Financial Stability 

Oversight Council

2011 Annual Report

Financial Stability Oversight Council

The Financial Stability Oversight Council (Council) was established by the Dodd-Frank Wall 

Street Reform and Consumer Protection Act (Dodd-Frank Act) and is charged with three primary 

purposes: 

1. To identify risks to the financial stability of the United States that could arise from the 

material financial distress or failure, or ongoing activities, of large, interconnected bank 

holding companies or nonbank financial companies, or that could arise outside the 

financial services marketplace. 

2. To promote market discipline, by eliminating expectations on the part of shareholders, 

creditors, and counterparties of such companies that the U.S. government will shield them 

from losses in the event of failure. 

3. To respond to emerging threats to the stability of the U.S. financial system. 

Pursuant to the Dodd-Frank Act, the Council consists of 10 voting members and 5 nonvoting 

members and brings together the expertise of federal financial regulators, state regulators, and 

an insurance expert appointed by the President. 

The voting members are: 

•	 the Secretary of the Treasury, who serves as the Chairperson of the Council; 

•	 the Chairman of the Board of Governors of the Federal Reserve System; 

•	 the Comptroller of the Currency; 

•	 the Director of the Bureau of Consumer Financial Protection; 

•	 the Chairman of the Securities and Exchange Commission; 

•	 the Chairperson of the Federal Deposit Insurance Corporation; 

•	 the Chairperson of the Commodity Futures Trading Commission; 

•	 the Director of the Federal Housing Finance Agency; 

•	 the Chairman of the National Credit Union Administration Board; and 

•	 an independent member with insurance expertise who is appointed by the President and 

confirmed by the Senate for a six-year term.

The nonvoting members, who serve in an advisory capacity, are: 

•	 the Director of the Office of Financial Research; 

•	 the Director of the Federal Insurance Office; 

•	 a state insurance commissioner designated by the state insurance commissioners; 

•	 a state banking supervisor designated by the state banking supervisors; and

•	 a state securities commissioner (or officer performing like functions) designated by the 

state securities commissioners.

The state insurance commissioner, state banking supervisor, and state securities commissioner 

serve two-year terms.
Statutory Requirements for the Annual Report

Section 112(a)(2)(N) of the Dodd-Frank Act requires that the Annual Report address the 

following:

(i) the activities of the Council;

(ii) significant financial market and regulatory developments, including insurance and 

accounting regulations and standards, along with assessment of those developments on 

the stability of the financial system;

(iii) potential emerging threats to the financial stability of the United States;

(iv) all determinations made under § 113 or title VIII, and the basis for such determinations; 

(v) all recommendations made under § 119 and the result of such recommendations; and

(vi) recommendations—

(I) to enhance the integrity, efficiency, competitiveness, and stability of United States 

financial markets;

(II) to promote market discipline; and

(III) to maintain investor confidence.

Approval of the Annual Report

This Annual Report was approved unanimously by the voting members of the Council on July 

22, 2011.

Abbreviations for Federal Member Agencies of the Council

•	 Department of the Treasury (Treasury)

•	 Board of Governors of the Federal Reserve System (Federal Reserve)

•	 Comptroller of the Currency (OCC)

•	 Bureau of Consumer Financial Protection (CFPB)

•	 Securities and Exchange Commission (SEC)

•	 Federal Deposit Insurance Corporation (FDIC)

•	 Commodity Futures Trading Commission (CFTC)

•	 Federal Housing Finance Agency (FHFA)

•	 National Credit Union Administration Board (NCUA)

•	 Office of Financial Research (OFR)

•	 Federal Insurance Office (FIO)
Letter from the Chair

The institutions, markets, and infrastructure that make up the U.S. financial system provide 

essential services to the U.S. and global economies—helping to allocate funds from savers to 

borrowers, allowing households and businesses to plan for the future and manage their risks 

over time, and facilitating the enormous volume of financial transactions necessary to support 

real economic activity and employment on a daily basis. 

Three years after the worst financial crisis in generations, our financial system is now on more 

solid ground, less prone to excessive leverage and risk-taking, more transparent to investors, 

creditors, and regulators, and more resilient to unexpected adverse events. Financial institutions 

hold substantially more capital relative to risk than they did before the crisis and fund themselves 

more conservatively. We have withdrawn most of the emergency actions we took to resolve the 

crisis and recovered most of the investments we made to stabilize the financial system.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) made 

important and fundamental changes to the structure of the U.S. financial system to strengthen 

safeguards for consumers and investors and to provide better tools for limiting risk in the major 

financial institutions and the financial markets. The core elements of the law were designed 

to build a stronger, more resilient financial system—less vulnerable to crisis, more efficient in 

allocating financial resources, and less vulnerable to fraud and abuse. 

•	 Tougher constraints on excessive risk taking and leverage across the financial 

system. To lower the risk of failure of large financial institutions and reduce the damage 

to the broader economy of such failures, the Dodd-Frank Act provided authority for 

regulators to impose more conservative limits on risk that could threaten the stability of the 

financial system.

•	 Stronger consumer protection. The Dodd-Frank Act created the Bureau of Consumer 

Financial Protection to concentrate authority and accountability for consumer protection 

in a single federal agency, with the ability to enforce protections on banks as well as other 

types of firms involved in the business of consumer finance.

•	 Comprehensive oversight of derivatives. The Dodd-Frank Act created a new regulatory 

framework for the over-the-counter derivatives market to increase oversight, transparency, 

and stability in this previously unregulated area.

•	 Transparency and market integrity. The Dodd-Frank Act included a number of measures 

that increase disclosure and transparency of financial markets, including new reporting 

rules for hedge funds, trade repositories to collect information on derivatives markets, and 

improved disclosures on asset-backed securities. 

•	 Orderly liquidation authority. The Dodd-Frank Act created a new orderly liquidation 

authority to break up and wind down a failing financial firm in a manner that protects 

taxpayers and the economy.

Letter from the Chair i
•	 Accountability for stability and oversight across the financial system. The Dodd-Frank 

Act established the Financial Stability Oversight Council (Council) to coordinate across 

agencies in monitoring risks and emerging threats to U.S. financial stability, and the Office 

of Financial Research to improve data quality and facilitate access to and analysis of data 

for the Council and its member agencies. 

The Council will play an important role in implementing and overseeing these reforms and 

mitigating current and potential future threats to financial stability. 

In our regulatory framework, a significant number of independent agencies are responsible for 

specific aspects of the challenge of promoting financial stability, including overseeing the safety 

and soundness of banking organizations, safeguarding the stability of financial infrastructure, 

promoting disclosure and market integrity, and protecting investors and consumers against 

abuse. Each of these individual responsibilities is critical to a stable and well-functioning financial 

system, but as the crisis demonstrated, threats to financial stability are often manifested across 

a range of markets and institutions and may not always be effectively mitigated by any one 

agency alone. 

The Dodd-Frank Act established the Council to create joint accountability for identifying and 

mitigating potential threats to the stability of the financial system. By creating the Council, 

Congress recognized that financial stability will require the collective engagement of the entire 

financial regulatory community. 

This is an inherently difficult exercise. No financial crisis emerges in exactly the same way as its 

predecessors, and the most significant future threats will often be the ones that are hardest to 

diagnose and preempt. Aspects of the financial system that appear to make markets more liquid 

and financial institutions more prosperous in normal times may be the same ones that make the 

world more dangerous in crisis. Actions taken to preemptively mitigate threats may appear at 

the time to be more dangerous than the problems they are designed to address. 

We cannot predict the precise threats that may face the financial system. The best way to 

prepare for this uncertainty is to continue to build the shock absorbers and safeguards that 

improve the resilience of the financial system. We need to recognize that policy and regulation 

will often be behind the curve of innovation, and we must meet assumptions of ongoing stability 

with a heavy dose of skepticism. Our best plan is to plan for constant change and the potential 

for instability, and to recognize that the threats will constantly be changing in ways we cannot 

predict or fully understand. 

Reducing threats to financial stability will require persistence, creativity, and a willingness 

to adapt more quickly to changes in markets. We must work to ensure that the regulatory 

framework keeps pace with the evolving global financial system. We cannot wait until we have 

passed the point of no return to strengthen safeguards against the type of race to the bottom in 

credit terms or underwriting standards that often characterizes periods of financial expansion. 

We need to be willing to act prudently and preemptively in the face of emerging vulnerabilities or 

imbalances.

This task will be made easier if we are able to better marshal the power of market discipline. 

Financial market participants and investors should no longer operate with the expectation that 

government assistance will be available to save the stakeholders in financial institutions from 

the consequences of their own mistakes. And the regulatory community needs to continue to 

work hard to improve the information available to investors and the public about the nature and 

magnitude of the risks individual institutions are taking. 

ii 2011 FSOC Annual Report
The challenge of maintaining a stable financial system is exacerbated by the difficulty of 

balancing the benefits of regulation against the costs of excessively restraining prudent risktaking behavior. If we were to set the overall combination of margin, liquidity, and capital 

requirements too high, we could handicap the ability of the financial system to support 

economic growth. Further, financial activity would inevitably move more quickly to firms, 

markets, and countries where the intensity of regulation is weaker. So we need to continue 

to strive for a careful balance between the imperatives of creating a more stable system and 

promoting a level of innovation and dynamism.

Measures of risk in the financial system before the crisis provided little warning of the force of 

the storm to come. Many of the standard observable measures of risk were very low; indeed the 

real warning sign was that neither credit ratings nor the pricing of a range of financial products 

showed any expectation of the fragility of the global financial system to a fall in U.S. house prices.

This should make us all humble about our ability to make judgments about the future, even as 

we strive to acquire better data and quantitative metrics. Nonetheless, there is a strong case 

for improving the quality of information available to the public, supervisors, and regulators about 

risks in financial institutions and markets. With our new authorities, we are working to build a 

broader set of quantitative metrics to assess not just what is happening in individual institutions 

and markets, but throughout the whole system.

The information we collect and the analysis we undertake will allow us to measure more 

accurately the nature of risk in individual firms and across the system, but it must be 

complemented with a forward-looking perspective that analyzes evolving market practices 

and activities and tests the resilience of the financial system to a wide set of future events. 

This perspective requires careful assessments of the relative likelihood of a range of potential 

outcomes, including assessing the potential impact on the functioning of the financial system 

and understanding where reforms to markets, firms, and infrastructure may mitigate threats. 

And it requires an ongoing focus on incentives within the financial system that might create or 

exacerbate vulnerabilities. 

Working through the Council, we will focus our efforts in four distinct areas:

•	 The ongoing interaction between the financial system and the economy. We need 

to continue to strengthen our analysis of the interactions between the financial system 

and the economy, including the impact that financial sector decisions have on the 

economy. We also need to better assess how potential external shocks could be amplified 

by structural weaknesses and imbalances in the financial system. Stress testing is an 

important tool in making such assessments. It is also important to develop techniques 

that give us the ability to analyze the destabilizing second-round effects of shocks across 

financial institutions and markets. While it is impossible for stress tests to capture all 

potential threats, the discipline of repeatedly stressing institutions and networks against 

low-likelihood adverse scenarios will help temper overly optimistic assumptions that might 

otherwise lead to harmful behaviors and outcomes. 

•	 The buildup of systemwide leverage and funding mismatches. It is crucial to 

complement the evaluation of the safety and soundness of individual institutions with 

an assessment of leverage in the financial system and imbalances between funding and 

assets across the financial industry. It is hard to detect vulnerabilities that can build in the 

interconnections between firms and markets. Thus, we need to work to ensure that the 

capital buffers and liquidity safeguards available to the system are sufficient. 

Letter from the Chair iii
•	 The ongoing evolution of financial market activity and practices. We will need to 

be attentive to the implications of very rapid growth in types of financial activity and 

new products. This is true in consumer product innovation, but also in the institutional 

markets where large institutions and firms interact. Innovation is an essential element of a 

healthy system, but rapid growth in products and activities untested by time and adversity 

necessarily entails challenges and requires more care and attention.

•	 The potential opportunities for regulatory arbitrage. Where the opportunity and 

incentive exist to avoid regulation and supervision, financial activity will migrate to areas of 

the system where there are gaps in authority or inconsistencies in regulatory standards. A 

substantial buildup in risk and leverage outside the regulated core of the financial system 

can increase threats to the system as a whole. We must also work to eliminate meaningful 

opportunities for arbitrage between countries, particularly in the key areas of capital and 

liquidity, derivatives, and resolution authority. 

A stable financial system cannot be maintained by regulation and oversight alone. Those in 

positions of leadership in the financial sector will need to establish and maintain much higher 

standards for integrity and a more sophisticated understanding of the risk inherent in the 

business of finance than prevailed before and during this crisis. 

This will require continued improvements in management structure and corporate governance 

practices. Compensation must be structured to create better incentives for robust risk 

management. Risk management officers in financial firms need to have a strong voice in 

decision making. Boards of directors need to actively engage with management and represent 

stakeholder interests by ensuring an appropriately long horizon and a broad perspective in 

making strategic choices. With improved disclosure and transparency, firms that take this longterm perspective should prosper in the long run, while those that do not will face higher funding 

costs and less indulgent investors. 

In this first annual report, we describe the current state of the U.S. financial system and some 

of the major forces that will shape its development going forward. The Council and its members 

will continue to implement the Dodd-Frank Act on a coordinated basis to enhance the integrity, 

efficiency, transparency, competitiveness, and stability of U.S. financial markets. The report 

also includes recommendations for additional steps that should be taken to complement these 

efforts and further strengthen the financial system.

