate" against further increases in nonperforming loans.
  - The economy and financial system remain vulnerable to an unexpected weakening of demand, credit quality in the commercial real estate (CRE) sector, and housing prices.
  - Heightened risks of "a sharp deterioration in market perceptions of sovereign risk" noted domestically and internationally.
- Stress test results:
  - "Thanks to substantial public and private capital injections, equity buffers now appear adequate from a systemic perspective."
  - Nonetheless, some institutions may still face strains even under a baseline macroeconomic scenario due to lagged effects on credit quality, regulatory demands for higher capital, and adjustment to sustainable leverage.
  - "Even a modestly adverse scenario could leave important parts of the system—especially the regional and smaller banks—facing further difficulties."

### Crisis management and liquidity provision — analysis
- Crisis management framework was "severely tested"; new arrangements need effective implementation.
  - Need for a "more systematic and forward-looking framework" that "clearly defines responsibilities and takes a broader, more systemic view."
  - The new systemic oversight council and a strengthened role for the Fed "as the consolidated supervisor of systemically important financial institutions and market utilities" are appropriate responses.
  - Critical to ensure mechanisms for "effective inter-agency coordination, accountability, and the will and capacity to act."
- Liquidity backstops:
  - "Decisive action was taken to expand official liquidity backstops" when traditional central bank standing facilities proved insufficient.
  - "Most of the crisis support facilities have expired without noticeable market impact" but the experience "illustrates the need to retain scope for broad liquidity provision."
  - As the Fed articulates principles for future lending to nonbank financial intermediaries, it will be important to "strengthen risk monitoring" in such areas.

### Failures of regulatory and supervisory framework — analysis
- Shortcomings in regulation and supervision "left [the system] ill-placed to stem the buildup of systemic risks."
- Administration’s white paper and agency heads identified numerous "gaps and weaknesses."
- Critical focus areas going forward:
  - Strengthening supervision of risk management across regulated and systemic entities via better implementation of rules, new processes, clear accountability, and stronger supervisory will to act.
  - Reinforcing consolidated supervision and attendant capital and liquidity rules; addressing legal and administrative constraints on bank holding company (BHC) oversight; establishing comparable oversight of broker-dealer, insurance, finance company, and savings and loan groups.
  - Broadening the perimeter for oversight of securities and derivatives to cover key funding and risk transfer markets (e.g., OTC derivatives, unregistered structured finance securities, off-exchange trading platforms).
  - Strengthening oversight of payment, clearing, and settlement infrastructures and providing the Fed authority over systemic infrastructure providers and payment, clearing, and settlement activities.
  - Addressing supervisory gaps and the shadow banking sector to "level the playing field," improve risk management in repo and funding markets, and ensure all systemic institutions and markets are inside the regulatory perimeter.

### Fragmentation of U.S. supervision — analysis
- Complexity and diffusion of powers across agencies "undermined [supervisory] efficiency, effectiveness, transparency, and accountability."
- Crisis highlighted weaknesses in systemic oversight, inter-agency communication, and consolidated supervision; blurring of lines between banks, broker-dealers, insurers, and other intermediaries amplified the problem.
- While steps to improve coordination have been taken, reinforcing effort to clarify mandates, accountability, and information sharing remains necessary.
- Reform legislation sought to address these issues but "bolder action would have been preferable." Some streamlining achieved, yet the number of U.S. oversight agencies "has been increased rather than shrunk," making coordination and effectiveness a critical challenge for the new council.

### Too-big-to-fail and systemic firm measures — recommendations and analysis
- The new council is to be mandated to identify and act upon systemic risk; effective discharge requires:
  - Authority to access information;
  - Power to mandate coordinated "horizontal" (cross-firm) supervisory reviews and market analysis;
  - Ability to require supervisory and regulatory actions to head off emerging systemic threats.
- The Fed should be defined as lead agent for systemic risk oversight given expertise and synergies with monetary policy and lender-of-last-resort responsibilities.
- Measures to reverse "too-big-to-fail" perceptions:
  - Subject systemic firms to stricter enterprise-wide standards for capital, liquidity, and risk management.
  - Require systemic firms to submit "living wills" and enable supervisors to order pre-emptive group-structure changes to facilitate orderly resolution.
  - Introduce a special resolution framework for early intervention and non-disruptive wind-down of failing systemic conglomerates.
  - Implement compensation and governance rules to discourage excessive risk taking.

### Housing GSEs — findings and policy direction
- Housing government-sponsored enterprises (GSEs) "have helped both underpin and unhinge the U.S. financial system" and require "fundamental reform."
- GSEs were pivotal in developing securitized credit and hedging markets, but implicit guarantees and social policy mandates softened credit discipline and contributed to systemic risk buildup.
- Recommended direction: move toward a public–private model in which GSEs' retained portfolios are privatized and their social objectives/guarantee functions are reassigned to an explicitly public utility.

### Key recommendations (timing and priority preserved as in source)
- Institutionalize and strengthen systemic risk oversight
  - Establish a council of the regulatory agencies, the Fed, and the Treasury, with a mandate for financial stability and powers including designation of potentially systemic firms for enhanced regulation and supervision focused on systemic risk. — ST, HP
  - Define the Fed as the lead executor of this council and the consolidated supervisor of designated potentially systemic financial firms, to work with other regulators. — ST, HP
  - Provide the Fed oversight authority over systemically important payment, clearing, and settlement infrastructure. — ST, HP
- Redesign the regulatory architecture
  - Strengthen the Fed’s role in consolidated regulation and supervision, including by enhancing coordination with bank and functional regulators and restricting deference requirements. — ST, HP
  - Unify safety-and-soundness regulation and supervision of commercial banks and thrifts in a single federal agency and eliminate the federal thrift charter. — ST, HP
  - Unify federal securities and derivative market regulation into one federal agency. — ST, MP
  - Establish an independent and accountable federal consumer protection agency, removing this responsibility from the other agencies. — ST, MP
  - Establish a federal office tasked with promoting greater regulatory uniformity in the insurance sector. — MT, MP
- Strengthen micro-prudential regulation and supervision
  - Banking: enhance capacity for group-wide oversight of banking groups and conduct regular inter-agency horizontal assessments of complex groups (possibly by establishing domestic supervisory "colleges"). — MT, HP
  - Banking: boost timeliness and forcefulness of supervisory and regulatory interventions to address enterprise-wide risk management weaknesses. — MT, HP
  - Banking: strengthen channels for cooperation, coordination, and learning from best practices among FBAs, market regulators, and the states. — MT, HP
  - Securities and derivatives: enhance enforcement and oversight capacities; re-examine capital rules and other prudential requirements. — ST, HP
  - Securities and derivatives: implement Joint Report recommendations to enhance investor protection and CFTC–SEC cooperation; close legislative and regulatory gaps. — MT, HP
  - Securities and derivatives: complete consolidation of equity and equity option market surveillance into a single entity, considering dark pools, high-frequency trading, predatory algorithms, and technology-based practices. — ST, MP
  - Promote standardization of OTC derivatives, increase reliance on exchange trading and multilateral clearing; require proper collateralization of all derivative transactions. — ST, MP
  - Improve transparency of OTC derivative and securities markets via timely transaction reporting and better investor information. — MT, MP
- Shadow banking and short-term funding markets
  - Discourage use of deposit-like instruments outside formal banking and ensure appropriate liquidity management by sectors potentially within the systemic liquidity safety net. — ST, HP
  - Set minimum haircuts for repo transactions and address incentives for repo clearing banks to extend intraday credit in clearing and settlement. — ST, HP
  - Require money market funds to make real-time disclosures of their actual (as opposed to "stabilized") net asset values. — MT, MP
- Insurance sector
  - Develop supervision of insurance groups through consolidated financial reporting and establish policies/procedures for regulation of systemically important institutions, markets, and instruments. — MT, HP
  - Increase information sharing and coordination between state regulators and federal authorities, including state representation in national bodies for system-wide oversight. — MT, MP
  - Strengthen regulation of bond insurance and securities lending and modernize solvency requirements. — MT, MP
  - NAIC and state legislatures should reform Commissioners’ appointments, rulemaking powers, funding, and staffing to bolster specialist skills. — MT, MP
- Market infrastructure oversight
  - Allow systemic payment, clearing, and settlement infrastructures to have accounts at the Fed to settle in central bank money and to have emergency access to Fed liquidity under terms established by the Fed’s Board of Governors. — ST, HP
  - The Fed should continue to assess infrastructures' ability to cope with extreme liquidity stress and explore introducing a queuing and offsetting mechanism in the Fedwire Funds Service. — ST, MP
  - Clearing and settlement infrastructures should increase frequency of stress testing from monthly to weekly and strengthen liquidity back-up facilities. — ST, MP
- Crisis management, resolution, and systemic liquidity
  - Extend FDIC special powers to enable receivership or conservatorship of BHCs and systemically important financial firms. — ST, HP
  - Review Deposit Insurance Fund funding by removing the ceiling on fund size and increasing its size. — MT, MP
  - Implement "living will" requirements for large and complex financial groups and address group structures that impede effective resolution. — MT, HP
  - Consider widening counterparties and collateral used for open market operations (OMO) and articulate policies for future Fed lending to nonbank financial firms to enhance scope and predictability of systemic liquidity provision. — MT, HP
- Too-big-to-fail and the GSEs
  - Discourage size and complexity by subjecting systemic institutions to more stringent prudential requirements. — ST, HP
  - Provide regulators authority to take pre-emptive actions when vulnerabilities build at potentially systemic firms. — ST, HP
  - Reform housing GSEs, possibly by privatizing retained asset portfolios and reassigning social objectives/system support to an explicitly guaranteed public utility. — MT, HP

*Source: Executive Summary, _cr10247 - Executive Summary.*

### 14. Decades of lax regulation of maturity and risk transformation rendered the

### 14. Decades of lax regulation of maturity and risk transformation rendered the U.S. financial system vulnerable to crisis

### Causes of vulnerability
- “Originate-to-distribute” model for residential mortgage and other debt gave rise to increasingly complex structured securities, credit derivatives, and funding chains with embedded leverage and poorly understood risk characteristics.
- A shadow banking sector provided short-term wholesale funding of longer-maturity, illiquid, structured credit.
- Drivers: regulatory gaps and arbitrage, information asymmetries, and diluted underwriting standards.

