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From Banking and Finance Law Daily, May 28, 2013

FSOC Identifies Current Systemic Risk Concerns

By Lene Powell, J.D.

The Financial Stability Oversight Council (FSOC) issued a report highlighting concerns of the Office of Financial Research (OFR), including the vulnerability of some sources of wholesale funding to fire sales, the reliance of the housing finance system on government support, and the reliability of market benchmarks such as LIBOR. The report also discussed factors in other countries that could negatively affect financial stability in the United States if conditions overseas deteriorate.

Vulnerabilities in wholesale funding. FSOC noted some positive and negative developments (from the FSOC perspective) in wholesale funding. On the positive side, intra-day credit exposure of the two clearing banks (JPMorgan and BNY Mellon) in the tri-party repo market has declined significantly. In addition, the reliance of broker-dealers on overnight repos as a source of funding has also declined, according to the report.

However, the potential for runs on broker-dealers or fire sales has not been completely eliminated, the report said. Furthermore, efforts to address potential instability in money market mutual funds have not yet been finalized by the SEC (as regulator of MMFs as issuers of securities).

Housing finance reliance on government support. According to the report, there has been significant improvement in mortgage markets, but additional progress is needed. Conservatorship agreements (Treasury Preferred Stock Purchase Agreements, PSPAs) have been modified to expedite the wind-down of the retained portfolios of Fannie Mae and Freddie Mac. Regulatory uncertainty in mortgage markets may be reduced by the publication of final rules for the Real Estate Settlement Procedures Act, the Truth in Lending Act, and the Dodd-Frank Act’s ability-to-pay standard.

Additional work may need to be done to raise GSE guarantee fees to make room for private competitors to the GSEs, said the report.

Technology, security, and operational risks. FSOC listed several initiatives to address operational issues. The tri-party repo task force has recommended improvements to the settlement and clearing processes in the two central clearing banks to reduce their intra-day credit exposure. Also, the SEC recently proposed Regulation Systems Compliance and Integrity (Regulation SCI) to try to address malfunctions in capital markets.

Interest rate risks. The report noted that a combination of a global savings glut, deficient aggregate demand, and central bank interest-rate policies has contributed to an extended period of low interest rates, by historical standards. Financial intermediaries can be damaged by rising interest rates if they have not adequately addressed the mismatch between the interest rates on their cost of funds and their revenues from longer-term lending. Furthermore, revelations of manipulation of the London Interbank Offered Rate (LIBOR) have cast doubt on the accuracy of key reference rates used to benchmark interest rates in many private contracts, stated the report.

FSOC pointed to a number of initiatives that should mitigate the risks when interest rates do rise. First, investigations and prosecutions related to LIBOR and similar reference rates may reduce the incentive to misreport and, combined with regulatory reform of reporting banks, may lead to more accurate interest rate benchmarks. FSOC did however report concern at potential reaches for yield, noting that the issuance of high-yield bonds (riskier classes of bonds) had increased markedly and that underwriting standards for collateralized loan obligations (CLOs) had reportedly loosened.

Threats to financial stability posed by rising rates are also mitigated in part by one of the potential causes of rising rates: improved financial conditions. Even if rates rise for the “wrong” reason — a second credit crunch — FSOC observed that the measurable financial resilience of major banks, such as capital levels and measures of liquidity, have improved, the report said.

Long-term fiscal imbalances. Thus far, the United States has not experienced any backlash in bond markets for running extended fiscal deficits. Over the long term, the combination of higher interest rates and higher outstanding debt can cause interest payments to crowd out other government programs (depending on the relative growth of interest payments to GDP). The long-run imbalances could threaten financial instability if there is a sudden spike in yields.

According to FSOC, the financial impact of potentially disruptive short-run fiscal events has been minimal thus far. For example, U.S. debt is still seen as a safe harbor despite the automatic tax increases and spending cuts at the start of 2013 (the fiscal cliff) and the February 2013 debt ceiling debates. Similarly, the downgrade of U.S. Treasury securities by Standard & Poor’s did not cause a significant spike in Treasury yields.

Exposure to international risk. Many financial regulators and financial institutions treat sovereign debt as if it were risk-free, said the report. Consequently, financial institutions and financial systems do not typically retain capital buffers against the possibility of sovereign debt restructuring or, in the extreme, a sovereign default. There is no formal way to address a sovereign default—no international bankruptcy law applies to sovereigns.

Moreover, even if central banks target domestic economies rather than exchange rates, expansionary monetary policies can cause exchange rates to depreciate, and thus exports to rise and imports to fall. But because one country’s declining imports is another country’s declining exports, expansionary monetary policies run the risk of competitive devaluation if policymakers fail to coordinate across countries, the report said.

FSOC noted a number of positive developments in Europe, including the potential for the European Central Bank (ECB) to purchase sovereign debt of member states under some circumstances. However, the report also noted that banking disruptions and policy responses in Cyprus, which briefly cast doubt on the status of insured bank deposits, created downside risk. The report also observed that austerity programs in Europe have contributed to a contraction in euro-area economies, although euro-area deficits may also have declined.

As to Japan, the report said that expansionary monetary policies in Japan have contributed to a depreciation of the Yen. FSOC took the view that the U.S. has a strong financial stability interest in Japan finally escaping from deflation and securing more robust growth.

Companies: BNY Mellon Fannie Mae; Freddie Mac; JPMorgan; Standard & Poor’s

MainStory: TopStory DoddFrankAct FinancialStability GovernmentSponsoredEnterprises RESPA TruthInLending

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