Timothy F. Geithner

Secretary of the Treasury

Chairperson, Financial Stability Oversight Council

iv 2011 FSOC Annual Report
Table of Contents

1 Member Statement .............................................................................. 1

2 Executive Summary ............................................................................. 3

3 Annual Report Recommendations .................................................... 11

4 Macroeconomic Environment ........................................................... 17

Box A: U.S. Dollar as the International Reserve Asset ..................................................34

Box B: Municipal Debt Market ....................................................................................38

Box C: Country Support Developments in Europe .......................................................42

5 Financial Developments .................................................................... 45

Box D: Money Market Funds ......................................................................................50

Box E: Exchange Traded Funds ..................................................................................66

Box F: Improvements in Regulatory Capital and Accounting Measures of Assets ..........72

Box G: Analytical Basis for Basel III Capital Standards .................................................84

Box H: Improving Capital Planning ..............................................................................88

Box I: Addressing Issues Related to Large Complex Financial Institutions ...................112

6 Progress in the Implementation of the Dodd-Frank Act; 

Council Activities ............................................................................ 115

7 Potential Emerging Threats to U.S. Financial Stability ................... 131

Box J: Measuring Systemic Risk ...............................................................................132

Box K: Stress Testing as a Forward-Looking Risk Mitigation Tool ...............................134

Box L: Improvements in the Monitoring of Risks to Financial Stability .........................139

Glossary ........................................................................................................................151

Abbreviations .................................................................................................................165

Notes on the Data ..........................................................................................................171

List of Charts .................................................................................................................173

1 Member Statement

The Honorable John A. Boehner

Speaker of the House

United States House of Representatives

The Honorable Nancy Pelosi

Democratic Leader

United States House of Representatives

The Honorable Mitch McConnell

Republican Leader

United States Senate

The Honorable Joseph R. Biden, Jr.

President of the Senate

United States Senate

The Honorable Harry Reid

Majority Leader

United States Senate

In accordance with Section 112(b)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 

for the reasons outlined in the annual report, I believe that additional actions, as described below, should 

be taken to ensure that the Council, the Government, and the private sector are taking all reasonable steps 

to help ensure financial stability and to mitigate systemic risk that would negatively affect the economy: the 

issues and recommendations set forth in the Council’s annual report should be fully addressed; the Council 

should continue to build its systems and processes for monitoring and responding to emerging threats to 

the stability of the United States financial system, including those described in the Council’s annual report; 

the Council and its member agencies should continue to implement the laws they administer, including 

those established by, and as amended by, the Dodd-Frank Act through efficient and effective measures; and 

the Council and its member agencies should exercise their respective authorities for oversight of financial 

firms and markets so that the private sector employs sound financial risk management practices to mitigate 

potential risks to the financial stability of the United States. 

Timothy F. Geithner

Secretary of the Treasury

Chairperson, Financial Stability Oversight Council

Ben S. Bernanke

Chairman

Board of Governors of the Federal Reserve System

John Walsh

Acting Comptroller of the Currency

Office of the Comptroller of the Currency

Mary L. Schapiro

Chairman

Securities & Exchange Commission

Martin J. Gruenberg

Acting Chairman

Federal Deposit Insurance Corporation

Gary Gensler 

Chairman

Commodity Futures Trading Commission

Edward J. DeMarco

Acting Director

Federal Housing Finance Agency

Debbie Matz

Chairman

National Credit Union Administration

Member Statement 1

2 Executive Summary

The efficient provision of financial services is critical to the nation’s economic growth and 

prosperity. A stable financial system can continue to provide financial services while absorbing 

a range of shocks. A stable financial system should not be the source of, nor amplify the impact 

of, shocks. 

The Financial Stability Oversight Council is charged with identifying risks to the financial 

stability of the United States, promoting market discipline, and responding to emerging threats. 

Council members have many tools at their disposal to accomplish these goals, owing to their 

involvement in supervision and regulation, consumer and investor protection, and market and 

infrastructure oversight.

Macroeconomic Environment

The U.S. economy continues to heal from the 2007–09 recession (the 

longest since the Great Depression). Consumer spending and business 

investment have increased, but housing markets remain depressed 

and the unemployment rate is elevated. The global economy is also 

recovering, albeit at varying rates across advanced and emerging 

economies. 

The financial crisis produced great upheaval in the U.S. financial 

sector, but the impact on the economy was even more devastating. 

At the height of the crisis, credit conditions tightened for households 

and businesses, as well as for financial firms of all sizes, reflecting 

severe disruptions to a range of financial markets that proved far more 

damaging than the disruptions from the initial credit losses themselves. 

Credit conditions have improved significantly from the depths of 

the crisis. Recently, credit flows have shown signs of recovery, with 

large corporate borrowers facing favorable financing conditions and 

households experiencing an increase in credit. Corporate balance 

sheets deteriorated significantly during the crisis, primarily as a result of 

falling asset values, but they have recovered since mid-2009 as cash 

flows and profits have increased. Corporate bond markets have also 

recovered for both investment-grade and non investment-grade issuers. 

The outlook is more challenging for small businesses, which tend to 

borrow against real estate assets. They report weak demand for their 

products and services, as well as borrowing constraints, although the 

number of small businesses reporting difficulties obtaining credit has 

declined since the crisis.

Executive Summary 3
Nonmortgage lending to consumers has grown recently after declining 

for several years. Household balance sheets are recovering, partly 

because of the rebound in stock prices, but they remain challenged 

by the weak labor market, slow income growth, and declines in real 

estate values. As a result of the fall in home values, a significant number 

of homeowners now have low or negative equity in their properties, 

and record numbers of homes have entered the foreclosure process. 

However, low interest rates have helped mitigate some of the costs of 

mortgage debt and, in the aggregate, households’ ability to meet debt 

payments has improved since 2007. 

Government budgets, both federal and nonfederal, have been strained 

by the cyclical response of revenues and expenditures to a weak 

economy as well as the fiscal actions taken to ease the recession 

and aid the recovery. The federal government deficit grew from 1.2 

percent of GDP in 2007 to 8.9 percent in 2010, and net publicly held 

federal debt outstanding rose from $5 trillion to $9 trillion. This public 

borrowing largely replaced private borrowing in the credit markets, 

and global financial markets readily accommodated the increase in 

federal debt. Even after economic conditions return to normal, the 

federal government faces a long-run imbalance between revenues and 

expenditures. This need for long-run fiscal sustainability has been a 

focus of recent attention from credit rating agencies. Achieving longrun sustainability of the national budget is crucial to maintaining global 

market confidence in U.S. Treasury securities and the financial stability 

of the United States.

State and local government revenues were severely affected by the 

economic downturn. While state finances started to improve in the 

second half of 2010, several quarters into the economic recovery, local 

governments remain challenged. The municipal debt market exhibited 

evidence of considerable stress last year.

Sovereign and banking sector strains are evident among a number of 

advanced economies. Three countries in the European Monetary Union 

have required financial assistance as markets have priced elevated 

sovereign credit risk into their debt. The relatively new phenomenon 

of differentiated compensation for sovereign credit risk in advanced 

countries has added to volatility in global markets. It has also exposed 

tensions within the European Monetary Union and limitations in the 

pre-crisis set of tools available to European policymakers to respond to 

economic and financial stress. 

In contrast, most emerging economies have recovered relatively quickly 

from the crisis, partly because of their lack of financial imbalances 

before the financial crisis. However, emerging economies face 

challenges from robust capital inflows and the potential for overheating. 

Recent instability in North Africa and the Middle East and the natural 

disaster in Japan have added to uncertainty in the international 

environment. 

4 2011 FSOC Annual Report
At the peak of the financial crisis, the U.S. government introduced 

unprecedented support for financial markets, injecting hundreds of 

billions of dollars of capital and liquidity into the financial sector. As 

market confidence has returned, private funding has gradually replaced 

those support programs: many financial institutions have returned 

the government’s capital; the Federal Reserve is no longer offering 

extraordinary liquidity support to financial markets; and the FDIC 

guarantees for bank senior debt will expire in 2012. 

Funding has not returned to the private securitized mortgage market, 

which financed a significant portion of household borrowing in the first 

decade of the 2000s. In the past, the government’s role encouraged 

housing purchases and real estate investment over other sectors 

and ultimately left taxpayers responsible for much of the risk incurred 

by a poorly supervised housing market. This led to the two large 

government-sponsored enterprises, Fannie Mae and Freddie Mac, being 

placed into federal conservatorship. These entities and the Federal 

Housing Administration now dominate mortgage lending, guaranteeing 

or insuring over 90 percent of mortgage loan originations. This is not a 

viable long-term solution, but, given the current fragility of the real estate 

market, the transition back to more private involvement will require time 

and care.

Profitability has returned in the banking sector and for many other 

financial institutions. Investors purchased large amounts of new 

equity in the largest bank holding companies in 2009 and 2010, partly 

responding to the results of the 2009 supervisory-run stress test. U.S. 

banking institutions now have substantially stronger capital and liquidity 

buffers than before the crisis. However, smaller banks, particularly those 

with large commercial real estate exposures, have not recovered as 

quickly as larger banks and have continued to fail at elevated rates. At 

the same time, in taking prudent measures to conserve their capital 

and liquidity, many banks have been slow to expand their direct lending 

activity since the financial crisis. 

Assets have grown at insured depository institutions relative to other 

financial institutions since the crisis, following a long period in which 

financial activities moved from banks to markets. In particular, money 

market fund assets declined as investors transferred significant funds 

into insured bank deposits during the crisis. At the same time, the 

crisis reinforced the trend toward concentration and globalization in the 

banking industry, and foreign banking organizations have expanded 

their activities in the United States in recent years.

The financial system is less leveraged than it was before the crisis. Four 

of the five largest independent investment banks, all highly leveraged 

institutions, were acquired by or converted their charters to become 

bank holding companies in 2008, and the fifth failed. The specialty 

finance sector, which also relied heavily on market financing, is now 

Financial Developments

Executive Summary 5
smaller and more stable. Several of the largest companies in the 

specialty finance sector also became bank holding companies 

during the crisis to expand their funding options. These and other 

companies have reduced their leverage significantly below the levels 

before the crisis. 

Short-term wholesale funding markets provide liquidity for financial 

institutions to support their activities, but the financial crisis showed 

that these markets can be fragile and subject to runs by risk-averse 

investors. In response to unprecedented strains in these markets, 

the Federal Reserve, the FDIC, and the Treasury took extraordinary 

steps to support market functioning. The crisis also revealed, in 

particular after the freezing of Lehman Brothers’ prime brokerage 

assets in London, that differences in international bankruptcy 

regimes can accelerate runs on short-term wholesale funding 

markets. Activity in several of these markets remains significantly 

below pre-crisis levels, as investors and supervisors have a new 

sensitivity to potential liquidity risks and other risks. 

The credit risk transfer markets that contributed to the financial 

crisis—specifically, those for credit default swaps and collateralized 

debt obligations—are now significantly smaller, partly owing to new 

regulatory and accounting rules. Derivatives markets generally will be 

subject to greater supervisory oversight under the Dodd-Frank Act.

Supervisors and market participants are more aware of the potential 

for extreme market fluctuations in the future and the need to 

maintain a stronger set of shock absorbers in individual institutions 

and in markets to absorb the impact of such events. These issues 

are particularly relevant when market participants are highly 

leveraged or when derivatives or other complex instruments are 

involved.

In general, the pricing of risk in important markets appears to be 

in line with historical averages. For example, the price-to-earnings 

ratios for corporate equities are well within historical ranges, and 

the credit risk premium on high-yield corporate debt is in the 

lower part of its long-run historical range. Prices for commodities 

and agricultural land have risen strongly but do not appear to be 

associated with high debt levels. 

Compensation practices that incented financial institution 

employees to take excessive risks are widely acknowledged to have 

been a contributing factor in the financial crisis. Under pressure from 

regulators and investors, financial institutions are reforming their 

compensation practices to better align the interests of managers, 

traders, and other employees with the long-term health of the firm, 

although more needs to be done. 

Following the rebound in equity markets, aggregate assets in mutual 

funds and hedge funds have recovered to pre-crisis levels. Assets 

in defined contribution plans have also recovered, although many 

6 2011 FSOC Annual Report
 

pension plans for state and local government employees appear to face 

funding shortfalls over the long run. Investors have increasingly turned 

to exchange traded funds, which offer low fees and intraday liquidity.

Regulatory reforms and advances in technology have altered the 

landscape for financial infrastructure, providing financial markets with 

advances in efficiency and transparency. While this infrastructure and 

the markets that it supports have generally performed their primary 

functions in an orderly fashion during and since the crisis, there were 

exceptions. One was the so-called flash crash of May 2010, when 

equities and equity futures markets plunged more than 5 percent and 

then rebounded in a matter of minutes. This incident illustrates some of 

the risks associated with increasingly complex and connected financial 

markets interacting with ever-faster automated trading systems. Poor 

functioning in mortgage servicing and the tri-party repo market were 

also identified during the crisis, and regulators are taking steps to 

address them.

Progress of Regulatory Reform

In the period after the financial crisis, the legal, regulatory, and 

accounting framework of our financial system has changed significantly. 

The Dodd-Frank Act, which created the Council, closed gaps in the 

financial regulatory framework and strengthened supervisory, risk 

management, and disclosure standards in important ways. The new 

Basel III international standards for banks, negotiated with major input 

from U.S. regulators, will require banks globally to hold more capital, 

particularly when they take market risk, and will subject banks to a 

liquidity standard for the first time, and new accounting rules will serve 

to limit financial institutions’ off-balance-sheet activities. 

For the first time, information on trading in swaps will be available 

through trade repositories. In addition, standardized derivatives will 

have to be traded on regulated trading platforms and centrally cleared, 

improving price transparency and reducing counterparty credit risk for 

market participants. Once regulators complete the implementation of 

the Dodd-Frank Act, the mix of complex structured credit products, 

derivatives, and short-term wholesale funding that helped produce the 

financial crisis is unlikely to reappear in its previous form. 

U.S. regulators continue to work out the details of several important 

initiatives, including those mandated by the Dodd-Frank Act and those 

agreed to with their international counterparts. For example, the Council 

has defined the characteristics under which it will designate systemically 

important financial market utilities for enhanced supervision. The Council 

is also in the process of defining the characteristics under which it will 

designate nonbank financial institutions for Federal Reserve supervision, 

and the Federal Reserve, in consultation with other Council member 

agencies, is establishing tougher supervisory guidelines for large 

financial institutions. Regulators are also developing new reporting and 

disclosure requirements for designated nonbank financial companies.

Executive Summary 7
 

The Dodd-Frank Act also established a new framework for resolving 

large complex financial institutions, limiting the expectation that the 

government will bail out such institutions in a crisis. As part of the 

enhanced supervisory standards, designated nonbank companies and 

large bank holding companies will be required to maintain detailed 

resolution plans. Until the Dodd-Frank Act is fully implemented, the 

public will not receive the full set of protections provided by the 

improved regulatory system. In addition, to maximize all the benefits of 

the new regulatory framework, it is imperative that relevant regulatory 

agencies be funded at levels consistent with their expanded missions. 