### Trigger and crisis dynamics
- Collapse of the subprime mortgage segment triggered downgrades of a broad range of structured debt securities, impairing investor confidence and causing markets to seize.
- Mistrust of counterparties and volatility of collateral values led to:
  - a jump in repo “haircuts”;
  - a run on wholesale funding;
  - spectacular failures and losses.

### Policy response and interventions
- The Fed relaxed monetary policy and provided liquidity support to depository institutions and critical nonbank financial firms and markets.
  - The Fed provided liquidity through its discount window and a new Term Auction Facility; introduced funding mechanisms to support primary dealers and the tri-party repo market, money market mutual funds and the asset backed commercial paper (ABCP) market, other commercial paper issuers, selected securitizations, and offshore dollar markets; and mounted a Large Scale Asset Purchase program to support mortgage and other private credit markets.
- The Treasury intervened through the Troubled Assets Relief Program (TARP; Box 1):
  - Treasury was given authority to use $700 billion under the TARP to purchase assets, make equity investments and loans, and provide asset guarantees.
  - Program focused on: (i) capital infusions to financial institutions through the Capital Purchase Program (CPP) or targeted assistance; (ii) supporting securitization markets through the Term Asset-Backed Securities Loan Facility (TALF); (iii) mitigating the foreclosure crisis through a mortgage modification program.
  - So far, some $310 billion of capital has been provided to around 400 financial institutions.
  - CPP has effectively been closed, earning $19 billion in dividends, interest income, and other income and representing a 17 percent return on investment on the top-25 institutions that have fully repaid.
  - The TARP was extended until October 3, 2010, to support small business lending, foreclosure mitigation efforts, and TALF commitments.
- Other government measures:
  - Treasury guaranteed over $3 trillion in assets to prevent runs on money market mutual funds at the height of the crisis.
  - FDIC extended insured deposit coverage to $250,000, provided an unlimited guarantee of transactions deposits, and guaranteed new bank debt issues.
  - The Fed provided liquidity to depository institutions, securities dealers, select foreign central banks, and key markets, and conducted unconventional large-scale asset purchases.
- Fiscal outcomes and program results:
  - By end-FY2009, the fiscal cost of stabilizing the financial system was estimated at less than $120 billion.
  - In September 2009, the Treasury ended its Temporary Guarantee Program for money market funds, with no losses and earning $1.2 billion in fees.
  - Issuances under the FDIC’s Debt Guarantee Program ended in October 2009, with over $10 billion in fees collected thus far.
  - The Fed’s crisis-related programs have expired progressively as scheduled, except for foreign exchange swap lines with foreign central banks (re-opened in May 2010).

### Banking sector conditions and vulnerabilities
- Capital positions have been improved and banks are provisioning substantially against loan losses.
- Early-2010 indicators:
  - Ratio of reserves to noncurrent loans showed first signs of stabilization by the first quarter of 2010.
  - Nonperforming loans and net charge-offs seem likely to rise further owing to high jobless rates and still significant weaknesses in the real estate sectors.
- Real estate and loan maturity pressures:
  - About $1.4 trillion of CRE loans will mature in 2010–14, nearly half of which are already seriously delinquent (90 days or more past due) or “underwater” (loan values exceeding property values).
  - The rising gap between residential real estate foreclosures and seriously delinquent loans suggests risk of further bank losses, especially for regional and community banks.
  - Very high level of underwater mortgages increases the risk of strategic defaults and further losses to banks and mortgage backed security (MBS) investors.
- Table 1 highlights financial soundness indicators (selected entries, 2002–March 2010):
  - Total regulatory capital to risk-weighted assets: 13.0, 13.0, 13.2, 12.9, 13.0, 12.8, 12.8, 14.3, 14.7
  - Tier 1 capital to risk-weighted assets: 10.4, 10.5, 10.8, 10.6, 10.5, 10.1, 10.0, 11.7, 12.1
  - Core capital (leverage) ratio: 7.9, 7.9, 8.1, 8.3, 8.2, 8.0, 7.5, 8.7, 8.6
  - Nonperforming loan ratio: 1.4, 1.1, 0.8, 0.7, 0.8, 1.4, 2.9, 5.4, 5.5
  - Reserve coverage ratio (allowances to nonperforming loans): 123.7, 140.3, 168.0, 154.8, 134.8, 91.7, 75.3, 58.1, 64.2
  - Net charge-off rates (selected): Consumer loans: 3.0, 3.1, 2.8, 3.2, 2.4, 2.8, 4.2, 5.4, 6.5; Residential loans: 0.2, 0.4, 0.1, 0.1, 0.2, 0.5, 1.6, 2.8, 2.4
  - Annual change in house price index (FHFA national index, not seasonally adjusted): 6.9, 7.0, 10.5, 11.2, 4.8, -0.1, -4.4, -4.5, -6.8
  - Number of institutions: 9,354; 9,181; 8,976; 8,833; 8,680; 8,534; 8,305; 8,012; 7,932
  - Household debt-service ratio: 13.2, 13.2, 13.3, 13.8, 13.9, 13.9, 13.6, 12.7, 12.5

### Remaining macrofinancial fragility and risks
- Stability appears restored but macrofinancial situation remains fragile.
  - Economy and key financial markets continue to depend heavily on fiscal, monetary, and financial policy support.
  - Output gap expected to remain wide for many years.
  - Household sector is deleveraging rapidly; household balance sheets undergoing significant adjustment.
  - Corporate default probabilities have been falling, but credit conditions for smaller firms are expected to tighten further.
- Key downside risks (as illustrated by recent events in Europe):
  - Sluggish growth: slower-than-expected recovery could dampen borrowers’ ability to honor debts and reduce credit demand, undermining balance sheet rehabilitation and financial sector earnings.
  - A sharp worsening of real estate conditions: a sharp rise in mortgage rates or a new wave of foreclosures could create a self-reinforcing dynamic between low property prices, tight financial conditions, and higher delinquencies and foreclosures; small or midsize depositories with significant CRE exposures and limited access to private capital could be especially vulnerable.
  - Mounting fiscal deficits and debt: Administration’s 2011 budget proposal projected federal debt to rise to over 70 percent of GDP by 2020; erosion of market confidence could trigger higher interest rates and impair balance sheet repair.

### Stability of financial markets
- Structure and linkages:
  - U.S. financial system comprises a broad range of intermediaries and markets with deep global linkages.
  - About one-quarter of aggregate financial assets is held by depository institutions and slightly over one-fifth is owned or guaranteed by the GSEs.
  - Private securitization pools, securities broker-dealers, pension and investment funds, and insurance firms account for most of the rest.
  - A large share of intermediation occurs in arm’s-length credit and capital markets, including vast OTC derivative markets subject to fewer market conduct and prudential regulations.
- Market conditions:
  - Financial markets broadly stabilized but remain more volatile than before the crisis; equity and fixed income markets recovered some ground and credit spreads narrowed.
  - Concerns about sovereign and banking risks in Europe raised broader concerns about public debt sustainability, including in the United States.
  - Some markets have not recovered: trading volume in the OTC municipal bond market is less than half pre-crisis levels; private-label residential mortgage securitization markets remain essentially closed.
- Exchange-traded securities and derivatives:
  - Derivative transactions (futures and options) conducted on exchanges maintained liquidity and tight bid-ask spreads.
  - SEC strengthened rules concerning failures to deliver on short sales and imposed a temporary ban on short selling for designated financial stocks (ban exempted certain bona fide market-making activities).

### Financial system structure and selected statistics (Table 2 highlights, 2002–March 2010)
- Shares of total financial assets (selected groups, percent and % GDP in various years):
  - Depository institutions: 24.0 (% share) — 88.3 (% GDP) — 22.1 — 97.8 — 25.9 — 109.0 — 25.9 — 112.6 — 26.5 — 113.6
  - GSEs: 14.8 (% share) — 54.5 (% GDP) — 12.3 — 54.3 — 13.7 — 57.8 — 13.3 — 58.0 — 12.7 — 54.3
  - “Shadow banking system”: 21.4 (% share) — 78.5 (% GDP) — 23.5 — 103.9 — 24.5 — 103.3 — 20.9 — 90.8 — 19.3 — 83.1
  - Investment and pension funds: 26.8 (% share) — 98.3 (% GDP) — 30.5 — 134.6 — 22.7 — 95.5 — 26.5 — 115.4 — 27.7 — 119.1
- Memorandum items (selected):
  - Total financial system = 100.0 (% share) — 367.2 (% GDP) — 100.0 — 441.7 — 100.0 — 420.9 — 100.0 — 435.3 — 100.0 — 429.3
  - NYSE equity market capitalization: 81.9, 86.1, 79.6, 111.2, 79.4, 63.8, 78.5, 81.9, 78.0, 85.1
  - Agency MBSs average monthly bond market trading volume: 24.5, 1.5, 31.6, 2.3, 33.4, 2.4, 36.8, 2.1, 34.1, 2.0

*Source: IMF staff chapter content as provided in the source PDF.*

### 23. The opacity of OTC markets exacerbated uncertainty and contributed to the

### _cr10247 - 23. The opacity of OTC markets exacerbated uncertainty and contributed to the

### Opacity of OTC markets and market functioning
- Trading volumes for bespoke products—including many forwards, options, swaps, credit derivatives, and private-label pool securities—fell sharply and trading sometimes ceased altogether, undermining the usefulness of market prices for valuing and hedging positions.
- Critical weaknesses identified:
  - Lack of transparency in pricing.
  - Opacity of the risk characteristics of many instruments (especially collateralized debt obligations).
  - Inadequate collateralization.
- Lack of publicly available information on derivatives transactions and financial institutions’ exposures to derivative counterparties exacerbated market uncertainty about risk management, losses, and capital positions.
- Weak margining practices and widespread rehypothecation of collateral exacerbated system-wide leverage and left the system highly vulnerable.
  - Example: Lehman had reused or rehypothecated an estimated $427 billion of securities posted as collateral by its counterparties or prime brokerage clients.
- Inadequate disclosure of massive, improperly collateralized derivative books contributed to the consequences of the collapse of Lehman Brothers and the near-failure of American International Group (AIG).

### Structured credit products, valuation uncertainty, and securitization markets
- Markets for structured credit products were subject to significant valuation uncertainty with substantial knock-on effects.
  - Heavy reliance on third-party ratings and under-appreciation of vulnerability to sharp downgrades and price declines.
  - Funding via maturity-mismatched portfolios (structured investment vehicles, securities lending, etc.) meant downgrades and price declines fed disruptive deleveraging.
- Markets for ABCP experienced similar problems.
- Securitization market dysfunction since 2007 could become a drag on the economic recovery:
  - Recent issuance of U.S. private-label MBSs comprised largely re-securitizations of formerly “AAA” senior securities (“re-remics”).
  - The Fed’s TALF was responsible for much of the 2009 issuance of other ABSs.
  - Care needed to avoid unintended consequences from tougher accounting rules, higher regulatory capital requirements, and “skin in the game” proposals for securitizers.
- The absence of well-functioning securitization markets may impair banks’ and others’ ability to roll over maturing securitized products and engage in new lending, weighing heavily on credit conditions—especially for small- and medium-sized companies without capital market access.

### Regulatory responses for credit rating agencies
- Legislative and other initiatives seek to strengthen SEC oversight of the credit rating agencies.
- New mechanisms will be established to avoid “ratings shopping” by issuers and to enhance the SEC’s regulatory authority to address conflicts of interest at credit rating agencies.

### Stress testing vulnerabilities in the financial system
- U.S. authorities’ 2009 Supervisory Capital Assessment Program (SCAP):
  - Involved multiple supervisory agencies and subjected the 19 largest BHCs to a comprehensive and uniform stress test.
  - Where capital deficiencies were identified, institutions were required to raise private capital or access public funds through the Capital Assistance Program.
  - The “SCAP-19” raised a total of some $205 billion of private capital, 54 percent of which was in common equity, and redeemed 86 percent of the $221 billion of preferred shares previously issued under the Treasury’s CPP.
  - The CPP remains an important source of capital, accounting for about one-quarter of the aggregate tier 1 capital of the roughly 260 institutions yet to redeem their government shares.
- FSAP team stress testing:
  - Stress tests covered the 53 largest BHCs, representing 85 percent of aggregate BHC assets, using three approaches: a balance sheet-based macro-prudential analysis, a distress-dependency model, and a contingent claims analysis (CCA).
  - Analysis used only publicly available data; lack of granular supervisory data, particularly on funding risk, was a constraint.
  - Results indicate pockets of vulnerability that could be amplified by inter-linkages; capital injections significantly lowered individual institutions’ (market-implied) contingent liabilities and reduced systemic tail risk, but portfolio cleanup may take time.

### Stress test scenarios, shocks, and specific risks
- Box 2: Scenario descriptions
  - Baseline Scenario: IMF’s April 2010 WEO update; output gap closes over the medium term; inflation stabilizes at about 2¼ percent; government bond yields rise moderately; government debt-to-GDP ratio increases.
  - Adverse Scenario: Calibrated to four combined adverse shocks: (i) sizeable persistent shock to potential output growth; (ii) additional short-run demand shock; (iii) further near-term fiscal stimulus; (iv) rising inflation expectations. Result: economic growth falters, inflation and government bond yields rise, government debt-to-GDP ratio climbs almost 10 percentage points above the baseline by 2013.
  - Alternative Scenario: Tests further deterioration in real estate sectors (lower real estate prices and higher loan losses). Nearly half of the $1.4 trillion in CRE loans maturing in 2010–14 have negative equity; CRE prices fall by another 8 percent by end-2012 (as opposed to 3.3 percent in the adverse scenario). CRE losses assumed to peak at 5.1 percent at end-2011.
  - Single-factor shocks calibrated to U.S. historical data for the last 50 years and other countries’ experience.
- Table and timing highlights (selected):
  - Residential real estate loans: peaks given as 2.7 (2009 Q4), 3.4 (2011 Q4), 3.5 (2012 Q1) in respective contexts.
  - Consumer loans: 6.5 (2010 Q1) in the displayed timing rows.
  - CRE loans: 3.4 (2011 Q2), 4.6 (2011 Q3), 5.1 (2011 Q4).
  - Commercial and industrial loans: 2.6 (2009 Q3) repeated entries.
  - Other loans: 3.4 (2009 Q4), 3.8 (2011 Q2), 3.6 (2011 Q3).
- Table 4 (Peak Net Loan Loss Charge-Off Rates, 2009–12) and Table 5 (BHC Capital Needs, 2010–14) summarize scenario outcomes and capital implications (numbers and detailed subtable entries are retained in source tables).

### Key stress-test findings and capital needs
- Baseline scenario findings:
  - Capital should be adequate for most banks.
  - The four largest BHCs and the former investment banking groups are expected to maintain a 6 percent tier 1 common equity ratio over 2010–14.
  - Four regional banks and seven smaller institutions (assets below $60 billion) would require a total of $8 billion in additional capital owing to high exposure to CRE losses.
  - Subsidiaries of foreign banks would require up to $26 billion.
  - Caveats: estimates do not allow for new capital injections nor the possibility of limiting dividend payments. The 6 percent threshold is not ambitious relative to historical norms (average 7.4 percent for SCAP institutions over 1997–2007).
- Adverse scenario findings:
  - Around one-third of U.S. BHCs would experience some capital shortfall, even assuming a less stringent capital threshold.
  - A total of $32 billion would be needed to maintain a 4 percent tier 1 common equity ratio until end-2014, including $15 billion for three SCAP banks.
  - Four regional banks would require $8 billion and ten smaller institutions another $15 billion; foreign BHCs would need $22 billion in additional capital.
  - Scenario assumes residential real estate and CRE losses continue to rise until the second half of 2011 (peaking at 3.4 percent and 4.6 percent, respectively) and consumer loan losses remain elevated (below the 6.5 percent peak in 2010 Q1).
  - Note: adverse scenario assumes a 2010–11 cumulative loan loss rate of 7.7 percent (or 8.7 percent including write-downs on securities), below the 9.1 percent 2009–10 cumulative loan loss rate assumed under the authorities’ SCAP stress tests.
- Alternative funding risk scenario results (select):
  - Capital needed to attain tier 1 common capital ratio thresholds and numbers of BHCs falling short are provided in the source tables for Baseline, Adverse, and Alternative scenarios.

### Liquidity, rollover risk, and interdependencies
- Market liquidity risks appear to have declined for systemic financial firms, though rollover risk requires careful monitoring due to bunching of loan maturities in 2011–13.
  - If banks face difficulties refinancing maturing loans, foreclosures could accelerate and raise bank losses significantly.
- Distress-dependency analysis (forward-looking, market data-based framework) indicates:
  - Substantial cumulative losses under both baseline and adverse scenarios could weigh on system capital adequacy.
  - Contribution to systemic risk depends on size and linkages, not size alone.
  - Simulations indicate approximately 20 percent of overall systemic losses are attributable to the housing GSEs.
- Tight inter-linkages persist between U.S. and European banks:
  - Interdependence eased from the early 2009 peak but remained above pre-crisis levels and began rising again by mid-2010.
  - As of June 2010, if all U.S. (or all European) banks in the sample were to fall into distress, there would be a roughly 40 percent chance that this distress would spill over to European (U.S.) banks.