Regulators are also working with their international counterparts to 

promote consistency in global regulatory reform, particularly with 

regard to implementing the new Basel III capital and liquidity standards; 

strengthening the supervision of, designing capital surcharges for, 

and developing a framework for the resolution of large, globally active 

financial institutions; promoting harmonization for the oversight of 

derivatives markets; and regulating global financial infrastructures.

Potential Emerging Threats to U.S. Financial Stability

Assessing future threats to financial stability will require attention to 

the broad forces driving the evolution of the financial system, which 

determine the profit opportunities available to market participants 

and financial institutions along with the risks they take. In addition to 

these long-run challenges to maintaining financial stability, a number 

of possible shocks and vulnerabilities could produce more immediate 

threats to U.S. financial stability.

Globalization and technological innovation are among the most 

important forces that could affect future financial stability. While the rise 

of international banking and the important role of foreign banks in U.S. 

financial markets allow risks to be transferred more broadly across the 

global economy, they also increase the links across economies and add 

to the complexity of the financial system. Global interconnectedness 

is heightened by the role of the U.S. dollar as the international reserve 

currency and the funding needs of large foreign firms that hold U.S. 

dollar-denominated assets. 

Financial product innovation and growth is crucial to support a vibrant 

economy, but at times it can result in dramatic changes in business 

models and can introduce increased complexity, thereby altering the 

evolution of linkages among firms. Three such products examined in the 

report are exchange traded funds, structured notes, and collateralized 

commercial paper. While the level of activity in these products in the 

United States is not high enough to represent a threat, the level of 

activity abroad and the links to derivatives have led regulators in other 

countries to focus special attention on them.

The functioning of the U.S. financial system has proven resilient to the 

impact of a number of recent shocks, such as the natural disaster in 

Japan and the fluctuating concerns over European sovereign debt. 

8 2011 FSOC Annual Report
Further, increases in trading volumes and enhanced market liquidity 

have been fostered, in part, by the increasing use of electronic trading. 

This liquidity can evaporate in stressed environments, as the flash crash 

demonstrated. New technology has helped strengthen the resilience of 

payment systems, data repositories, and other financial infrastructure. 

This has given firms the tools to handle increasingly intricate 

transactions, including transactions in short-term wholesale funding 

markets that can provide hundreds of billions of dollars overnight to 

cover daily funding needs. Operational risk events, along with recent 

high-profile cyberattacks, are important reminders that both regulators 

and firms need to continuously upgrade the resilience of their electronic 

systems and networks.

There is significant market uncertainty in Europe, notably associated 

with the sovereign credit risk of Greece, Ireland, and Portugal. U.S. 

financial institutions have very limited net direct exposure to these 

three countries. They have larger exposure and important ties to 

major financial institutions elsewhere in Europe that in turn have large 

exposures to Greece, Ireland, and Portugal. 

Some major European banks obtain substantial short-term wholesale 

U.S. dollar funding from U.S. money market funds. Further, money 

market funds remain an important supplier of cash to the tri-party repo 

market. Structural vulnerabilities in money market funds and tri-party 

repo amplified a number of shocks in the financial crisis. Reforms 

undertaken since the crisis have improved resilience, and money market 

funds report de minimis exposure to Greece, Ireland, and Portugal; 

however, amplification of a shock through these channels is still 

possible.

The impact on the U.S. financial system of events in Europe depends 

on how the peripheral European sovereign debt crisis evolves and on 

the resilience of U.S. financial institutions and markets. If the crisis, now 

affecting Greece, Ireland, and Portugal, were to intensify significantly 

or spread more broadly across the euro area, then the impact on the 

U.S. financial system would be greater. Supervisors have for some time 

been working with U.S. financial institutions to improve their ability to 

withstand a variety of possible financial contagion stress scenarios 

emanating from Europe. The Council and its member agencies will 

continue to carefully monitor the potential risks that could emerge from 

the peripheral European sovereign debt crisis.

Real estate-related exposures remain a significant risk for many U.S. 

financial institutions. However, the improvement in capital across the 

financial system provides an important buffer against further declines 

in real estate prices and larger losses; this makes it less likely that 

U.S. financial institutions will have to reduce assets or reduce growth 

in lending in response to a more prolonged period of weakness in the 

housing market or in the U.S. economy more generally. On the other 

hand, the transition path back to a greater role for private capital in the 

housing finance system remains uncertain. 

Executive Summary 9
The weakness of the current recovery has delayed monetary policy 

normalization and exacerbated the unsustainable fiscal trajectory in 

the United States. Despite the sustained low interest rate environment, 

there is limited evidence of major U.S. market participants “reaching for 

yield.” One possible exception has been in some of the activity in the 

markets for non investment-grade bonds and loans.

Both monetary policy normalization and fiscal consolidation will have 

important consequences for the business models of many financial firms 

that are currently funding large holdings of government securities and 

reserves at the Federal Reserve with low-cost deposits. Uncertainty 

over the pace of monetary policy normalization and fiscal consolidation 

has the potential to generate shocks; however, with appropriate 

planning and risk diversification, the financial market impact of such 

shocks should be absorbed without affecting the functions of the 

system.

The capital and liquidity of the largest U.S. financial institutions have 

improved substantially. However, many large U.S. financial institutions 

currently receive the highest credit rating for short-term funding partly 

because of a presumption of possible government support in stressed 

conditions. Further, the Federal Reserve, in its Comprehensive Capital 

Analysis and Review, found a number of weaknesses in the capital 

planning processes at many large banking institutions. These factors 

highlight some of the challenges still ahead in building a stronger 

financial system.

The recent financial crisis provides a stark illustration of how quickly 

confidence can erode and financial contagion can spread, as well as 

how challenging and expensive it is to repair the damage. This lesson 

is important to bear in mind in the current debate over the increase in 

the federal government’s debt limit. It is vital to the stability of the U.S. 

financial system and the global financial system for the debt limit to be 

raised in a timely manner to avoid creating any risk of default on U.S. 

obligations.

10 2011 FSOC Annual Report
3 Annual Report Recommendations

The Dodd-Frank Act requires the Council to make annual recommendations to (1) enhance 

the integrity, efficiency, competitiveness, and stability of U.S. financial markets; (2) promote 

market discipline; and (3) maintain investor confidence. The Council fulfills this requirement by 

recommending (1) heightened risk management and supervisory attention in specific areas; (2) 

further reforms to address structural vulnerabilities in key markets; (3) steps to address reform of 

the housing finance market; and (4) coordination on financial regulatory reform. 

The Council recommendations work together to balance the stated requirements of integrity, 

efficiency, competition, market discipline, and investor confidence, while maintaining 

financial stability. For instance, recommendations to improve capital and liquidity planning, 

address vulnerabilities in the money market fund and tri-party repo markets, and coordinate 

implementation of the Dodd-Frank Act will improve the stability of the financial system. To 

promote market discipline, the Council recommends responsible credit underwriting standards; 

housing finance reforms, including mortgage servicing standards and servicer compensation; 

and effective implementation of orderly liquidation authority for the largest financial firms. To 

maintain investor confidence, the Council also recommends that market participants keep 

pace with infrastructure and technological advances and conduct heightened due diligence on 

emerging financial products. Collectively, the Council recommendations address the identified 

vulnerabilities in the system and emerging threats to financial stability. Regulatory agencies 

and market participants should take these steps to enhance the resilience and integrity of the 

system. The discussion below outlines the Council recommendations and their fulfillment of the 

Council’s statutory mandate. 

I. Heightened Risk Management and Supervisory Attention

In the following areas, market participants should employ heightened 

risk management, and Council member agencies should enhance 

ongoing supervisory attention to determine whether any of these market 

dynamics rises to a level that merits a regulatory response. 

•	 Construct robust capital, liquidity, and resolution plans. To 

support stability in the financial system, financial institutions 

should ensure that they have in place robust capital, liquidity, 

and resolution planning processes. The Federal Reserve’s 

Comprehensive Capital Analysis and Review exercise found that 

all of the largest banking companies need to bolster their capital 

planning processes. The largest financial institutions must also 

incorporate within their planning processes contingencies for 

resolution that would facilitate resolvability under bankruptcy 

without government assistance. In addition, the largest banks 

Annual Report Recommendations 11
 

should plan further improvement in their capital levels and liquidity 

risk profiles to support funding models without any assumption of 

government assistance and their continued smooth transition to 

new global standards.

•	 Bolster resilience to unexpected interest rate shifts. In 

light of a sustained, historically low interest rate environment, 

market participants should work to ensure that they have robust 

processes for measuring and, where necessary, mitigating their 

exposure to a range of interest rate scenarios. Preparedness to 

face unexpected rate changes or yield curve shifts will enable 

market participants to make a stable transition to a new rate 

environment, minimizing potential disruption to the system. 

•	 Maintain discipline in credit underwriting standards. Although 

it is difficult to make definitive determinations regarding the 

appropriateness of risk pricing, there have been some indicators 

that credit underwriting standards might have overly eased 

in certain products, such as leveraged loans, reflecting the 

dynamics of competition among arranging bankers. Greater 

market discipline can be supported through robust due diligence 

practices and processes for monitoring and responding to 

developments in credit underwriting standards, including deal 

features that may allow borrowers to take on excessive risk. 

Sound underwriting standards, which were abandoned in the runup to the crisis, will encourage greater investor confidence and 

stability in the market. 

•	 Employ appropriate due diligence for emerging financial 

products. Council agencies are highly attentive to the emergence 

and growth of financial products, particularly those that may be 

designed to arbitrage new capital and accounting standards by 

moving financial activities outside the regulated core. A robust 

financial system should facilitate innovation. Market participants, 

as issuers or investors, should work to ensure that they have 

an adequate understanding of the risks that products such as 

exchange traded funds and structured notes present, including 

impacts under strained market conditions. 

•	 Keep pace with competitive, technological, and regulatory 

market structure developments. Equity trading markets in the 

United States have experienced changes in market structure over 

the past several years, including an expansion of the number of 

trading venues and the rise of electronic trading. The flash crash of 

May 6, 2010 demonstrated that regulators and market participants 

should continue to monitor these changes and take action as 

necessary to help ensure that the market structure regulatory 

framework and operational policies keep pace with changes 

to trading and other market practices. Regulators and market 

participants should also continue to foster investor confidence by 

promoting market integrity, efficiency, and competition. 

12 2011 FSOC Annual Report
II. Additional Reforms to Address Structural Vulnerabilities

Financial systems are vulnerable to shocks that can be exacerbated 

by weaknesses in the structure of financial institutions, markets, and 

infrastructure. 

The Council recommends reforms to address structural vulnerabilities 

in the tri-party repo market, for money market mutual funds, and in 

mortgage servicing: 

•	 Elimination of most intraday credit exposure and reform of 

collateral practices in the tri-party repo market to strengthen 

the market. Given the vital importance and size of tri-party 

repo financing and the broad array of financial institutions 

active in this market, the regulatory community should exert its 

supervisory authority over the industry’s reform efforts to ensure 

that the Tri-Party Repo Infrastructure Reform Task Force meets 

its commitments as promptly as possible. The Task Force’s 

efforts should ultimately improve market functioning, but several 

important structural reform issues require coordinated supervisory 

and regulatory attention. Chief among these priorities are 

enhancing dealer liquidity risk management practices, alleviating 

the propensity of cash investors to withdraw funding and exit the 

market when risk surfaces, and implementing mechanisms to 

manage a potential dealer default. The fragility of broader market 

liquidity facilities and the constraints on the types of collateral that 

certain investors are prepared to take (particularly money market 

funds) heightens the risk of contagion in the market. Reform 

efforts should practically eliminate intraday credit exposures 

of clearing banks to borrowers and strengthen collateral 

management practices to improve the stability of this critical shortterm funding market. 

•	 Implement structural reforms to mitigate run risk in money 

market funds. When the SEC adopted new rules for money 

market funds (MMFs) in February 2010, it noted that a number 

of features still make MMFs susceptible to runs and should be 

addressed to mitigate vulnerabilities in this market. To increase 

stability, market discipline, and investor confidence in the MMF 

market by improving the market’s functioning and resilience, the 

Council should examine, and the SEC should continue to pursue, 

further reform alternatives to reduce MMFs’ susceptibility to runs, 

with a particular emphasis on (1) a mandatory floating net asset 

value (NAV), (2) capital buffers to absorb fund losses to sustain a 

stable NAV, and (3) deterrents to redemption, paired with capital 

buffers, to mitigate investor runs. 

•	 Improve the overall quality of mortgage servicing by 

establishing national mortgage servicing standards and 

servicer compensation reform. The mortgage servicing 

industry was unprepared and poorly structured to address the 

rapid increase in defaults and foreclosures. To address this 

Annual Report Recommendations 13
structural vulnerability, regulators should establish national 

mortgage servicing standards and promote alternative servicer 

compensation models. 

» National mortgage servicing standards should provide clarity

to borrowers and investors, and servicers should be held to 

the same quality and responsiveness standards regardless of 

whether the loans being serviced are held on the originator’s 

books, have been sold, or have been securitized. National 

standards would align incentives and provide clarity and 

consistency to borrowers and investors, especially in the case 

of delinquency. These standards will enhance the integrity and 

efficiency of mortgage servicing and help reestablish investor 

confidence in the housing finance market.

» Today, the structure of servicing compensation generally 

does not adjust to reflect the amount of servicing effort 

and expense required. This flat-fee structure does not 

appropriately incent servicers to invest the time and effort to 

work with borrowers to avoid default or foreclosure. The FHFA 

and the Department of Housing and Urban Development 

should continue to coordinate a review of the structural flaws 

in the current mortgage servicing compensation model and 

should consider alternatives. 

 

III. Housing Finance

The U.S. housing finance system required extraordinary federal 

government support during the crisis. Over 90 percent of the market 

continues to function on the basis of this government support 

and without sufficient return of private capital. This dynamic is not 

sustainable over the long term. The Council member agencies and 

the Department of Housing and Urban Development should continue 

their work to strengthen the housing finance system, which includes 

developing a framework for the return of private capital to the system. 

The framework should include regulatory activities that set forth 

standards and guidelines for participants in the housing finance system, 

and other actions that strengthen mortgage underwriting. To give further 

confidence to the market and provide long-term stability to the U.S. 

financial system, the Council believes Congress must pass responsible 

legislation to reform the housing finance system. The reform efforts 

should not further destabilize the fragile housing market. 