*Italic line for source attribution provided by the pipeline.*

### 33. The team’s analysis demonstrated the

### _cr10247 - 33. The team’s analysis demonstrated the

### Efficacy of public support to financial institutions (CCA analysis)
- Systemic CCA indicates that capital injections into the three largest TARP recipients significantly lowered individual (market-implied) contingent liabilities and systemic tail risk.
- CCA simulations suggested that doubling the original amount of capital injected into these firms would have had little additional effect over time.
- Conversely, in the absence of capital injections, the tail risk and average risk would have escalated substantially (Figure 7 and Table 7).
- Methodological note: The systemic CCA framework combines equity market and balance sheet information to infer underlying asset dynamics and expected losses in a multivariate set up. 1/
- Figure 7: United States: Total Market-Implied Contingent Liabilities of the Financial Sector (in US dollar billions) — charted across Apr-07 to Jan-10 showing series:
  - Total Cont. Liabilities (sum of ind. alpha*put option)
  - Total Expected Losses (sum of individual put options)
  - Total Cont. Liabilities (GEV, 50th percentile)
  - Lehman Collapse indicated on the time series
- Distress dependence and regional distress probabilities plotted Jan-05 to Jan-10 for groups: US-EUR, US-ASIA, EUR-US, ASIA-US; regional probabilities: Average-US, Average-EU, Average-AS.

Key CCA-based contingent liabilities (Table 7, 95th percentile, in billions of dollars)
- Full period April 1, 2007–January 29, 2011:
  - Assuming no capital injection: 2382
  - Actual: 1419
  - Assuming 2x actual capital injection: 197
- Pre-crisis period July 1, 2007–September 14, 2009:
  - Assuming no capital injection: 991
  - Actual: 919
  - Assuming 2x actual capital injection: 191
- Crisis period 1 September 15–December 31, 2009:
  - Assuming no capital injection: 4844
  - Actual: 779
  - Assuming 2x actual capital injection: 469
- Crisis period 2 January 1–May 8, 2010:
  - Assuming no capital injection: 4143
  - Actual: 593
  - Assuming 2x actual capital injection: 353
- Crisis period 3 May 11, 2009–December 31, 2010:
  - Assuming no capital injection: 3562
  - Actual: 2722
  - Assuming 2x actual capital injection: 226
- Source: IMF staff estimates. 1/ 95th percentile.

### Insurance sector: resilience, vulnerabilities, and stress testing
- Much of the insurance industry, especially the property and casualty segment, remained resilient through the crisis but severe distress was experienced at some firms (Table 8).
- The monolines—writers of financial guarantees—lost their high credit ratings after serious losses on structured finance exposures.
- Life insurers are exposed to weakness in the economy due to exposure to CRE, both in loans and investments.
- Health insurers face significant uncertainty from implementation of recently enacted legislation to reform the U.S. healthcare system.
- Property and casualty risks are more dispersed; largest catastrophe risks are carried by reinsurers offshore.

Stress test results for life insurance (NAIC cooperation)
- Stress tests covered the largest 30 life insurance companies (accounting for two-thirds of U.S. life insurance premium income).
- Adverse scenario combined:
  - Negative shocks to assets (bond, stock, real estate, loan portfolios)
  - Liability-side shock impacting variable annuity writers
  - Major insurance shock (a pandemic)
- Pandemic shock impact: equivalent to 100 percent of RBC (see technical note on stress testing).
- Aggregate RBC ratio would decline from 843 percent at end-2008 to 459 percent after the shocks.
- Six out of the 30 companies would have RBC ratios below 200 percent.
- No company would have a negative RBC ratio under the scenario.

Insurance sector financial soundness indicators, 2004–09 (Table 8, source: NAIC)
Life insurance
- Total adjusted capital ($ billion): 2004: 340, 2005: 344, 2006: 364, 2007: 383, 2008: 338, 2009: 385
- RBC requirement ($ billion): 2004: 444, 2005: 245, 2006: 484, 2007: 546, 2008:  (blank), 2009: (blank)
- Aggregate RBC ratio (percent): 2004: 775, 2005: 814, 2006: 811, 2007: 802, 2008: 758, 2009: 835
- Median RBC ratio (percent): 2004: 940, 2005: 975, 2006: 996, 2007: 1,009, 2008: 910, 2009: 989
- Number of companies in action levels: 2004: 17, 2005: 11, 2006: 13, 2007: 13, 2008: 23, 2009: 18
- (Percent of all companies): 2004: 1.7, 2005: 1.1, 2006: 1.4, 2007: 1.5, 2008: 2.7, 2009: 2.2

Property and casualty insurance
- Total adjusted capital ($ billion): 2004: 485, 2005: 524, 2006: 599, 2007: 641, 2008: 579, 2009: 644
- RBC requirement ($ billion): 2004: 949, 2005: 499, 2006: 1039, 2007: 710, 2008: 100, 2009: (blank)
- Aggregate RBC ratio (percent): 2004: 518, 2005: 556, 2006: 608, 2007: 624, 2008: 598, 2009: 645
- Median RBC ratio (percent): 2004: 828, 2005: 877, 2006: 935, 2007: 957, 2008: 992, 2009: 1,047
- Number of companies in action levels: 2004: 108, 2005: 86, 2006: 75, 2007: 179, 2008: 65, 2009: (blank)
- (Percent of all companies): 2004: 4.3, 2005: 3.4, 2006: 2.9, 2007: 2.7, 2008: 3.0, 2009: 2.5

Health insurance
- Total adjusted capital ($ billion): 2004: 47, 2005: 62, 2006: 72, 2007: 80, 2008: 75, 2009: 82
- RBC requirement ($ billion): 2004: 8, 2005: 10, 2006: 11, 2007: 12, 2008: 13, 2009: 14
- Aggregate RBC ratio (percent): 2004: 578, 2005: 642, 2006: 662, 2007: 655, 2008: 592, 2009: 590
- Median RBC ratio (percent): 2004: 548, 2005: 574, 2006: 582, 2007: 589, 2008: 545, 2009: 533

Additional notes
- The U.S. insurance market comprised 7,948 licensed insurance companies at end-2008.
- Total premium volume in 2008: $1.24 trillion, accounted for 29 percent of the global market.
- No detailed stress testing of property and casualty insurance companies was carried out because a high-level test indicated a relatively limited sensitivity of the sector to macroeconomic shocks.

### Systemic liquidity arrangements, exit issues, and Fed operational considerations
- During the crisis authorities expanded liquidity backstops in extraordinary ways, invoking the “unusual and exigent” provisions of Section 13(3) of the Federal Reserve Act to support a broader range of firms and markets.
- The maturity transformation activities of the shadow banking sector (money market funds with stabilized NAVs, ABCP conduits) were systemically important and bank-like in liquidity risk, yet neither supervised as banking activities nor backstopped by the official safety net.
- Although extraordinary facilities have been allowed to expire, the Fed’s balance sheet is likely to remain swollen for years.

Key balance sheet and facility details (as of end-May 2010 unless otherwise stated)
- Conventional borrowing under the Fed’s discount window fell below $5 billion at end-May 2010; peak was $112 billion at end-October 2008.
- Borrowing under the Term Auction Facility peaked at nearly $500 billion and was fully repaid by mid-April 2010.
- Fed holdings of GSE bonds and MBSs totaled $1.3 trillion at end-May 2010, with the counterpart being excess bank reserves of over $1 trillion.

Operational instruments and challenges for policy with large excess reserves
- Likely initial focus: reverse repos of assets into the market, auctions of term deposits, and adjustments to the rate of interest on excess reserves (IOER).
- Operational and communications challenges:
  - (i) Gauging the post-crisis demand for reserve balances and its elasticity to the IOER rate.
  - (ii) Estimating the impact of large reserve balances, or the use of tri-party repos and term deposits, on the transmission of changes in money market rates to lending rates.
  - (iii) Ensuring that the various policy rates are consistent and properly aligned while providing markets with clear signals regarding the policy stance.

Potential amendments to the Fed’s OMO framework
- Consideration could be given to expanding the list of regular OMO counterparties beyond primary dealers to include selected money-center banks, recognizing potential drawbacks but possible benefits in encouraging broader counterparties to hold reliably liquid assets and become familiar with Fed operating procedures.
- Consideration could be given to widening the range of collateral eligible for OMO, with caution to avoid exposing the Fed to unnecessary risk and distorting markets.

### Strengthening financial sector oversight: weaknesses identified and recommended actions
- The financial crisis revealed important weaknesses in U.S. supervision and regulation arising from the system’s exceptional complexity, a large number of agencies, gaps in coverage and responsibility, and a tilt toward a laissez-faire approach.
- Key shortcomings identified:
  - The multiplicity of regulators creates challenges for systemic oversight because no single body has a clear financial stability mandate and information sharing and tools are inadequate.
  - Consolidated regulation and supervision have fallen short for effective oversight of systemic groups, a concern given complexity, size, and interconnectedness of the U.S. financial system.
  - Weaknesses in regulation and supervision of risk management—credit concentration build-up and deterioration in underwriting standards did not trigger timely responses.
  - Funding arrangements for supervisors are a concern, especially for the SEC, the CFTC, and state insurance regulators.

Recommended enhancements for banking supervision
- A comprehensive effort is needed to strengthen both structure and conduct of U.S. banking supervision to improve forcefulness of interventions, timeliness of guidance, and consistency of follow-up.
- Additional investments required in staff skills, data collection and processing, and examination procedures.
- Specific actions:
  - Enhance the capacity for group-wide oversight of complex banking groups and conduct regular inter-agency horizontal assessments (possibly by establishing domestic supervisory “colleges”).
  - Boost the timeliness and forcefulness of supervisory and regulatory interventions to address weaknesses in credit risk management practices.
  - Strengthen channels for cooperation, coordination, and learning from best practices—within and among the FBAs, functional regulators, and relevant state authorities—including with regard to charter conversions.

Basel II and oversight of risk management
- Improvements under Basel II will be important given weaknesses in oversight of risk management.
- The United States is a key sponsor of the new capital adequacy framework and preparations for implementation by large internationally active banks are advanced.
- Authorities have yet to take a final view on the capital regime for small and midsize banking institutions.
- Authorities will need to account for changes in the Basel Framework being considered internationally, while giving due weight to Pillars II and III.

Securities market oversight shortcomings
- Regulatory oversight lagged innovation: securitization, growth in certain OTC derivative markets, and shadow banking contributed to the crisis.
- Oversight of these markets, prudential regulation of firms trading in them, and market conduct rules fell behind, creating regulatory gaps.
- Despite a strong legal framework and independent agencies, institutional insularity, over-specialization, and lack of a comprehensive risk map undermined effectiveness.
- Recent securities scandals revealed shortcomings in enforcement programs and a need to enhance inspections.
- The May 2010 sharp intra-day crash in stock prices illustrated risks associated with algorithmic trading; “flash trading” and “dark pools” challenge regulatory goals of equal market access and transparency.

*Source: IMF staff estimates; NAIC; excerpt from IMF chapter PDF: _cr10247 - 33. The team’s analysis demonstrated the*

### 46. Significant gaps existed in the regulation of OTC derivative products and

### _cr10247 - 46. Significant gaps existed in the regulation of OTC derivative products and

### OTC derivatives: gaps and legislative reforms
- Finding: Legislation in 2000 generally excluded derivatives from much market regulation, and the lack of collateral requirements for certain significant market participants in bilaterally-settled OTC derivatives contributed to the undetected build up of leverage.
- Key provisions in the new legislation intended to strengthen OTC derivative market regulation and resiliency:
  - (i) registration requirements for OTC derivative dealers and “major swap participants”;
  - (ii) powers for the CFTC and SEC to determine which instruments should be subject to clearing and to trading on an exchange or swap execution facility;
  - (iii) reporting requirements for all derivative transactions and the trading positions of major market participants;
  - (iv) enhanced prudential requirements for risk exposures arising from OTC derivative trading for transactions that are not centrally cleared and collateral requirements for OTC derivatives;
  - (v) authority for regulators to safeguard market stability.
- Implementation risk: Decisions by regulatory agencies on what services a swap execution facility is required to provide, what is suitable for clearing, and the breadth of exemptions for trades with end-users will be critical to the effectiveness of these reforms.

### Securitized credit instruments: risks and reforms
- Finding: Structured securitized credit instruments increased diversification and lowered borrowing costs but, due to complexity, opacity, poor risk management, and overreliance on ratings, they contributed to a build-up of systemic risk.
- Reforms and proposals:
  - Improve disclosure standards for issuers, including requirements to publicly provide the computer coding for complex cash-flow “waterfalls”.
  - Improve the quality of credit ratings.
- Caution: Care will be needed to ensure that the interaction between accounting rule changes, higher capital charges, and requirements that issuers retain some exposure to the performance of their products (“skin in the game”) do not result in disincentives for these instruments beyond that warranted by the systemic risk they pose.
- Related numeric/legal notes:
  - New accounting rules referenced: Financial Accounting Standards 166 and 167 (footnote 20).
  - FDIC proposed rules limiting the “safe harbor” provided to securitized assets in the case of bank failures (footnote 20).

### Insurance sector: supervisory shortcomings and recommended reforms
- Finding: Important shortcomings existed in insurance supervision (a state responsibility). Segments of the insurance industry (notably monoline insurers and AIG) contributed to systemic pressures. The state-based system was effective for policyholder protection and soundness of individual companies but lacked a systemic focus and group-wide oversight capacity. Federal regulators had limited responsibility, extending only to insurers affiliated with commercial banks or thrifts. The multiplicity of state regulations imposes inefficiencies and can constrain U.S. multilateral participation.
- Recommended insurance regulatory reforms:
  - Improve regulation of bond insurance and securities lending, including reserving and capital treatment of market risks associated with guarantees (as in variable annuities) and the treatment of liquidity risks.
  - Modernize solvency requirements through more forward-looking approaches (e.g., utilizing stress and scenario testing and other forms of dynamic financial analysis).
  - Develop supervision of groups via consolidated financial condition reporting and analysis of the group as a whole (including unregulated affiliates) and further develop colleges of supervisors.
  - Move further from the current, rules- and compliance-based supervisory approach to relatively more emphasis on principles and risk-based techniques.
- Note: A more detailed assessment is provided in the ROSC on the International Association of Insurance Supervisors’ Insurance Core Principles included in this report (footnote 21).

### Payment and securities settlement systems: resilience and vulnerabilities
- Finding: Payment and securities settlement systems held up well during the crisis, aided by exceptional liquidity injections, but systemic concerns remain.
- Payment system:
  - The Fed’s new intraday liquidity policy—to be implemented in late 2010 or early 2011—will facilitate collateralization of daylight credit and reduce the Fed’s credit risk, but it remains to be seen whether incentives to discourage late-day payments will be strong enough (footnote 22).
  - U.S. wholesale payment infrastructure comprises two systems that are of systemic importance and settle in central bank money: the Fedwire Funds Service and the Clearing House Interbank Payments System. Payment services are also provided by CLS Bank International (footnote 22).
- Securities settlement systems:
  - Concentration of government securities settlement in two clearing banks exposes the FICC and its participants to potential settlement bank risk, requiring careful monitoring.
  - Recommendations for FICC and NSCC to reduce vulnerability to participant defaults:
    - Increase the frequency of stress testing.
    - External validation of testing parameters.
    - Create a separate pool of collateral to cover exceptional losses in extreme but plausible scenarios.
    - Access to liquidity outside the repo market.
  - FSAP coverage included two securities settlement systems (the FSS and the Depository Trust Company) and two securities CCPs (the FICC–Government Securities Division and the NSCC) (footnote 23).

### New oversight powers and systemic utilities
- The reform legislation will give the Fed new powers to oversee systemically important payment, clearing, and settlement systems. Previously the Fed could supervise only systems chartered as state member banks or Edge corporations; the new legal mandate addresses systemic importance irrespective of charter type.
- The new Act vests the FSOC with responsibility to designate as systemic any payment, clearing, or settlement activity or financial market utility to be subject to heightened and uniform risk management standards, including on margin, collateral, capital, and default policies (paragraph 62).
- The Fed’s Board of Governors may authorize designated financial market utilities to open deposit accounts at the Fed and, in unusual and exigent circumstances and after consultation with the Treasury Secretary, access the discount window (paragraph 62).

### AML/CFT assessment and follow-up
- The June 2006 FATF AML/CFT mutual evaluation report indicated that the U.S. system is broadly in line with the international standard but made a number of recommendations (footnote 24).
- Since then the regime has been significantly strengthened via enhanced legislation and continued aggressive law enforcement. A financial intelligence unit has been established that is fully operational and substantially meets the FATF standard.
- Remaining deficiencies:
  - The majority of designated non-financial business categories and professions are not subject to the preventive measures regime required under the FATF standard.
  - Deficiencies remain in transparency and availability of beneficial ownership and control information for legal persons and arrangements.
- Note: The June 2006 mutual evaluation report is the latest available comprehensive AML/CFT assessment of the United States; a technical note has been prepared for the U.S. FSAP to update some findings (footnote 24).

### Regulatory architecture, macroprudential oversight, and institutional reforms
- Finding: The complexity of the U.S. regulatory system—multiple federal and state authorities—contributed to regulatory gaps, overlaps, and weaknesses in supervisory accountability.
- The team’s recommended reorganization along six axes:
  - Micro-prudential safety-and-soundness regulation and supervision of all financial firms deemed systemically important, individually or collectively, at both the legal-entity and consolidated levels.
  - Special resolution procedures for firms requiring carve-outs from the creditor-centered U.S. Bankruptcy Code, at legal-entity or consolidated levels as appropriate.
  - Market conduct and investor protection covering all financial products, markets, and investors, tailored to product complexity and participant sophistication.
  - Consumer protection in retail financial products (residential mortgages, credit cards and consumer loans, deposits, and other household-targeted services).
  - Oversight of payment, settlement, and clearing systems deemed systemically important.
  - Cross-sectoral systemic risk oversight bringing together the above elements and a macroeconomic perspective.
- Legislative outcome and critique:
  - The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 was passed on July 1, 2010. It heralds far-reaching changes but focused more on the “what” than the “who” of regulation; substantive streamlining of the regulatory architecture was not achieved (paragraph 56).