IV. Financial Regulatory Reform 

Council member agencies are committed to implementation of financial 

regulatory reform. While important steps have been taken, both 

domestically and in the international policy arena, much work remains 

to be done. The agencies are approaching reform carefully, mindful 

of the need for sufficient public comment and the risks of unintended 

consequences. 

14 2011 FSOC Annual Report
Coordinated implementation of regulatory reform will enhance the 

integrity, efficiency, competitiveness, and stability of U.S. financial 

markets; promote market discipline; and maintain investor confidence by 

closing regulatory gaps that contributed to the crisis and previous market 

dislocations.

Dodd-Frank Act

The Dodd-Frank Act provides comprehensive reforms and protections 

across the financial regulatory system. These reforms include the creation 

of a regulatory framework for the over-the-counter derivatives market; 

investor protection measures that increase disclosure, transparency, 

and confidence; reporting for managers of hedge funds and other 

private funds; and the establishment of a single agency dedicated to 

ensuring consumer financial protection and the integrity of the market 

for consumer financial products and services. The Dodd-Frank Act also 

requires regulators to impose heightened prudential standards on certain 

large financial firms to help foster market discipline and stability, and 

to make clear that no firm will be considered too big to fail, by creating 

a new authority to break up and wind down a failing financial firm in a 

manner that protects taxpayers and the economy. In addition, the DoddFrank Act created the Council to monitor risks that could build across 

the system in a way that threatens the stability of the financial markets in 

the United States, and the OFR to collect data on the Council’s behalf, 

working closely with supervisors.

The Council member agencies have made significant progress in 

implementing the many reforms that the Dodd-Frank Act requires. 

The Council and its member agencies recognize that successful 

implementation of reform across complex areas of the financial system 

requires independent agencies to coordinate their efforts, even if 

such consultation is not statutorily required. Coordination is critical to 

implementing reforms that not only work together in a sensible, coherent 

way, but also appropriately balance market efficiencies, competitiveness, 

and stability while providing for innovation. To meet the challenges 

of designing and enforcing these new rules, the quality and scale of 

resources dedicated to financial oversight must increase. Agencies must 

have sufficient resources to attract and retain talented individuals and 

invest in systems to monitor market activity and enforce the new rules. 

International Coordination

At the September 2009 summit in Pittsburgh, the G-20 heads of state 

agreed that reforms were needed to build high-quality capital and 

mitigate pro-cyclicality in the financial system; improve compensation 

practices to support financial stability; reform the over-the-counter 

derivatives markets for greater transparency and risk management; and 

address cross-border resolutions and systemically important financial 

institutions. The implementation of the Dodd-Frank Act will accomplish 

many of these goals within the United States, but international 

coordination is required to ensure that similar reforms are applied 

consistently across the global financial system to mitigate regulatory gaps 

Annual Report Recommendations 15
 

and level the playing field. Council member agencies are committed to 

working with their international counterparts to implement these reforms 

in a timely manner. Key reforms include the following:

•	 Capital and liquidity standards. In 2010, central banks and 

supervisors reached agreement on the core elements of new 

global capital and liquidity standards, Basel III. As a result of 

this agreement, internationally active banks will have to hold 

substantially more capital in the form of common equity against 

the risks they take. This agreement was the foundation of a 

comprehensive new capital framework to further stabilize global 

markets, but it left open several areas for further analysis, including 

the size and composition of additional capital requirements to 

impose on the largest global institutions, how to implement the new 

liquidity standards, and how to bring more consistency to the risk 

weighting of assets across countries.

•	 Globally active systemically important banks. The Financial 

Stability Board, a global body of finance ministers, central bankers, 

and supervisors, has been working to develop guidelines for 

cooperation in the supervision of large, globally active financial 

institutions, and to develop a consistent international framework 

for the orderly resolution of such companies. These initiatives 

complement Dodd-Frank Act requirements, and Council members 

are actively supporting efforts to promote international consistency 

on resolution frameworks.

•	 Derivatives markets. A core element of the international 

framework for reform of the over-the-counter derivatives market is 

a requirement for standardized derivatives to be centrally cleared. 

While there will continue to be bilaterally executed derivatives 

transactions that are not cleared, there is international agreement 

that non-centrally cleared derivatives should be subject to higher 

capital requirements. In addition, Council member agencies 

are committed to working with international counterparts to 

develop global standards for central counterparties and margin 

requirements for swaps and security-based swaps that are not 

centrally cleared. Other key elements of reform are the reporting 

of over-the-counter derivatives to trade data repositories and the 

trading of standardized over-the-counter derivatives on exchanges 

or electronic trading platforms. In each of these areas, Council 

member agencies are committed to working with international 

counterparts to harmonize requirements.

•	 Infrastructure. International authorities have released revised 

standards for financial market infrastructures that provide a single 

set of principles (CPSS-IOSCO Principles for financial market 

infrastructures) for greater consistency in the oversight and 

regulation of financial infrastructures worldwide, including enhanced 

requirements for governance and risk management practices, and 

new standards on transparency and general business practices. 

These principles should provide greater consistency in the oversight 

and regulation of financial infrastructures worldwide and thus 

enhance the integrity of markets and global investor confidence.

16 2011 FSOC Annual Report
4 Macroeconomic Environment

The U.S. economy expanded at a moderate pace in 2010 and early 2011. The economy is 

healing slowly from the lingering effects of the extraordinary financial market dislocations 

in 2008–09 and the severe declines in employment and output (Chart 4.0.1). Businesses 

have increased investment, and consumers have increased spending (Chart 4.0.2). 

However, construction and housing demand remain depressed, the unemployment 

rate is elevated, and the gains in total employment have been insufficient to raise the 

employment-population ratio. 

Most foreign economies also continue to 

recover from the most severe global downturn 

since the Great Depression, albeit at differing 

paces. Emerging economies, which suffered 

fewer financial disruptions from the crisis, have 

been able to recover more quickly, and many of 

those economies have returned to or exceeded 

their previous trend growth rate. Recovery in 

the advanced economies has been slowed 

by the weakness of the financial sector, and 

many have not yet reached their pre-crisis 

level of economic activity. With interest rates in 

advanced economies at historically low levels to 

support economic growth, funds have flowed to 

emerging markets, where returns are relatively 

higher. Political tensions in North Africa and the 

Middle East, and the natural disaster in Japan 

added to uncertainty in the first half of 2011. 

The recession depressed tax revenues and 

required additional public sector spending, 

leading to substantial increases in government 

debt in many advanced economies

(Charts 4.0.3 and 4.0.4). For the most 

part, financial markets have been able to 

smoothly accommodate elevated government 

borrowing, as private savers have increased 

their demand for government debt. However, 

certain governments and financial institutions 

in peripheral Europe have encountered 

severe difficulties in maintaining access to 

private financial market funding. As the global 

economy continues to recover, governments 

Chart 4.0.1 Real GDP Growth and the Unemployment Rate

Chart 4.0.2 Real GDP Growth and Its Components 4.0.2 Real GDP Growth and Its Components

Macroeconomic Environment 17
face the challenge of rebalancing revenue and 

expenditures.

4.1 Provision of Financial 

Services to the Real Economy

Functions of the Financial System

The financial system has three primary 

functions: (1) credit flow facilitation, (2) risk 

transfer, and (3) transaction and payment 

services. 

Credit flows: A primary function of the financial 

system is to facilitate the flow of funds from 

savers to borrowers at prices that appropriately 

compensate all parties for the inherent riskiness 

of lending; hence, financial markets and their 

participants play a key role in price discovery.

Risk transfer: Another key function of the 

financial system is to facilitate the efficient 

allocation of risk across households and 

businesses.

Transaction and payment services: The 

financial system is also responsible for providing 

reliable and robust transaction and payment 

services to the real economy.

4.1.1 Credit Flows

The reduction in credit flows to households 

and businesses during the crisis reflected both 

a decline in demand for credit and a reduction 

in the supply of available credit. Combined 

credit flows to businesses and households 

have started to increase. However, persistent 

weakness in real estate markets continues to 

restrain demand for and supply of mortgage 

credit. 

Before the financial crisis, many households 

and financial market participants increased 

their debt loads. Some of this credit flowed 

to borrowers with limited ability, and at times 

limited incentives, to repay their loans. Further, 

some companies that originated mortgages and 

sold them for securitization were compensated 

on the basis of volume and did not always 

retain a stake in the mortgages. This meant 

that they had less incentive than traditional 

Chart 4.0.3 United States Nonfinancial Net Debt Flows

Chart 4.0.4 Euro Area Nonfinancial Net Debt Flows

Chart 4.1.1 Net Debt Outstanding as a Percent of GDP

18 2011 FSOC Annual Report
originate-to-hold lenders to underwrite loans to 

high standards. 

The crisis triggered significant reductions 

in the flow of credit and an unprecedented 

deleveraging by consumers, businesses, and, 

most dramatically, the financial sector itself. 

Even as the recession stressed government 

budgets, public borrowing largely replaced 

private borrowing in the credit markets 

(Chart 4.1.1). These trends have begun to 

moderate, and net flows of credit to the private 

nonfinancial sector have turned marginally 

positive owing to increases in both demand for 

and supply of credit. 

Credit Flows to the Corporate Sector

The nonfinancial corporate sector continues 

to recover as increased demand and low labor 

costs contribute to profitability. In the aggregate, 

corporate borrowers are experiencing more 

favorable financing conditions from banks, 

bond markets, and syndicated loan markets, 

which allow large corporate firms to finance 

their activities on better terms. For instance, 

bank underwriting standards have eased from 

the extremely tight conditions at the peak of the 

crisis (Chart 4.1.2). 

Credit intermediation for large corporations 

in the United States is characterized by a 

high degree of funding through debt capital 

markets rather than through banks. Debt 

capital markets, somewhat impaired during the 

crisis, are again functioning well. Corporate 

bond markets have recovered, and issuance 

of investment-grade and speculative-grade 

bonds has been robust in recent months (Chart 

4.1.3). Spreads between yields on corporate 

bonds and comparable-maturity U.S. Treasury 

securities have narrowed, although they remain 

above the very low pre-crisis levels (Chart 

4.1.4). In addition, new equity issuance has 

been robust lately and M&A activity has picked 

up, indicating that credit has become more 

available. 

Corporate leveraged buyouts (LBOs) remain 

well below the elevated levels seen during the 

last credit cycle, although they have increased 

somewhat as credit conditions have improved 

Chart 4.1.2 4.1.2 Bank Business Lending Bank Business Lending Standards and Demand Standards and Demand

Chart 4.1.3 Corporate Bond Market Issuance

Chart 4.1.4 Corporate Bond Spreads

Macroeconomic Environment 19
(Chart 4.1.5). Private equity firms continue to 

hold high levels of committed but uninvested 

capital available for LBO activity. 

Credit Flows to the Small Business Sector 

Banks are a large source of credit for small 

businesses: banks provide these businesses 

with term loans, credit cards, credit lines, 

commercial mortgages, and capital leases. 

Regulatory data on business loans less than 

$1 million and agricultural loans less than 

$500,000 suggest that small business lending 

had increased solidly in the years leading up to 

2008, before declining by more than 10 percent 

through 2010 (Chart 4.1.6). A number of 

related factors explain the decline, including the 

general dislocation of credit during the crisis, 

the adverse effect of the crisis on borrowers’ 

balance sheets and on the value of their 

available collateral, and the reduced demand 

for credit in light of lower inventory investment 

and cuts in investment and payrolls as these 

businesses have experienced weak demand 

and stagnant prospective sales.

In the National Federation of Independent 

Business (NFIB) June 2011 Small Business 

Survey, the number of small businesses 

reporting that credit is “harder to obtain” has 

declined to mid-2008 levels. Small businesses 

continue to cite weak demand for their products 

or services as the main factor limiting growth. 

Additionally, with more than half of credit to 

small businesses secured by some form of real 

estate, borrowing capacity is limited by the 

ongoing stress in real estate. 

Credit Flows to the Household Sector

Consumer spending has risen at a moderate 

pace since mid-2009, contributing to overall 

economic growth. However, consumer credit 

flows, which fell sharply during the crisis, have 

only recently begun to recover. The modest 

recovery of these flows reflects restraints on 

the availability of consumer credit as well as 

subdued demand as households face weaker 

income prospects. Nonmortgage lending to 

consumers, which declined for several years, 

began growing in 2010, driven by nonrevolving 

credit (Chart 4.1.7). The amount of revolving 

credit available to consumers has been 

Chart 4.1.5 North American Completed LBOs

Chart 4.1.6 Proxy for Small Business Lending

Chart 4.1.7 Nonmortgage Consumer Credit Flows

20 2011 FSOC Annual Report
substantially reduced, although aggregate 

borrowing capacity remains considerable 

(Chart 4.1.8). Demand for auto financing 

has risen along with the increase in vehicle 

purchases from the lows of the crisis. Student 

loan volumes increased during the downturn 

in part because of rising enrollments and 

increased tuition costs; these volumes have 

been increasingly supported by governmentguaranteed loan programs. 

Real Estate and Mortgage Markets

The housing sector remains depressed. To 

date, real residential investment has fallen 

nearly 60 percent since its peak in early 2006. 

Housing starts and sales of new homes have 

remained near record low levels, and distressed 

sales have increased, recently comprising 46 

percent of all sales (Charts 4.1.9 and 4.1.10). 

As a result of the pullback in mortgage lending 

and an elevated level of charge-offs, overall 

mortgage debt outstanding contracted for two 

years (Chart 4.1.11).

Home prices face continued downward 

pressure from excess inventory, lackluster 

demand, and distressed sales, in part coming 

from foreclosures. After stabilizing in late 

2009 and early 2010, home prices have 

fallen further since the summer of 2010. The 

CoreLogic repeat sales home price index, 

which is representative of conforming and 

non-conforming mortgages, is back down to 

its mid-2003 levels, about one-third below its 

2006 peak (Chart 4.1.12). The Federal Reserve 

Board’s Senior Loan Officer Opinion Survey for 

April 2011 showed that demand for residential 

mortgages at banks continued to decrease.

Some of the housing market fundamentals 

have shown signs of improvement. Indexes of 

affordability based on current interest rates, 

median incomes, and median home prices have 

risen to historic highs (Chart 4.1.13). The very 

low levels of new home construction in recent 

years have helped trim the backlog of excess 

new homes for sale. In addition, the unusually 

low levels of household formation over the past 

several years could reverse once the labor 

market improves sufficiently, suggesting the 

possibility of pent-up demand for housing.

Chart 4.1.8 4.1.8 Credit Card Limit and Outstanding Balance Credit Card Limit and Outstanding Balance

Chart 4.1.9 Single-Family New Home Starts and Sales

Chart 4.1.10 Distressed Sales Share of Total Home Sales

Macroeconomic Environment 21
More than offsetting the developments in these 

fundamentals, ongoing operational deficiencies 

and legal challenges in the processing of 

foreclosure filings have significantly slowed 

the foreclosure process, adding to a growing 

inventory of distressed properties. Moreover, 

the government-sponsored enterprises (GSEs) 

Fannie Mae and Freddie Mac, as well as the 

Federal Housing Administration (FHA) and 

the Department of Veterans Affairs (VA)—

which together account for the guarantee 

and insurance of more than 90 percent of 

originations—have tightened their underwriting 

standards. Standards have been tightened 

across product, credit score, and loan-tovalue (LTV) spectrums, and fewer loans with 

low down payments are being guaranteed. 

FICO scores on mortgage originations have 

risen sharply, reflecting the tighter underwriting 

standards as well as the characteristics of 

borrowers who are applying for credit (Chart 

4.1.14). 

On the other hand, FHA/VA loans, which 

typically have higher LTVs and hence greater 

risk compared with GSE loans, have gained a 

larger share of the market, rising from 3 percent 

of total market originations in 2005 to more 

than 30 percent in mid-2010.

National commercial real estate (CRE) 

markets also weakened dramatically during 

the credit crisis and recession. Moody’s/

REAL commercial property price index fell 

by about 45 percent from its 2007 peak 

(Chart 4.1.15). Sales activity also decreased 

sharply: commercial property transactions 

fell 89 percent to $66 billion in 2009 from a 

peak of $579 billion in 2007. A combination of 

weaker cash flows, lower collateral values, and 

tightened underwriting standards since 2008 

has made it more difficult for CRE owners to 

refinance their debt, putting further stress on 

the market. Since mid-2008, bank lending to 

finance commercial property has fallen by 50 

percent. One-quarter of recent CRE activity 

has involved distressed properties.

Commercial mortgage-backed security (CMBS) 

issuers account for nearly 25 percent of the 

total CRE debt. Reflecting the credit crisis 

Chart 4.1.11 Net Consumer Sector Credit Flows

Chart 4.1.12 National Repeat Sales Home Price Indexes

Chart 4.1.13 4.1.13 Housing Affordability Index Housing Affordability Index

22 2011 FSOC Annual Report
and economic stress, issuance of CMBS 

in the United States was only $2.7 billion in 

2009 and $11.6 billion in 2010, well below the 

approximately $200 billion issued in both 2006 

and 2007 (Chart 4.1.16). 

Recently, the commercial property market has 

shown tentative signs of recovery, with more 

sales activity among higher quality, well-leased 

properties in major metropolitan markets, as 

well as signs of increased demand for and 

supply of commercial property loan financing. 

The Senior Loan Officer Opinion Survey for 

April 2011 showed that about 35 percent of 

domestic banks on net had seen increased 

demand for CRE loans, and a few large banks 

and foreign banks had eased their lending 

standards somewhat, although outstanding 

bank commercial property loans have continued 

to fall. 

Securitization Markets

Much of the large increase in credit leading 

up to the financial crisis was driven by an 

expansion of securitized credit, particularly in 

the mortgage market. During this time, financial 

market participants and regulators tended to 

view securitization favorably: it allowed banks 

to reduce their exposure to certain types of 

loans, redistributing those risks to investors 

who were more willing to handle them and 

lowering the borrowing costs for households 

and businesses.

However, the crisis revealed deep flaws in 

the implementation of securitization. For 

example, banks and other firms that originated 

mortgages and packaged them into residential 

mortgage-backed securities (RMBS) for sale 

to investors often did not retain an interest in 

those mortgages and, thus, had no incentive 

to adequately monitor the performance of the 

originated mortgages. In the years before the 

crisis, underwriting standards deteriorated and 

nontraditional mortgage products proliferated 

(Chart 4.1.17). 

The private-label (non-GSE) RMBS market 

collapsed in 2007 after house prices began to 

fall, which led to greater and more correlated 

Chart 4.1.14 Median Credit Score at Mortgage Origination

Chart 4.1.15 4.1.15 Commercial Property Price Indexe Commercial Property Price Indexes s

Chart 4.1.16 CMBS New Issuance

Macroeconomic Environment 23
delinquencies of nontraditional mortgages 

and thus reduced the value of these securities 

considerably. This market remains severely 

impaired and has affected other assetbacked securities markets. In the absence 

of strong offsetting developments, the lack 

of a meaningful rebound to overall private 

sector securitization activity is likely to have 

implications for the types of lending or feebased activities that banks will choose to 

engage in and, in turn, for the future cost and 

level of credit intermediation (Chart 4.1.18). 

For nearly all asset classes, securitization 

activity remains at levels well below those that 

prevailed before the crisis. Recent issuance 

has been concentrated in securitizations of 

consumer auto loan and lease receivables, as 

well as resecuritizations of real estate mortgage 

investment conduits, which are repackaged 

CMBS and RMBS. 

4.1.2 Risk Transfer 

The financial system provides risk transfer 

services to the economy through a wide 

range of insurance and derivatives products. 

Certain credit risk transfer products played 

an important role in exacerbating the financial 

crisis and have not returned to their pre-crisis 

form.

A key role of financial markets and institutions 

is to allocate risk efficiently across households 

and businesses. The insurance market is a 

key market in financial risk transfer. Unlike 

most cases of credit intermediation, in which 

borrowers receive a large payment at the 

start and then repay the obligation over time, 

insurance policies typically involve upfront 

customer payments (premiums) in exchange for 

a contractual promise from the insurer to pay 

benefits upon a specified event in the future. 

The traditional U.S. insurance market largely 

functioned without disruption in payments to 

consumers throughout the financial crisis and 

the recovery. 

Derivative contracts have become another 

important source of risk transfer in the financial 

system. The market for these contracts, which 

Chart 4.1.17 4.1.17 Private-Label RMB Private-Label RMBS Gross Issuance S Gross Issuance

Chart 4.1.18 GSE and Private-Label RMBS Gross Issuance

24 2011 FSOC Annual Report
may be traded on exchanges or over the 

counter (OTC), has grown significantly over the 

past 10 years. Gross notional volume amounts 

of OTC derivatives contracts peaked in June 

2008 at over $670 trillion. Derivatives—whose 

value can be based on interest rates, foreign 

exchange, credit, equities, and commodities—

have long been used by financial and 

nonfinancial institutions for both risk insurance 

(hedging) and risk acquisition (speculation) 

purposes, enabling risks to be traded globally 

(Charts 4.1.19, 4.1.20, and 4.1.21). While 

OTC derivatives markets, with the exception of 

credit risk transfer products, were not a central 

cause of the crisis and did not experience any 

specific clearing or settlement failures, they 

were a factor in the propagation of risks, as 

their complexity and opacity contributed to 

excessive risk taking and a lack of clarity about 

the ultimate distribution of risks, exacerbating a 

loss in confidence.

Credit Risk Transfer Products

The rapid growth in the private-label RMBS 

market in the years preceding the financial 

crisis was enabled by two market innovations: 

collateralized debt obligations (CDOs), which 

are instruments to bundle pieces of previously 

issued asset-backed securities, and credit 

default swaps, which are credit derivatives. 

By allocating credit risks in complex ways that 

market participants, credit rating agencies, 

and regulators did not understand well, these 

products contributed to the buildup of the 

housing boom, the severity of the subsequent 

bust, and the broadening of the financial crisis 

beyond its origins in the subprime mortgage 

market. 

Private-label RMBS and CDOs shared two key 

characteristics. First, they combined many 

assets into pools, which should have helped 

diversify the risks of loss. Second, they were 

sold to investors in tranches that varied in 

risk and return, with payments going first to 

senior tranche investors. The independent 

credit rating agencies played an important 

role in this process by giving the vast majority 

of these securities their highest rating (e.g., 

AAA), anticipating that junior tranche investors 

Chart 4.1.19 4.1.19 OTC Derivatives OTC Derivatives

Chart 4.1.20 OTC Derivatives Growth

Chart 4.1.21 Distribution of OTC Derivatives

Macroeconomic Environment 25
would cover expected losses based on the low 

historical default rates for residential mortgages, 

the diversification of the asset pools, and the 

assumption that house prices would generally 

continue to rise. 

During the mortgage boom, senior tranches 

of RMBS attracted broad classes of investors, 

including banks, insurance companies, and 

GSEs (Chart 4.1.22). The riskier juniorinvestment-grade tranches of RMBS were 

typically pooled by investment banks and 

purchased by CDOs (Chart 4.1.23). Although 

most of the securities issued by these CDOs also 

received the highest credit rating (again, based 

on the presumed benefits of diversification), 

senior CDO tranches had a very different investor 

base from senior RMBS tranches. They were 

typically retained by the originating bank or sold 

with liquidity or credit guarantees provided by 

the originating bank or with insurance written by 

a segment of the insurance industry known as 

financial guarantors. In many cases, the credit 

rating agencies based their high ratings on these 

securities on the availability of these guarantees. 

Junior-investment-grade CDO tranches were 

typically purchased by other CDOs. 

An important component in maintaining this 

structure during the mortgage boom was credit 

default swaps (CDS). Financial institutions and 

investors purchased CDS to help manage their 

risks from RMBS and CDO securities. The 

insurance conglomerate AIG was a large seller 

of these CDS. In addition, synthetic CDOs grew 

rapidly during the pre-crisis period. These were 

derivative-linked CDOs that packaged long 

positions in CDS referencing RMBS or CDO 

securities; if the underlying securities did not 

perform, the synthetic CDO investors would 

lose money as if the CDOs owned positions in 

actual securities (Chart 4.1.24). 

The result of this complex and opaque system 

was that a surprising amount of the credit risk 

in the mortgage market was concentrated in 

senior CDO tranches held or guaranteed by 

the banks that created CDOs and by a small 

number of financial guarantors. These large 

institutions and other investors in MBS and 

CDOs suffered billions of dollars in losses 

Chart 4.1.22 Private-Label Residential MBS Exposures 4.1.22 Private-Label Residential MBS Exposures

Chart 4.1.23 Ownership of Investment Grade Subordinates in 

RMBS and ABS CDOs (June 2007)

Chart 4.1.24 4.1.24 ABS Structured Finance CDO Issuance ABS Structured Finance CDO Issuance

26 2011 FSOC Annual Report
when mortgage defaults across the country 

exceeded expectations and the performance of 

diverse pools of RMBS turned out to be highly 

correlated. By the end of 2009, $319 billion of 

subprime and Alt-A MBS had been materially 

impaired, as had $479 billion of CDOs that 

invested in MBS (Chart 4.1.25). 

The market for CDOs has not recovered since 

the crisis. The financial guarantors, with one 

exception, are not currently providing such 

guarantees and appear unlikely to return to the 

market in the near term. However, the broader 

market for CDS referencing the risk of default 

by corporate entities remains robust. 

4.1.3 Transactions and Payment Services to 

Households and Businesses

Transaction and retail payment services, which 

facilitate a high volume of payments across 

the financial system, functioned well during 

the crisis.

Depository institutions provide a variety of 

retail payment services to consumers and 

businesses, such as check, debit card, credit 

card, automated clearing house, and prepaid 

card transaction services. Retail payments, 

which are characterized by high volumes 

but low average dollar transaction values, 

have undergone significant technological and 

financial innovation in recent years, changing 

how they are transacted. According to the 

most recent Federal Reserve Payments 

Study, the estimated number of noncash 

payments totaled $109 billion in 2009, with a 

total value of approximately $72 trillion. More 

than three-quarters of these retail payments, 

by volume, were made electronically, a 9.3 

percentage point increase since 2006 (Charts 

4.1.26 and 4.1.27). Retail payments depend 

critically on consumer and business accounts 

at depository institutions that are used for 

transaction purposes.

While there have been a number of bank, thrift, 

and credit union failures—including several highprofile failures or near-failures of large complex 

financial institutions—the FDIC and the NCUA 

were able to prevent any disruptions in retail 

Chart 4.1.25 4.1.25 Impaired MBS and CDO Securities Impaired MBS and CDO Securities

Chart 4.1.26 4.1.26 Noncash Retail Payments: 2006 Noncash Retail Payments: 2006

Chart 4.1.27 4.1.27 Noncash Retail Payments: 2009 Noncash Retail Payments: 2009

Macroeconomic Environment 27
payments and transaction services as a result 

of the failure, or fear of failure, of an insured 

depository institution. In contrast, certain parts 

of the financial system, such as prime money 

market funds, experienced the equivalent of a 

bank run in late 2008 (Chart 4.1.28). 

The Transaction Account Guarantee Program 

(TAGP) brought stability and confidence to 

deposit accounts that are commonly used 

for payroll and other business transaction 

purposes. Through the TAGP, the FDIC 

guaranteed, for a fee, noninterest-bearing 

transaction accounts held at participating 

insured depository institutions. More than 7,100 

banks and thrifts, or 86 percent of FDIC-insured 

institutions, initially opted into the program. 

The Dodd-Frank Act replaced TAGP with a 

provision mandating unlimited deposit insurance 

coverage without a separate fee through 

December 2012 for certain noninterest-bearing 

accounts at all insured depository institutions.

4.2 Private Nonfinancial Sector 

Balance Sheets

The ability of households and businesses 

to repay loans depends on the income they 

generate from productive activities and on 

their net worth: the value of their assets less 

liabilities. If income from productive activities 

does not meet expectations, as occurred during 

the recession, the ability to repay falls more 

heavily on net worth. 

Corporate income has recovered more quickly 

than household and small business income, 

and corporate balance sheets were less 

exposed to the decline in real estate values. The 

decrease in real estate and other asset values 

has increased the leverage of the household 

sector, the debt levels of which had increased 

in the years before the crisis. Low interest rates 

and extended unemployment benefits have 

mitigated some of the loss of income and the 

decline in asset values. 