### Financial Stability Oversight Council (FSOC) and Fed’s role
- FSOC:
  - Defined as the statutory systemic risk regulator, bringing together the Treasury, the Fed, and essentially all financial regulators, supported by an Office of Financial Research.
  - Powers include:
    - (i) demand information from any member agency or regulated or unregulated financial firm;
    - (ii) deem any nonbank financial firm potentially systemic for enhanced regulation and supervision (by the Fed), and deem financial market utilities and payment, clearing, or settlement activities potentially systemic;
    - (iii) recommend (but not require) surveillance or corrective regulatory or supervisory actions by member agencies;
    - (iv) approve the break-up of systemic financial firms deemed by the Fed to pose a “grave threat” to financial stability.
  - FSOC tasked to publish periodic reports and testify before Congress on emerging systemic and regulatory challenges, emphasizing issues that might call for legislative response (paragraph 57).
- Fed’s strengthened role:
  - The Fed is positioned as the “lead executor” of the FSOC, with strengthened consolidated supervision of potentially systemic financial groups. Success requires a more muscular approach to consolidated regulation and supervision (paragraph 58).
  - The team stressed need for consolidated oversight of holding companies owning FDIC-insured depository institutions and group-level capital and liquidity requirements; Dodd–Frank did not close related exceptions in the Bank Holding Company Act and imposed moratoria pending GAO review (footnote 25 and paragraph 60).

### Special resolution mechanism and structural issues
- A new special resolution mechanism grants the FDIC powers analogous to those used for insured depository institutions, enabling intervention at the ultimate holding company level for failing systemic financial groups, while subsidiaries remain under pre-existing resolution regimes with adjustments (paragraph 59).
- The team had encouraged greater automaticity (based on prompt corrective action triggers) and greater reach (e.g., extending to all BHCs) to mitigate moral hazard.
- Structural fragmentation remaining:
  - Only partial steps to streamline federal safety-and-soundness regulation; OTS eliminated but federal thrift charter preserved and responsibilities transferred to OCC, FDIC, and the Fed, leaving three FBAs with overlapping oversight responsibilities (paragraph 60).
  - No steps taken to unify securities and derivatives market responsibilities between the SEC and CFTC; a merger was suggested as beneficial (paragraph 61).
  - Dodd–Frank introduces the “major swaps participant” designation, with securities swaps and commodities swaps under SEC and CFTC jurisdiction respectively (footnote 27).

### Consumer protection and insurance monitoring
- Consumer protection:
  - Dodd–Frank establishes a new, independent Bureau at the Fed for consumer protection in financial services, aiming to ensure clarity of mandate, independence/autonomy for rulemaking/enforcement, and coverage of customers of all firms providing consumer financial services (paragraph 63).
- Insurance monitoring:
  - The reform legislation establishes a federal office to monitor the insurance sector to track industry developments and help identify systemic insurance groups, promote uniformity of certain state regulations, assure a coordinated system-wide perspective, and enhance U.S. participation in international discussions on insurance.
  - The team considers it appropriate to re-consider past proposals for an optional federal insurance charter given costs associated with the existing state-based system (paragraph 64).

*Source: IMF financial sector assessment content unit _cr10247 - 46. Significant gaps existed in the regulation of OTC derivative products and*

### 65. As noted above, a new framework for macro-prudential oversight is to be

### _cr10247 - 65. As noted above, a new framework for macro-prudential oversight is to be

### Macro‑prudential framework and the Financial Stability Oversight Council (FSOC)
- The FSOC will be the keystone of a new macro‑prudential oversight framework.
- Powers and duties of the FSOC include:
  - gather information;
  - designate systemically important nonbank financial firms for consolidated regulation and supervision by the Fed;
  - make broad recommendations to its member agencies;
  - report to Congress.

### Implementation challenges for the FSOC
- Composition and decisionmaking:
  - The FSOC will be composed of ten voting members; ensuring consensus and timely responses to emerging risks will be important.
- Data and information:
  - Timely availability of data will require investment in systems and commitment to inter‑agency information sharing.
- Regulatory adjustment:
  - Member agencies will need to develop or adjust regulations to focus more on systemic risk mitigation, combining automatic triggers with room for discretionary action.
- Accountability and communication:
  - Transparency and communication should underpin agency accountability and the “will to act,” ideally including policies governing the release of minutes of FSOC proceedings.

### Moral hazard and addressing too‑big‑to‑fail
- The substantial liquidity and capital support provided in recent years may exacerbate concerns that larger institutions bear an implicit government guarantee.
- Recommended actions and instruments (many enumerated in the Dodd–Frank Act) include:
  - penalizing size, complexity, and interconnectedness through measures such as liquidity and capital surcharges, anti‑cyclical provisioning, leverage ratios, contingent capital, resolution fees, or insurance schemes;
  - encouraging financial firms to build capital buffers in good times;
  - tightening risk exposure limits on rapidly expanding asset classes;
  - limiting the impact of corporate governance and compensation policies on risk‑taking.
- Prudential norms:
  - International efforts are underway to redefine capital and liquidity charges that apply to banks, including with regard to trading books.
  - Enhanced supervisory oversight and application of prudential norms will also need to apply to CCPs, in concert with efforts to encourage a greater role for them in the clearing of OTC derivatives.
- Systemic risk charges:
  - Subjecting all systemically important financial institutions to comprehensive, consolidated supervision should help limit systemic risks; these institutions should also face prudential norms to internalize systemic risks they pose.
- Narrow banking / size limitation:
  - Legislation includes limitations on banks’ proprietary trading and investments in or sponsoring of hedge or private equity funds, but these are not substitutes for effective supervision, prudential norms, and limits on complexity.
- Compensation and governance:
  - Compensation practices should avoid encouraging excessive risk taking; shareholders must be engaged; Boards of Directors must have competence and authority; management information systems need to be state of the art.
- Prompt corrective action (PCA):
  - PCA triggers based on regulatory leverage ratios were established after the U.S. savings and loan crisis, but many very large institutions experienced liquidity pressures before breaching these triggers, highlighting the need for better forward‑looking maturity mismatch and liquidity indicators and willingness for swift, pre‑emptive supervisory action.
- Living wills:
  - Ex ante resolution plans (“living wills”) are important to ensure group structures are manageable and to prepare resolution agencies to act; these plans need critical review, periodic updating, and pre‑emptive use to require systemic firms to simplify structures.

### Regulatory perimeter and shadow banking
- FSOC role:
  - A key role of the FSOC will be to monitor and adjust the regulatory perimeter.
- Steps to address shadow banking risks should include:
  - requiring money market funds to make real‑time disclosures of their actual, as opposed to “stabilized,” net asset values;
  - eliminating restrictions that bar depository institutions from remunerating transaction deposits;
  - subjecting ABCP conduits and ABS issuers to stringent disclosure and other requirements;
  - restructuring the tri‑party repo system to make it more resilient to stress.

### Governance of the Federal Reserve
- Concern:
  - Presidents of regional Federal Reserve Banks are elected by boards of directors majority‑controlled by supervised entities, which presents a seeming conflict of interest.
- Reform:
  - The Dodd–Frank Act moves to eliminate this seeming conflict of interest.

### Strengthening crisis management and resolution
- Shortcomings in crisis management:
  - The multiplicity of agencies, the lack of a statutory crisis management framework, and limited toolkits were exposed during the crisis.
- FSOC and crisis arrangements:
  - Reform legislation will formalize most crisis management arrangements under the FSOC, requiring enhanced coordination, information sharing, and decision making in crisis.
  - Such arrangements should be tested periodically in simulation exercises.
- Liquidity provision:
  - Authorities expanded liquidity backstops decisively during the crisis to nonbank financial intermediaries and markets; many extraordinary facilities have largely been wound up.
  - International dimension:
    - Swap agreements with 14 foreign central banks provided dollar liquidity to strained offshore markets. Some swap arrangements have been resurrected amid new market turbulence in Europe.
    - Recommendation: ensure such facilities are readily available in the future and seek close international cooperation to systematically collect information on relevant markets for timely coordinated responses.
  - Dodd–Frank changes:
    - The Act introduces new requirements on future use of the “unusual and exigent circumstances” clause of Section 13(3) of the Federal Reserve Act, limiting it to broadly available liquidity programs for solvent nonbank financial firms, subject to ex ante Treasury sign‑off and ex post reporting to Congressional committees and GAO audit.
    - The Fed, in consultation with the Treasury Secretary, must develop regulations to guide such emergency lending.
    - While restricting Fed liquidity support to failing individual firms is generally appropriate, the inherent unpredictability and scale of crises argues for retaining some flexibility.