4.2.1 Business Sector

The levels of debt to net worth in the 

corporate and noncorporate business sectors, 

Chart 4.1.28 Money Market Funds and Checking Deposits 4.1.28 Money Market Funds and Checking Deposits

28 2011 FSOC Annual Report
which spiked during the downturn as a result 

of deteriorating asset values, remain elevated 

but are showing modest improvement.

Corporate

Nonfinancial corporate balance sheets 

deteriorated significantly during the downturn, 

as leverage reached historical highs, primarily 

because of unprecedented declines in the 

value of assets held by these firms. Corporate 

balance sheets have recovered somewhat 

over recent quarters. Nevertheless, leverage 

has decreased only modestly and remains at 

elevated levels, as the value of assets in the 

sector have increased only moderately faster 

than liabilities (Chart 4.2.1).

Since mid-2009, corporations have generated 

strong profit growth and improved cash flow, 

reflecting the impact of aggressive cost-cutting, 

moderate revenue growth, and lower interest 

costs. This has driven equity market valuations 

back to near pre-crisis levels and has allowed 

nonfinancial corporations to increase capital 

through retained earnings. These developments 

have also allowed corporations to significantly 

bolster their liquidity (Chart 4.2.2).

Nonfinancial corporate balance sheets were in 

relatively good condition entering the crisis. As 

a result, the corporate bond default rate, which 

spiked to a similar level as that in the previous 

recession, was lower than expected given the 

severity of this recession, particularly compared 

with the level implied from bond prices in early 

2009 (Charts 4.1.4 and 4.2.3). Since the 

crisis, high-yield issuers have improved their 

ability to cover their debt payments out of 

cash flow. These firms also have only a limited 

amount of debt maturing over the near term 

and (as discussed in Section 4.1.1) benefit from 

improved financing conditions.

Noncorporate

Balance sheets in the noncorporate sector, 

composed primarily of small businesses, were 

adversely affected by the credit crisis and 

recession owing to poor sales, declines in asset 

values, and a reduction in credit availability. 

Chart 4.2.1 4.2.1 Corporate Credit Market Debt to Net Worth Corporate Credit Market Debt to Net Worth

Chart 4.2.2 Financial Ratios for Nonfinancial Corporations

Chart 4.2.3 Nonfinancial Corporate Bond Default Rate

Macroeconomic Environment 29
In the aggregate, the assets of small businesses 

are composed primarily of real estate (Chart 

4.2.4). Consequently, the sharp drop in real 

estate values during the crisis had a severe 

impact on the balance sheets of many small 

businesses and led to a sharp increase in 

the measured leverage of small businesses. 

Leverage in this sector has fallen only modestly 

since then and remains well above its pre-crisis 

levels (Chart 4.2.5).

Small businesses generally have less access 

than corporations to capital markets and thus 

depend more on bank financing. Therefore, 

the improvements in the functioning of 

corporate bond markets have had little direct 

positive impact on the small business sector. 

Also, continued strains in the banking sector, 

particularly for smaller community banks, 

have constrained credit availability for small 

businesses. According to the Federal Reserve 

Board’s Senior Loan Officer Opinion Survey, 

loan standards to small firms, which were 

tightened sharply during the crisis, have not 

been loosened to any significant extent over the 

past year.

The Senior Loan Officer Opinion Survey also 

indicates that the demand for bank loans from 

small businesses has not picked up much 

over the past year. The weakness in demand 

probably reflects two main factors. First, 

because many small business loans are secured 

by real estate collateral, declines in real estate 

prices have affected available collateral, which 

may prevent small businesses from seeking 

loans. Second, small businesses still report 

weak sales; in the latest NFIB survey, nearly 

one-quarter of respondents cited poor sales as 

their primary problem. 

4.2.2 Household Sector

Household net worth increased over the year 

through the first quarter of 2011, as equity 

values increased and debt levels decreased 

modestly. The burden of debt payments 

relative to income has improved. However, 

mortgage-related debt remains high relative to 

the value of housing. Households have taken 

on more debt to fund college education. 

Chart 4.2.4 Noncorporate Assets

Chart 4.2.5 Noncorporate Credit Market Debt to Net Worth

30 2011 FSOC Annual Report
In the aggregate, household balance sheets 

are recovering, with net worth increasing 

moderately over the year through the first 

quarter of 2011 after large falls in 2008 

and 2009. Declines in housing wealth have 

restrained the increase in aggregate net worth, 

which has been driven primarily by a rebound in 

stock values from their March 2009 lows (Chart 

4.2.6). However, the recovery in household 

balance sheets has not been evenly distributed 

across income levels, particularly for lower 

income households that do not have much 

participation in equity markets. Because of the 

continued weakness in home prices, owners’ 

equity in housing has remained near a record 

low of approximately 40 percent since mid2008, more than 20 percentage points lower 

than its average over 1990–2005 (Chart 4.2.7). 

Consumer debt outstanding, driven primarily by 

mortgages, peaked in 2008 and has declined 

by about $1 trillion. In part, this decline is the 

result of households’ active efforts to reduce 

their debt levels. But it also reflects the impact 

of foreclosures, which have removed mortgage 

debt from household balance sheets. 

Many homeowners who were delinquent on 

their mortgages have been able to lower their 

payments through government and private 

modification programs. Nearly five million 

mortgage modification arrangements were 

started between April 2009 and the end of April 

2011, which is more than double the number 

of foreclosure completions for the same period 

(2.1 million), although some homeowners 

may have received help from more than one 

program. More than 730,000 homeowners 

have received permanent modifications under 

the Troubled Asset Relief Program’s Home 

Affordable Modification Program, with estimated 

median savings of about 37 percent, or $525 

per month per homeowner. Others have been 

helped by government programs to modify 

second liens or to encourage foreclosure 

alternatives, such as short sales and deedsin lieu. Still, with about 2.5 million mortgages 

entering the foreclosure process annually 

in recent years, many homeowners remain 

financially stressed.

Chart 4.2.6 Household and Nonprofit Balance Sheets

Chart 4.2.7 Share of Owners’ Equity in Household Real Estate 4.2.7 Share of Owners’ Equity in Household Real Estate

Macroeconomic Environment 31
Deleveraging by households, along with 

low interest rates and the extension of 

unemployment benefits, has helped households 

meet their debt obligations. The household 

debt service ratio (the ratio of household debt 

payments to disposable income) has fallen 

sharply, highlighting the improved ability of 

households to make debt payments (Chart 

4.2.8). The financial obligations ratio (which 

measures a household’s ability to service a 

broader measure of commitments, including rent 

payments and homeowners’ insurance) has also 

fallen since 2007. These declines signal that, 

overall, both homeowners and renters are better 

able to meet their financial commitments than 

they were in the pre-crisis period (Chart 4.2.9). 

Education loans are the only major consumer 

debt category to have increased over the 

past three years (Chart 4.2.10). Increased 

college tuition costs and a finite pool of grants 

have, in part, resulted in increased demand 

for student loans. Repayment ability depends 

on both the completion rate of educational 

programs and labor market conditions over the 

repayment period. Unlike revolving credit card 

debt, student loan debt generally cannot be 

discharged in bankruptcy. Education lending 

has been increasingly provided by federal 

government-guaranteed loan programs.

4.3 Government Balance 

Sheets

The recent recession produced a marked 

deterioration in finances at all levels of 

government in the United States. Global 

financial markets have been able to readily 

accommodate the substantial increase in U.S. 

federal debt. With interest rates low, the current 

financing costs of government debt are small. 

All levels of government face challenges in 

achieving and maintaining sustainable budgets, 

particularly with growing future obligations as 

the baby boom generation ages and retires. 

4.3.1 Federal

Federal government debt has increased for a 

number of reasons, including the direct effects 

of the recession and the fiscal interventions to 

prevent a deeper recession. 

Chart 4.2.8 4.2.8 Household Debt Service Ratio Household Debt Service Ratio

Chart 4.2.9 4.2.9 Household Financial Obligations Ratio Household Financial Obligations Ratio

Chart 4.2.10 Outstanding Balances of Consumer Loans

32 2011 FSOC Annual Report
The U.S. federal government is the largest 

issuer of debt in the world. This mainly reflects 

the large size of the U.S. economy relative to 

the rest of the world. The size of the market 

for U.S. debt, its liquidity, and the long-term 

stability and flexibility of the U.S. economy 

have made the U.S. dollar the dominant global 

reserve asset (see Chart 4.3.1 and Box A: 

U.S. Dollar as the International Reserve 

Asset).

In fiscal year (FY) 2007, the federal government 

had a deficit of 1.2 percent of GDP and net 

debt outstanding of $5.02 trillion. In FY2010, 

the deficit increased to 8.9 percent of GDP; 

it is projected to remain around this level in 

FY2011. At the end of FY2010, net public debt 

outstanding reached $9.01 trillion, 62 percent 

of GDP (Chart 4.3.2). Total public outstanding 

debt increased from $9.00 trillion in FY2007 to 

$13.56 trillion in FY2010. In May 2011, total 

Treasury debt reached the limit set by Congress 

in February 2010. 

Much of the increase in the debt was driven 

by the direct effects of the recession on 

revenues and expenditures, and the use of 

fiscal policy to mitigate some of the risks of a 

deeper recession. A small part of the increase 

in debt is due to direct government assistance 

to the financial sector, mainly in the form of 

capital provided to Fannie Mae and Freddie 

Mac, the two large GSEs. The Congressional 

Budget Office estimates that the net cost of 

the Troubled Asset Relief Program will be less 

than 0.25 percent of GDP. The assistance to 

the financial sector resulted in the government 

accumulating financial assets.

Even before the recession and the attendant 

increase in the deficit, government finances 

were acknowledged to be on an unsustainable 

path, partly owing to the increased expenditures 

for Medicare and Social Security anticipated 

with the aging of the baby-boom generation. 

The unsustainable path of government debt 

under the continuation of certain revenue 

and expenditure policies is widely recognized 

(Charts 4.3.2 and 4.3.3). The need for longrun fiscal balance has been a focus of recent 

Chart 4.3.1 Total Treasury Market Turnover

Chart 4.3.2 Federal Government Debt Held by the Public 4.3.2 Federal Government Debt Held by the Public

Chart 4.3.3 Outlays and Revenues Using CBO Projections

Macroeconomic Environment 33
 

Box A: U.S. Dollar as the International Reserve Asset

The United States and the rest of the global financial system continue to receive important benefits from the role 

of the dollar as the principal international reserve asset.

The U.S. dollar is the world’s most actively traded 

currency in foreign exchange markets and the main 

reserve asset held by foreign central banks and finance

ministries. This has been true since the end of World 

War II. 

The attraction of U.S. assets for foreign investors 

reflects the large size and stability of the U.S. economy 

and the relative stability of U.S. economic and political 

institutions. It also reflects the fact that the United 

States has the world’s largest and most liquid financial 

markets. One measure of this liquidity is average daily 

trading volume in the Treasury market, which remained 

robust through the financial crisis (Chart 4.3.1). These 

characteristics are highly valued by global investors and, 

in times of financial market turmoil such as the recent 

crisis, investors often use U.S. assets as a safe haven. 

The dollar’s share of “known allocated” global reserves 

adjusted for exchange rate fluctuations has generally 

exceeded 70 percent. Without adjusting for valuation 

effects from exchange rate fluctuations, the share has 

declined over the past decade from approximately 

70 percent to just over 60 percent (Chart A.1). The 

Chart A.1 U.S. Dollar Share of Allocated Reserves

A.1 U.S. Dollar Share of Allocated Reserves

Chart A.2 Currencies in Allocated Global Reserves

dollar has maintained its dominant role even as global 

reserve assets have increased rapidly in the last 10 

years (Chart A.2).

The value of all U.S. securities held by foreign investors, 

public and private, totaled $10.7 trillion as of June 

2010, an increase of $1.1 trillion from June 2009. 

Some of this increase represented net purchases, 

while valuation changes in bonds and equities also 

contributed. Foreign holdings of all U.S. securities were 

estimated at $11.3 trillion as of April 2011, and foreign 

holdings of U.S. Treasury securities totaled $4.5 trillion, 

or just under half of publicly held net federal government 

debt. These large holdings lower the cost of funding 

the current U.S. account deficit. In fact, net investment 

income received by the United States from the rest of 

the world was estimated to be $174 billion in 2010.

The U.S. and global financial systems receive important 

benefits from the role of dollar assets. While foreign 

investors benefit from the liquidity in U.S. financial 

markets, they are also an important source of that 

liquidity. High demand from abroad for Treasuries lowers 

the cost of funding for the U.S. government. 

34 2011 FSOC Annual Report
attention from credit rating agencies. Current 

pricing of U.S. government debt implies that 

markets assume a long-term solution to the 

fiscal imbalance will be found and that, in the 

short run, the debt limit will be raised without 

disrupting market functioning (Chart 4.3.4).

Despite the large increase in public debt 

outstanding, net interest costs as a percentage 

of GDP fell to 1.34 percent in FY2010, below 

the 2.97 percent average observed in the 1990s 

(Chart 4.3.5). This decline reflects the fact 

that interest rates have fallen considerably and 

remain near historically low levels. The average 

maturity of marketable debt outstanding has 

risen in the past two years from a low of 49 

months to its current level of 62 months. This 

is modestly above the 30-year average of 58 

months but below the average maturity of 

outstanding debt in other developed countries.

Over the past three years, the balance sheet 

of the Federal Reserve has also grown. At first, 

much of this growth was driven by liquidity 

support to the financial sector; recently, growth 

has been sustained by the monetary policy tool 

of large-scale asset purchases (Chart 4.3.6). 

During the financial crisis, the Federal Reserve 

was granted immediate authority to pay 

interest on reserve balances held by depository 

institutions. As of June 30, 2011, reserve 

balances stood at about $1.62 trillion. While 

the current interest rate on these reserves is 25 

basis points, it is below the average interest rate 

(across all Treasury debt maturities) of around 

3 percent paid by the federal government. 

Incorporating these liabilities would lower the 

average maturity of the federal government’s 

debt obligations.

4.3.2 State and Local

Municipal governments experienced varying 

degrees of stress during the downturn. 

States are rebalancing budgets as federal 

government support is withdrawn; local 

governments are recovering more slowly. The 

municipal debt market has been strained amid 

concerns about state and local government 

finances. Longer term challenges associated 

with retirement benefits owed to government 

employees remain. 

Chart 4.3.4 4.3.4 Interest Rate Payer Skew Interest Rate Payer Skew

Chart 4.3.5 Interest Outlays and Average Maturity

Chart 4.3.6 Outright Holdings of Domestic Assets in the SOMA

Macroeconomic Environment 35
State constitutions generally require balanced 

operating budgets, but states and localities 

may issue long-term debt to finance activities 

such as investments in bridges, schools, and 

other public infrastructure projects. In addition, 

certain public and quasi-private authorities can 

issue municipal debt to finance their activities. 

Total outstanding municipal debt from all 

sources is $3 trillion, which is about 20 percent 

of GDP, up from record lows in 2000 but in 

line with average levels from the mid-1980s to 

the mid-1990s (Chart 4.3.7). The annual rate 

of increase in total state and local debt has 

slowed markedly from an average of 9 percent 

in 2001–07 to an annual average rate of less 

than 4 percent since 2008, although some 

municipalities’ debt loads have increased much 

more than the average. 

Municipal bonds are broadly divided into 

general obligation (G.O.) and revenue bonds. 

G.O. bonds, with approximately $1 trillion 

outstanding, are secured by the full faith and 

credit of the issuer, meaning that the issuer 

(typically a government with the power to levy 

taxes) is committed to raising revenue sufficient 

to repay. Revenue bonds are more common, 

with approximately $2 trillion outstanding; they 

are secured by a defined stream of revenues 

from a particular project and possibly by the 

project itself. Revenue bonds are the principal 

instrument for special-purpose and quasiprivate entities. Because of their narrower and 

less certain revenue support, municipal projects 

that depend on increases in use (e.g., new toll 

roads) or increases in property values (e.g., 

tax increment bonds), or those with a tie to a 

corporate entity (e.g., industrial development 

bonds), are generally riskier than revenue bonds 

related to the provision of essential services 

(e.g., water/sewer revenue bonds). 

States rely on cyclically sensitive income and 

sales taxes for over half of their revenue. The 

lower level of economic activity during the 

recession had a significant adverse effect on 

these revenues from 2007 through the first half 

of 2010. Part of the decrease was absorbed 

by the federal government, which provided, 

on average, $53 billion in annual support to 

municipalities from FY2009 to FY2011, and 

Chart 4.3.7 Municipal Liabilities as a Percent of GDP

36 2011 FSOC Annual Report
bridged approximately a third of state budget 

shortfalls in 2010. Tax revenue is recovering 

and states are going through the process 

of rebalancing revenues and expenditures 

as federal government support is withdrawn 

(Chart 4.3.8).

Local governments and smaller municipal 

issuers are more vulnerable as they have 

smaller tax bases than states and are less 

able to raise revenue (Chart 4.3.9). Cities are 

currently facing reductions in state aid, on 

which they have historically relied for 30 percent 

of their funding. They also face declining 

property tax collections, traditionally their 

largest independent source of revenue, due to 

the sustained declines in real estate values and 

lower sales tax revenue (Chart 4.3.10). Funding 

has also become more difficult to obtain 

for single-purpose entities such as hospital 

authorities. 

Despite the strains induced by the recession, 

municipal bond defaults are historically low. 

Defaults are associated with smaller municipal 

entities in geographic areas hardest hit by the 

housing crisis and recession. Also, defaults 

are more common for municipal projects that 

relied on future growth that did not materialize, 

or revenue bonds backed by issuers with 

corporate credit characteristics, such as 

industrial development bonds, pollution control 

bonds, or bonds in the health care sector (see 

Box B: Municipal Debt Market).

State and local governments face longer term 

challenges associated with the unfunded 

portion of future benefits owed to their 

employees. With high equity valuations in 

2000, state pension systems were considered 

more than adequately funded; however, by 

2008, declines in asset values led to significant 

underfunding, and approximately 80 percent of 

states failed to make their actuarially required 

contributions to their pension funds. Estimates 

of the unfunded portion of state and local 

retirement liabilities range from $1 trillion to 

$3 trillion. Other postemployment benefits 

represent an additional $0.5 trillion to $0.9 

trillion in unfunded liabilities. The widening 

unfunded portion of pension obligations 

Chart 4.3.8 State Tax Revenue

Chart 4.3.9 City General Fund Revenues and Expenditures

Chart 4.3.10 City General Fund Tax Receipts

Macroeconomic Environment 37
Box B: Municipal Debt Market

The municipal bond market provides a critical source of private capital for state and local governments and 

certain nongovernment issuers. 

Municipal bonds may be exempt from federal, state, 

and local taxes if the proceeds of such bonds are used 

by a government unit for its own purposes and if the 

property financed by the bonds will be owned by the 

government unit. Generally, with some exceptions, 

bonds that do not meet these standards are considered 

private activity bonds and are not tax-exempt. 

Furthermore, some types of private activity bonds that 

are exempt from the regular tax may be subject to the 

alternative minimum tax. 

Most municipal debt issuance is tax-exempt (Chart 

B.1), which has made it an attractive class for retail 

investors. As a result of the financial crisis, the market 

has undergone significant structural changes that have 

left it even more dependent on retail demand.

Municipal bonds may have fixed or variable interest 

rates, or they may be zero coupon bonds. Many 

variable rate municipal bonds give investors the right 

to put the bond back to the issuer. Such securities are 

known as variable rate demand obligations (VRDOs). 

If the investor exercises the put, a remarketing agent 

sells the bonds to another investor. If the bonds cannot 

be resold, either a bond insurer or a liquidity facility 

provides the funds for the issuer to purchase the bonds. 

Chart B.1 Issuance by Tax Status

The auction rate securities (ARS) and tender option 

bond (TOB) programs were large pre-crisis sources of 

liquidity in the long end of the municipal bond market. 

Like other off-balance-sheet maturity transformation 

vehicles, these were almost completely eliminated in the 

financial crisis, as banks and other investors became 

less willing to assume the associated credit and interest 

rate risks. As a result, many municipal bond issuers 

replaced auction rate debt and insured VRDOs with 

uninsured VRDOs supported by liquidity facilities. These 

facilities generally have terms of three years, and many 

of the facilities originated in 2008–09 are currently up 

for renewal (Chart B.2).

Chart B.2 ARS and VRDO Funding of Long-Term Muni Bonds

Following significant dislocations experienced by the 

municipal market in 2008 and early 2009, the federal 

government launched the Build America Bonds (BAB) 

program to stimulate infrastructure spending and ease 

the pressure on the municipal bond market. The BAB 

program was designed to broaden the municipal bond 

investor base beyond those who typically invest in 

municipal bonds by providing a federal subsidy that 

allowed municipal borrowers to issue long-term taxable 

bonds. Specifically, municipal borrowers could issue 

long-term taxable bonds for capital expenditure instead 

38 2011 FSOC Annual Report
Box B: Municipal Debt Market

of tax-exempt bonds, with the federal government 

rebating 35 percent of the taxable interest expense 

directly back to the issuer. 

The program played an important role in increasing 

the investor base for municipal bonds and indirectly 

provided support for the long-term tax-exempt 

municipal market by limiting the amount of taxexempt supply. During the first three quarters of 2010, 

borrowing costs for 30-year municipal issuance fell by 

45 basis points, and nearly $500 million flowed into 

municipal bond mutual funds.

However, in advance of the BAB program’s expiry on 

December 31, 2010, expectations that supply would 

shift back to the tax-exempt market pressured yields 

higher. At the same time, widespread press and analyst 

commentary on the credit conditions of state and local 

governments began to trigger sharp outflows from retail 

municipal bond mutual funds (Chart B.3). Muni-toTreasury yields, which had already become increasingly 

differentiated, rose further for some issuers to levels 

well above their long-term average of 85 percent (Chart 

B.4). Even though most municipal bond investors 

generally employ negligible levels of leverage, there 

were reports of forced selling at distressed levels as 

some mutual funds struggled to meet redemptions. 

Chart B.3 Municipal Bond Flows

The increasing speed of redemptions created concern 

about municipalities’ ability to issue certain short-term 

debt instruments called revenue anticipation notes, 

which cover the mismatch between revenue collections 

and operating expenditures. However, relatively 

attractive valuations induced investors to enter the taxexempt space, and demand from crossover institutional 

buyers helped counteract redemptions from tax-exempt 

mutual funds, although these have since recovered. 

Going forward, structural issues with the municipal 

bond investor base remain. Long-term debt generally 

is not attractive to retail investors. As VRDOs expire, 

and without maturity transformation structures such as 

ARS and TOB, it is unclear how cost-effective longer 

term funding will be sourced through the municipal 

bond market. 

Chart B.4 Municipal Tax-Exempt Bond Ratios

Macroeconomic Environment 39
increases the likelihood of changes in fiscal 

policy, such as increases in tax revenues or 

service reductions to close funding gaps. 

4.4 External Environment

Many advanced economies face high debt 

levels and an uneven recovery. Growth in 

emerging market economies has rebounded 

more quickly, with implications for capital flows 

and the potential for overheating.

The United States was not alone among 

advanced countries in experiencing a large 

increase in government debt during the financial 

crisis, while private sector debt shrank or grew 

at much slower rates than in previous years 

(Charts 4.0.3 and 4.0.4). For some countries, 

the direct cost of support to the financial sector 

has been a large contributor to the increase in 

government debt. 

Starting in early 2010, financial markets 

began to apply additional pressure on certain 

peripheral European countries through sharply 

higher government funding costs. Amid 

considerable market turmoil in the spring of 

2010, concerns over sovereign credit risk 

came to the forefront (Chart C.2). European 

authorities working with the International 

Monetary Fund have developed financial 

assistance packages for three countries and 

established mechanisms to resolve future debt 

problems in the euro area (see Box C: Country 

Support Developments in Europe).

The abilities of advanced countries to service 

their debts without provoking sharp market 

concerns are not exclusively related to total 

public debt or current fiscal deficits. The size 

of a country’s net external liabilities, the size 

of the financial sector relative to GDP, and the 

share of government debt held externally are 

other considerations (Chart 4.4.1). Lingering 

balance sheet weaknesses in the advanced 

economies are limiting the pace of their 

recoveries. The natural disaster in Japan has 

not had widespread impacts on capital flows, 

as markets effectively absorbed this exogenous 

shock; but it has interrupted some international 

supply chains.

Chart 4.4.1 Indebtedness and Leverage in Selected Advanced 

Economies (April 2011)

4.4.2 Indebtedness and Leverage in Selected Advanced 

Economies (April 2011)

Chart 4.4.2 Real GDP Growth

Chart 4.4.3 Emerging Markets: Public Debt to GDP

40 2011 FSOC Annual Report
In contrast, most emerging market economies 

(EMEs) have recovered strongly from the global 

recession (Chart 4.4.2). Moreover, most EMEs 

currently do not exhibit the macroeconomic 

and balance sheet vulnerabilities that have 

been associated with past EME crises, such as 

large fiscal or current account deficits, banking 

sector weaknesses, heavy debt burdens, or 

significant currency and maturity mismatches. 

However, some countries in emerging Europe 

are still working through the aftermath of abrupt 

reversals in financial and economic conditions 

(Charts 4.4.3 and 4.4.4).

Nonetheless, prospects for sustained strong 

capital inflows and moderately strong credit 

growth in some EMEs present challenges. A 

number of EMEs are now experiencing record 

private capital inflows, spurred by their strong 

growth prospects and by low interest rates in 

the advanced economies (Chart 4.4.5).

To head off the risks of overheating, authorities 

in many EMEs are tightening policy through 

a number of channels, including interest rate 

increases and macroprudential measures 

such as restrictions on LTV ratios, stricter 

lending criteria, and restraints on credit growth. 

However, some policy actions pose difficult 

trade-offs; for example, they may encourage 

further capital inflows. Against this backdrop, 

many countries continue to add to their large 

holdings of foreign exchange reserves while 

running current account surpluses, reflecting a 

desire to limit currency appreciation against the 

U.S. dollar (Chart 4.4.6).

Chart 4.4.4 4.4.4 Emerging Emerging Markets: Current Account Markets: Current Account

Chart 4.4.5 Private Capital Flows to Emerging Markets 4.4.5 Private Capital Flows to Emerging Markets 

Chart 4.4.6 EM Foreign Exchange Reserves Coverage

Macroeconomic Environment 41
Box C: Country Support Developments in Europe

In the wake of the financial crisis, several European countries have experienced severe macroeconomic and 

financial challenges. These challenges have exposed tensions within the European Monetary Union and 

limitations in the pre-crisis set of tools available to European policymakers to respond to economic and 

financial stress. 

The European Union (EU), supported by the International Monetary Fund (IMF), committed to lend €255.5 

billion to help Greece, Ireland, and Portugal address their vulnerabilities through adjustment programs. 

In addition, European leaders have agreed on a more comprehensive response that includes increased 

emergency financing, new EU economic governance rules, and member country commitments to take 

measures to support fiscal sustainability and competitiveness.

Vulnerabilities differ across the supported European 

countries. Greece’s crisis has stemmed from 

unsustainable growth in the public sector, fueled by 

low-cost cross-border finance that has led to very large 

fiscal deficits and public debt (Chart C.1). Portugal’s 

public debt is more moderate, but its private and bank 

debt is large. Even during periods of vibrant global 

expansion, Portugal’s growth rates have been anemic, 

and the structure of the economy is skewed toward 

low value added industries. In Ireland, the collapse 

of the property sector and a deep and prolonged 

recession produced very large banking sector losses 

and structural fiscal deficits. Irish government support 

for the banking system has amounted to 46 percent of 

GDP, which along with large fiscal deficits, has pushed 

public debt close to 100 percent of GDP.

As of early 2008, markets were not significantly 

differentiating among euro area countries, with 10-

year yields for Greece, Portugal, and Ireland trading at 

just 10 to 30 basis points above those for Germany. 

But Greek bond spreads surged following a late 2009 

announcement by the Greek government that its budget 

deficit would be more than three times the original 

forecast (Chart C.2). Spreads have since increased 

sharply in Ireland and Portugal. Markets remain attentive 

to the risk of further contagion.

In May 2010, Europe launched a multipronged effort 

to address the crisis, making two emergency financing 

vehicles available to member states: the European 

Chart C.1 2009 Gross General Government Debt & Deficits

Financial Stability Facility (EFSF), with an initial effective 

lending capacity of €255 billion, and the European 

Financial Stability Mechanism (EFSM), with a capacity of

€60 billion. Adjustment programs are to be undertaken 

jointly with the IMF. 