### Deposit insurance and the Deposit Insurance Fund
- Performance:
  - Deposit insurance arrangements performed well; FDIC’s capacity to resolve small or midsize banks quickly bolstered confidence.
- Fund erosion and restoration:
  - Resources in the Deposit Insurance Fund have been eroded and should be restored under revised rules.
  - The FDIC’s restoration plan will only restore funding to pre‑crisis levels by 2017.
  - The system remains subject to procyclical funding arrangements: under current rules, banks pay premiums up to a certain level after which they are rebated; premiums are risk‑based but do not build in any allowance for systemic risk.
- Recommendation:
  - Review deposit insurance funding arrangements, revisit premiums and the size of the fund.
  - The mission welcomes increased target ratios in the Dodd–Frank Act and additional flexibility for the FDIC to set risk‑based premiums and revise funding arrangements.

### Resolution arrangements for large complex financial conglomerates
- Pre‑reform deficiencies:
  - A special resolution regime exists for depository institutions (FDIC), but most other financial firms are subject to the Bankruptcy Code, limiting the authorities’ scope to take control of groups at the holding company level.
  - The Lehman Brothers collapse, Bear Stearns sale, and AIG rescue highlighted the greater costs and systemic disruption resulting from these limitations.
- Orderly liquidation authority:
  - The Dodd–Frank Act’s “orderly liquidation authority” for systemic financial firms should substantially fortify the U.S. resolution toolkit.
  - It is unfortunate that earlier proposals for a pre‑funded special resolution fund were dropped.
- Operational challenges:
  - Large entities can lose access to wholesale funding quickly, play critical roles in markets and payment and settlement systems, and require rapid rescue operations.
  - Contagion risks may require honoring short‑term funding in repo and securities lending and avoiding close‑out of foreign exchange and derivative contracts.
  - Ex ante information gathering, preparation, and “war gaming” will be essential.
- Qualified financial contracts (QFCs):
  - Under both the Federal Deposit Insurance Act and the new systemic resolution authority, repos, forwards, swaps and similar transactions are defined as “qualified financial contracts” (QFCs).
  - The FDIC must decide within a day of intervening whether to transfer QFCs to another solvent entity or to leave them in the failed firm subject to termination and close out.

### Withdrawing crisis interventions and housing finance reform
- TARP exit:
  - An orderly withdrawal from government ownership of financial firms, as conditions permit, is important to level the playing field and reduce distortions.
  - Given the TARP is likely to maintain significant ownership of financial and nonfinancial firms for some years, transferring these to a trust or similar arrangement may be appropriate to avoid conflicts of interest with the supervisory function.
- Risks of continued official ownership:
  - Continued ownership risks undermining system dynamism, exposing institutions to political influence, aggravating “too‑big‑to‑fail” concerns, moral hazard, and expansion of safety nets.
- Housing finance:
  - Government support for the housing market is extensive, with housing GSEs—Fannie Mae, Freddie Mac, and the FHLB system—as cornerstones; these entities support liquidity in the MBS market and provide guarantees that assure a supply of credit risk‑free “rates products.”
  - Statutory privileges bestow a risk‑insensitive funding advantage that incentivizes growth and leverage.
  - Fannie and Freddie’s Senior Preferred Stock Purchase Agreements commit the Treasury to providing unlimited capital support to these entities through 2012 and capped but large amounts thereafter.
- Status and recommendation:
  - Lasting reforms will be defined once the mortgage market stabilizes; this remains an important unfinished area.
  - The mandate of the GSEs should be streamlined, guarantees removed or made explicit, and Fannie and Freddie’s retained portfolios privatized. Strong oversight will be required of any new public entities to ensure robust asset‑vetting and pool‑structuring standards, and derivative market involvement consistent with systemic stability.
- Alternatives for GSE reform:
  - Full privatization:
    - Recapitalize and sell the GSEs to the public, as a whole or in pieces, and rescind federal charters and associated privileges.
    - This would resolve competitive equality issues but could leave the system without a public body to promote securitization.
  - Part privatization / part public utility:
    - Restore GSE investment operations to profitability, recapitalize via public share sales, rescind federal charters, and establish a new public entity to take over guarantee operations.
    - Resulting privatized investment companies would have no special privileges; the utility would preserve government support for securitization subject to appropriate criteria.

*Italicized source: IMF mission staff report text from the provided PDF content unit.*

### 85. The U.S. financial system represents a significant and deeply connected

### _cr10247 - 85. The U.S. financial system represents a significant and deeply connected

### Global linkages and systemic importance
- The U.S. financial system is described as "a significant and deeply connected component of the global financial system."
- U.S. large complex financial institutions (LCFIs) "play a critical role in international financial markets," and U.S. payment and securities settlement systems involve a large volume of transactions with foreign entities.
- "Over one-fifth of U.S. ABSs are estimated to have been held abroad in the lead up to the crisis."
- Transactional, reputational, and ownership ties between leading intermediaries in the U.S., U.K., and Euro area help explain the speed and virulence of the freeze of the U.S. funding markets.
- The growth in transactions booked in offshore tax havens "illustrates the channels that have opened for regulatory and tax arbitrage" and underscores the importance of U.S. participation in coordinated and consistent supervisory and regulatory policies.

### International coordination, supervision, and crisis management
- Interlinkages "increase the premium on mutually consistent macroeconomic and financial policies."
- U.S. authorities can play a leading role in strengthening international crisis coordination; U.S. agencies achieved a high level of coordination with counterparts during the recent crisis and should further develop arrangements for coordinating supervisory policies.
- Recommendation: establish a more permanent and coordinated mechanism for addressing periodic pressures in offshore dollar markets.
- The United States has "embraced efforts to improve information sharing and cooperation in the supervision of internationally active financial firms," helping to establish supervisory colleges for some 30 globally active firms, aimed at producing joint risk assessments under a lead supervisor and remedial plans as needed.
- Suggestion: consider extending supervisory colleges to include major emerging markets consistent with efficient functioning.
- Reforms to U.S. markets for structured securitization and OTC derivatives will encourage greater reporting, standardization, and oversight via greater use of exchanges and CCPs; hedge fund advisers will be required to register and regularly report information to facilitate systemic risk assessment.
- Caution: coordinate these reforms with other key jurisdictions "to avoid pushing transactions to less stringent jurisdictions."

### Cross-border resolution and "living wills"
- U.S. reforms could provide impetus for international efforts to improve arrangements for the resolution of global financial conglomerates.
- Lehman collapse highlighted constraints on coordinated solutions due to differences in insolvency, regulatory, accounting, and governance regimes.
- Recommendation: ensure "living wills" required for systemically important financial firms identify inconsistencies with foreign legal frameworks and catalyze preparation of coordinated ex ante crisis management frameworks, building on the Financial Stability Forum’s Principles for Cross-border Cooperation in Crisis Management.

### Dodd–Frank Act: key features and implementation challenges
- Passage and timing:
  - The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 was passed in the Senate on July 15 and signed by the President on July 21.
- Principal elements summarized:
  - Financial Stability Oversight Council (FSOC): improves upon the President’s Working Group; will designate systemic nonbank financial firms and financial market utilities.
  - Federal Reserve consolidated oversight: Fed will regulate and supervise designated nonbank financial firms as well as bank holding companies (BHCs), subjecting systemic firms to higher standards including "living wills."
  - Special resolution authority: enables intervention at the holding company level, management replacement, equity extinguishment, and transfer of systemic operations to state-owned "bridge" structures.
  - Regulation of derivative markets: greater transparency, clearing, trade-execution, business-conduct requirements, and capital and margin norms for swap dealers and major swap participants.
  - Infrastructure oversight: designated systemic financial market utilities subject to heightened and uniform risk management standards; utilities not chartered as banks may be granted access to Fedwire and, in unusual and exigent circumstances, to the discount window.
  - Bureau of Consumer Financial Protection (BCFP): will assume most federal consumer protection functions with exclusive rule making and examination authorities and primary enforcement powers over large federally insured commercial banks, thrifts, and credit unions.
- Box 1 selected highlights:
  - FSOC composition: ten voting members (Treasury Secretary (Chairperson), Fed Chairman, Comptroller of the Currency, Chairman of the FDIC, Chairman of the National Credit Union Administration, Chairman of the SEC, Chairman of the CFTC, Director of the Federal Housing Finance Agency, Director of the new BCFP, and an independent member appointed by the President with insurance expertise).
  - FSOC powers include recommending prudential norms, designating systemically important nonbank firms (two-thirds majority including Treasury Secretary), and approving break-up of systemic companies (two-thirds majority).
  - Regulatory architecture: Office of Thrift Supervision abolished; four new bodies set up (FSOC, Office of Financial Research, BCFP, Federal Insurance Office).
  - Bank supervision: Fed will regulate and supervise BHCs, SLHCs, and state Fed-member banks; OCC will oversee national banks and federal thrifts; FDIC will oversee state nonmember banks and state thrifts.
  - Consumer protection: BCFP housed within Fed’s Board of Governors; exclusive rule making and examination and primary enforcement powers over federally insured depositories with assets of $10 billion or more.
  - Federal Insurance Office: located at the Treasury; gathers information, monitors insurance industry, recommends insurers for FSOC designation, represents U.S. internationally on insurance regulatory issues.
  - Micro-prudential: BHCs and SLHCs required to serve as sources of strength; new risk-based prudential norms; BHCs with group assets of $50 billion or more will automatically be subject to enhanced prudential standards.
  - "Volcker rule": banks and BHCs proscribed from proprietary trading and investing in or sponsoring hedge or private equity and hedge funds (initially not systemic nonbank financial firms), with complex exceptions and transition arrangements.
  - Infrastructure oversight: designated utilities subject to heightened and uniform risk management standards; Fed may grant access to Fedwire and, in unusual and exigent circumstances and after consulting the Treasury Secretary, access to the discount window.

- Implementation challenges and concerns:
  - The legislation increases the number of agencies involved rather than streamlining the regulatory architecture; three agencies for federal safety-and-soundness oversight of banks and thrifts and two for market regulation of securities and derivatives.
  - Action to close exceptions to consolidated supervision is deferred to a GAO study.
  - FSOC must coordinate nine federal bodies and significantly improve inter-agency cooperation and information sharing.
  - Law requires a very large number of separate and time-bound rulemakings, one-off reports or studies, and new periodic reports.
  - FSOC needs to define systemically risk-sensitive prudential norms for capital, leverage, and liquidity.
  - Cross-border issues in resolving a failing systemic international group would remain a challenge despite the special resolution mechanism.
  - The legislation "leaves untouched the housing government-sponsored enterprises," where action is critically important given their weakened financial situation pending an ongoing review.

### Financial sector performance and near-term outlook
- Second-quarter earnings releases: "disappointing" and illustrate balance sheet risks identified in the FSSA’s section on stress testing.
- Trading income has "dropped" after having been the backbone of earnings in preceding quarters.
- Credit-impairment costs, while lower, "are likely to remain elevated for some time to come."
- Regulatory reforms are widely expected to dampen shareholder returns, although the ultimate impact is still uncertain.

### Appendix I — Risk Assessment Matrix: main threats, likelihoods, and expected impacts
- Inability to roll over outstanding CRE loans
  - Staff assessment: High (likelihood)
  - Key facts:
    - "Around $1.4 trillion of CRE loans are expected to mature by 2014, and almost half of these are underwater or seriously delinquent."
    - The market for commercial MBSs remains depressed.
  - Staff assessment: Medium (expected impact)
    - Banks comprise nearly 50 percent of CRE debt outstanding.
    - CRE exposure accounts for 10 percent of total bank loans, but represents 50 percent of smaller banks’ loan books.

- Further weaknesses in residential real estate prices
  - Staff assessment: High (likelihood)
  - Key facts:
    - Rising gap between the volume of delinquent mortgages and the number of foreclosures suggests an overhang of homes still to be placed on the market.
    - "Strategic defaults" by underwater but performing mortgage borrowers are on the increase.
    - "A modest rise in mortgage rates could speed up the rate of foreclosures, dampening a recovery in house prices."
  - Staff assessment: Medium (expected impact)
    - Worsened house price outlook would hurt the value of repossessed homes on banks’ balance sheets.
    - Could induce banks to foreclose more aggressively the rising stock of seriously delinquent residential mortgages, raising losses and lowering bank capital.

- Double-dip recession
  - Staff assessment: Low (likelihood)
  - Key facts:
    - Consumption spending could remain lower than projected given still-high debt loads, substantive hits to household net worth, high unemployment, and possible further pressures on house prices.
  - Staff assessment: Medium (expected impact)
    - Slower GDP growth would reduce credit demand and net interest margins, possibly impact financial sector fee and trading income.
    - Lower profits would make it more difficult for banks to re-build capital buffers.

- Loss of credibility of long-term fiscal consolidation
  - Staff assessment: Low (but rising) (likelihood)
  - Key fact:
    - "Under the authorities’ current projections, the federal debt-to-GDP ratio is expected to rise to nearly 100 percent by 2020."
  - Staff assessment: Medium (expected impact)
    - Higher U.S. interest rates could undermine growth prospects and credit quality; increase rollover risks and hurt convexity hedging by mortgage holders, triggering a re-pricing of long-term instruments.

- Credit crunch/limited securitization
  - Staff assessment: Low (likelihood)
  - Key facts:
    - Some banks continue to face balance sheet pressures and private securitization markets remain impaired.
    - Signs of easing bank lending standards and uneventful expiration of the Fed’s Large Scale Asset Purchase program have reduced the risk of more severe disruption.
  - Staff assessment: Low (expected impact)
    - Constrained credit and crisis legacies likely to depress potential output, with negative spillovers on banks’ asset quality and earnings.
    - Limited securitization could be particularly difficult for small community banks, which almost doubled their market share of residential loans in the run up to the crisis expecting to sell them after origination.

- Regulatory uncertainty
  - Staff assessment: Low (likelihood)
  - Key facts:
    - New financial reform legislation "is likely to be passed into law before end-July 2010, but rule writing will take some time."
    - Implementation delays could impede lending with negative macroeconomic consequences, especially if new rules are not mutually consistent.
  - Staff assessment: Low (expected impact)
    - Unless new requirements are carefully phased in, a sharp increase in funding costs could weaken credit growth, and credit quality, bank capital, and earnings could be hurt.
    - Lending could be pushed to new (less well managed) channels, contributing to new systemic risks.

- Failure of systemically important institutions
  - Staff assessment: Low (likelihood)
  - Key facts:
    - Recent efforts to boost capital have borne fruit and regulatory reform will further improve regulation and supervision of systemic firms, including expanding the supervisory perimeter to include systemically important nonbank financial firms.
  - Staff assessment: Medium (expected impact)
    - The new reform legislation introduces a new mechanism to resolve failing systemically important financial conglomerates, but cross-border challenges remain.

*Prepared by the Monetary and Capital Markets Department; Approved by José Viñals; July 22, 2010.*

### Box 1 (concluded). Selected Highlights of the Dodd–Frank Act

### Box 1 (concluded). Selected Highlights of the Dodd–Frank Act

### Shadow banking sector
- Interest on demand deposits: Banks and thrifts will be permitted to pay interest on demand deposits, improving their competitiveness vis-à-vis money market mutual funds.
- Hedge/private equity fund registration: Hedge fund and private equity fund advisors will be required to register with the SEC, which will be authorized to require information on trades and portfolios. Conversely, the assets-under-management threshold for federal regulation of investment advisers will be raised from $30 million to $100 million.

### Securities and derivative market oversight
- “Skin in the game”: Originators of asset- and mortgage-backed securities will be subject to a 5 percent risk retention requirement, although there will be exemptions for securities backed by “qualified residential mortgages” and government-guaranteed loans. Structured products will face stronger disclosure requirements on pooling arrangements and on the quality of underlying assets.
- Regulation of derivatives: The SEC and CFTC will regulate most swaps, which will be required to clear through central counterparties and trade on exchanges as possible. Trade data will be collected for surveillance purposes, and disseminated, and new capital and margin requirements will be imposed on dealers and major swap participants.
- Swaps “push-out”: Banks will be allowed to use swaps to hedge risk or trade in standardized interest rate and foreign exchange swaps. Other derivative trades will have to be spun off to separately capitalized affiliates within two years.

### Crisis management, resolution, and systemic liquidity arrangements
- Special resolution mechanism: In the event of a finding of unacceptable systemic risk by two-thirds of the Fed and FDIC Boards with written concurrence by the Treasury Secretary (after consulting with the President), and subject to appellate judicial review, the FDIC will be able to intervene any failing financial company not already subject to a carve-out from the U.S. Bankruptcy Code. Public funds will be available up-front, with unrecovered excess liquidation costs recouped through ex post assessments on large financial companies (with assets of $50 billion or more).
- “Living wills”: Identified systemic nonbank financial firms and large interconnected BHCs (the latter to be defined by the Fed, but including all BHCs with assets of $50 billion or more) will be required to submit rapid and orderly resolution plans to the FDIC, Fed, and FSOC. If the plans are found deficient by the FDIC and Fed, higher capital requirements will be imposed, with mandatory divestitures as the final sanction.
- Deposit insurance: Deposit insurance limits are raised permanently to $250,000. The minimum reserve ratio for the Deposit Insurance Fund is also to be increased, by 20 basis points, to 1.35 percent by 2020, with the assessment base moving from insured deposits to assets less equity.
- Fed lending to nonbanks: The Fed will be proscribed from lending to individual failing nonbank entities, with broadly available programs subject to ex ante approval by the Treasury Secretary and ex post reporting to Congressional committees and GAO review. The Fed, in consultation with the Treasury Secretary, must issue regulations guiding any future “unusual and exigent” lending.
- FDIC guarantees: These will be limited to broadly available guarantees of obligations of solvent banks, thrifts, BHCs, and SLHCs, after a joint determination by the Fed, FDIC, and Treasury Secretary (in consultation with the President) that a “liquidity event” exists. Maximum amounts will be recommended by the Treasury Secretary to the President and transmitted to Congress for expedited approval. The FDIC, in consultation with the Treasury Secretary, will issue regulations.

*Box 1 (concluded). Selected Highlights of the Dodd–Frank Act*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10247.pdf_