In March 2011, European leaders announced 

broad agreement on a more comprehensive debt 

crisis response, which must be ratified by national 

parliaments. The agreement covers three broad areas: 

(1) an increase in emergency financing; (2) new EU 

economic governance rules; and (3) a commitment by 

countries to take additional policy measures on fiscal 

sustainability and competitiveness. 

42 2011 FSOC Annual Report
Box C: Country Support Developments in Europe

Leaders committed to raise the EFSF’s lending capacity 

to its notional cap of €440 billion. The European Stability 

Mechanism (ESM) will become the permanent financing 

vehicle in 2013, with €500 billion in lending capacity. 

Lending under both the EFSF and the ESM requires 

unanimous agreement by member countries and an 

adjustment program with IMF participation. 

Leaders agreed to enhanced EU surveillance of fiscal 

sustainability and economic imbalances and to a broader 

array of potential sanctions for noncompliance. Member 

states also agreed to undertake structural reforms to 

boost competitiveness, fiscal sustainability, employment, 

and financial stability to safeguard the common currency. 

Meanwhile, Europe and the IMF are extending financing 

to the three countries most affected by the crisis. 

Greece is receiving €110 billion in IMF and EU loans 

while it undertakes fiscal adjustment and structural 

reforms. Despite concerns about domestic support for 

reform, the government enacted a fiscal consolidation of 

5 percent of GDP last year, even as the economy shrank 

by 4.4 percent. 

In December 2010, Europe and the IMF committed 

€67.5 billion to Ireland for budget support and to 

finance a fundamental restructuring of the banking 

sector. In May 2011, Portugal entered into a €78 billion 

IMF/EU program for fiscal consolidation and extensive 

structural reforms to boost growth. 

Chart C.2 European Sovereign 10-year Spreads

Macroeconomic Environment 43

5 Financial Developments

Over the past 30 years, the inner workings of the U.S. financial system grew increasingly 

complex and interconnected amid technological advances and globalization. These 

developments were generally intended to further facilitate the allocation of risk, increase 

liquidity, and enhance pricing in order to improve the provision of financial services. But 

the financial crisis illustrated that complex new forms of financial activity also can produce 

instability and imbalances that can pose extraordinary costs to the real economy. 

Most observers only became aware of these powerful destabilizing forces in the summer 

of 2007, when the interbank market seized up (Chart 5.0.1). It took more than two years 

of unprecedented interventions for financial markets to return to more normal functioning.

Chart 5.0.1 The Financial Crisis in the Interbank Market 5.1 Restoration of Private 

Sector Funding and Capital

To maintain the key functions of the financial 

system during the extraordinary disruptions 

of the crisis, governments provided 

unprecedented liquidity, guarantees, and capital 

support to markets and institutions. With the 

exception of housing finance, most of the 

explicit U.S. government support has been 

replaced by private sector sources.

Government support proved effective in 

reducing the severity of the crisis. Congress 

passed the Dodd-Frank Act to address the 

weaknesses in the financial system revealed 

during the financial crisis and to help prevent 

another crisis. As Section 6 of this report 

outlines, implementation of the Dodd-Frank Act 

is progressing. The Dodd-Frank Act requires 

enhanced capital requirements for financial 

institutions and stronger supervision, risk 

management, and disclosure standards for 

the largest firms that pose the greatest risk to 

the system. It also requires the establishment 

of an orderly liquidation regime for financial 

companies that otherwise might be perceived 

as “too big to fail.” At the same time, the 

Dodd-Frank Act eliminated several avenues 

of government support for firms in a crisis to 

improve market discipline. 

Financial Developments 45
5.1.1 Liquidity Support

Official support was first provided to banks to 

address liquidity pressures. Liquidity programs 

broadened to directly or indirectly support 

the firms and related secondary markets that 

had increasingly facilitated risk transfer in the 

global financial system leading up to the crisis. 

Liquidity support wound down in 2009 as 

secondary markets returned to more normal 

functioning. 

The Federal Reserve provided substantial 

liquidity support to global markets and 

institutions (Chart 5.1.1). That support at first 

was in the form of extended discount window 

lending in new ways to banks and, then, 

emergency lending to independent investment 

banks that traditionally did not have access 

to the discount window. Later, facilities were 

introduced to deal with malfunctioning in 

specific secondary markets—such as those 

for repurchase agreements (repos), assetbacked commercial paper, and asset-backed 

securities—and to support certain institutions. 

Federal Reserve facilities were designed to 

provide collateralized funding at rates above 

those prevalent for creditworthy borrowers 

when markets were functioning normally, but 

below rates available to such borrowers when 

markets were functioning poorly. Thus, as 

secondary markets normalized, private sector 

funding naturally replaced government funding. 

Use of the facilities relative to announced 

capacity varied widely, and some of them 

stabilized markets with little or no drawdown 

(Chart 5.1.2).

The first facilities, the Term Auction Facility 

(TAF) and the central bank liquidity swap lines, 

were introduced in late 2007 amid pronounced 

strains in short-term wholesale funding markets. 

The TAF provided term funding to depository 

institutions with access to the Federal Reserve’s 

primary credit facilities through an auction 

process and helped to address domestic dollar 

funding pressures. 

The swap lines gave foreign central banks the 

capacity to provide U.S. dollar funding directly 

to institutions in their jurisdictions, enhancing 

Chart 5.1.1 Federal Reserve Balance Sheet: Assets

Chart 5.1.2 Federal Reserve Facilities

Chart 5.1.3 US$ FX Swap Facility Usage Since Inception

46 2011 FSOC Annual Report
U.S. financial stability by relieving pressures 

in U.S. dollar funding markets and reducing 

incentives for foreign financial institutions to 

sell dollar assets at fire-sale prices. The swap 

lines expired on February 1, 2010, as market 

conditions normalized and the pricing of 

funds from the facility became unattractive. 

However, the Federal Open Market Committee 

reauthorized currency swap lines in May 2010 in 

response to the reemergence of strains in shortterm U.S. dollar funding markets associated 

with the fiscal crisis in the peripheral euro area. 

Use of the swap lines has been minimal since 

May 2010, reaching a peak of $9.2 billion 

compared with a previous peak of $586 billion 

(Charts 5.1.3 and 5.1.4).

Among the many new facilities that were 

introduced at the height of the crisis, the 

Commercial Paper Funding Facility (CPFF) 

and Term Asset-Backed Securities Loan 

Facility (TALF) involved a wide range of market 

participants. For example, the CPFF helped 

financial and nonfinancial firms meet short-term 

funding requirements by offering collateralized 

liquidity directly to both secured and unsecured 

commercial paper (CP) issuers when private 

markets were frozen after the failure of Lehman 

Brothers in September 2008. The CPFF selfliquidated according to plan, falling from 

20 percent of the market at its peak to less 

than 1 percent by late 2009 (Chart 5.1.5).

Improvements in market conditions over time, 

evidenced by contracting spreads, allowed 

some borrowers to obtain financing from private 

investors (Chart 5.1.6). However, decreased 

use of the CPFF was also driven by a significant 

decline in the supply of commercial paper, as 

issuers reduced the size of CP programs and 

other sources of funding became available. 

As the recovery progressed, unsecured 

domestic financial issuers exited the CPFF 

first, followed by European banks and finally 

by issuers of asset-backed commercial paper 

(ABCP). For unsecured domestic financial 

issuers, the facility was a critical temporary 

source of funding through the worst of the 

crisis. European banks required more time 

to exit the CPFF, because they had limited 

Chart 5.1.4 EUR-US$ FX Implied Basis Spreads 5.1.4 EUR-USD FX Implied Basis Spreads 

Chart 5.1.5 CPFF Support of Commercial Paper Market 5.1.5 CPFF Support of Commercial Paper Market

Chart 5.1.6 30-Day CP Rates Less 1-Month OIS Rates 5.1.6 30-Day CP Rates Less 1-Month OIS Rates

Financial Developments 47
options to meet dollar funding needs. For ABCP 

issuers, the CPFF provided a safety net that 

allowed them to gradually downsize their ABCP 

programs with minimal market disruption.

The TALF was established in 2008 as a 

temporary facility to address the severe 

deterioration of liquidity in securitized markets 

that provide critical sources of funding for 

consumer, small business, and commercial 

real estate lenders. Unlike subprime residential 

mortgage securitizations, the seizure in market 

functioning in the nonmortgage asset-backed 

security (ABS) and commercial real estate 

mortgage-backed security (CMBS) markets was 

not driven by credit concerns but rather by a 

lack of liquidity. Investors fled indiscriminately 

from all securitized credit, even though ABS 

and CMBS structures generally performed 

well during the crisis. Liquidity provided by 

TALF helped finance three million auto loans, 

one million student loans, and 900,000 small 

business loans. TALF-levered investors led 

renewed demand for consumer ABS and 

CMBS. Later, as secondary and then primary 

market spreads narrowed in these markets, 

issuance became increasingly less reliant on 

TALF. This restoration of private funding is most 

clearly seen in the nonmortgage ABS market 

(Charts 5.1.7, 5.1.8, 5.1.9, and 5.1.10).

All Federal Reserve loans extended during the 

crisis were well collateralized. A large fraction of 

TALF loans have been repaid early. Remaining 

loans are current in their payments and well 

collateralized. All other loans were repaid on 

time, in full, with interest.

5.1.2 Guarantee Support

Temporary programs to guarantee deposits, 

unsecured bank debt, and investor assets in 

money market mutual funds helped stabilize 

investor confidence. 

In October 2008, at the peak of the financial 

crisis, the FDIC introduced the Temporary 

Liquidity Guarantee Program (TLGP). In addition 

to the Transaction Account Guarantee Program, 

the TLGP guaranteed, for a fee, unsecured 

debt with a term of up to three years issued 

by financial entities participating in its Debt 

Chart 5.1.7 Nonmortgage ABS Issuance

Chart 5.1.8 ABS Issuance

Chart 5.1.9 Securitized Auto ABS Spreads

5.1.9 Securitized Auto ABS Spreads

48 2011 FSOC Annual Report
Guarantee Program (DGP). The issuance of 

new guaranteed debt expired on October 31, 

2009, and the guarantee on outstanding debt 

expires on December 31, 2012. The NCUA also 

introduced temporary guarantees to stabilize 

the corporate credit union system.

The DGP enabled financial institutions to 

meet their financing needs during a period 

of systemwide turmoil and record-high credit 

spreads. On January 7, 2009, less than three 

months after the first TLGP medium-term note 

was issued, the spread between a composite 

of three-year TLGP debt and three-year U.S. 

Treasury securities was 88 basis points, while 

the comparable spread on nonguaranteed bank 

debt was 458 basis points (Chart 5.1.11). By 

the end of the DGP issuance period on October 

31, 2009, these spreads had decreased by 

about two-thirds.

Banks and their holding companies are now 

issuing nonguaranteed debt at volumes 

comparable to pre-crisis levels. At the peak of 

the TLGP, the FDIC guaranteed almost $350 

billion of debt outstanding. As of June 30, 

2011, the total amount of remaining FDICguaranteed debt outstanding was $236.9 

billion, of which $70.7 billion will mature in 

2011 and the remaining $166.2 billion will 

mature in 2012 (Chart 5.1.12). The majority 

of the debt exposure resides within the largest 

financial entities. 

The Treasury Department announced its 

temporary money market fund guarantee 

program on September 19, 2008, to stop the 

run on money market funds (MMFs) (Chart 

5.1.13). Certain structural features of MMFs 

can produce incentives for investors to cash 

in shares if they fear that a fund will suffer a 

loss (see Box D: Money Market Funds).

The temporary guarantee program provided 

coverage to shareholders for amounts they held 

in participating MMFs at the close of business 

on September 19, 2008. The guarantee would 

have been triggered if a participating fund’s 

net asset value fell below $0.995 per share. 

The temporary guarantee, along with Federal

Reserve facilities aimed at stabilizing markets 

linked to MMFs, was successful in restoring 

Chart 5.1.10 CMBS AAA Spread 5.1.10 CMBS AAA Spread

Chart 5.1.11 Debt Spreads vs. 3-year U.S. Treasury Securities 5.1.11 Debt Spreads vs. 3-year U.S. Treasury Securities

Chart 5.1.12 Total Debt Outstanding for TLGP Firms

Financial Developments 49
Box D: Money Market Funds

 

The run on money market funds (MMFs) added considerably to market stress during the financial crisis. Some of 

the key features of MMFs that make them susceptible to runs remain today.

Money market funds are mutual funds that offer 

individuals, businesses, and governments a convenient 

way to pool investments in money market instruments. 

MMFs provide an economically important service

by acting as intermediaries between shareholders 

who desire liquid investments, often for cash 

management, and borrowers who seek term funding. 

The composition of MMF assets has recently remained 

stable among various government and short-duration 

assets (Chart D.1).

Chart D.1 Money Market Fund Assets

MMFs generally invest in the highest rated (A1/P1-rated) 

short-term collateral. SEC Rule 2a-7 places stringent 

limitations on MMF holdings of lower rated securities. 

MMFs must comply with the rule, which permits these 

funds to maintain a stable net asset value (NAV) per 

share, typically $1, through the use of amortized cost 

accounting and rounding. However, if the mark-tomarket per share value of a fund’s assets falls more 

than one-half of 1 percent, or below $0.995, the fund 

must reprice its shares, an event known as “breaking 

the buck.” MMF investors benefit from the simplicity and 

convenience of the stable NAV feature and from the risk 

management, monitoring, and diversification services 

that MMFs provide. However, several of these MMF 

features contribute to their fragility.

Investors’ Incentives and the Fixed NAV 

The stable, rounded $1 NAV fosters an expectation that 

MMF share prices will not fluctuate. However, when 

shareholders perceive that a fund may suffer losses, 

each shareholder has an incentive to redeem shares 

before other shareholders, causing a run on the fund. 

Such redemptions can accelerate the likelihood of a 

break-the-buck event to the extent that the fund’s asset 

sales to meet redemptions significantly depress the 

market value of the fund’s remaining assets. In such a 

scenario, the ability of early redeemers to receive the full 

$1 NAV is essentially subsidized by the losses absorbed 

by remaining shareholders.

Maturity Transformation and Liquidity

MMFs offer shares that are payable on demand, but 

they invest in cash-like instruments and in short-term 

securities that are less liquid. Redemptions in excess of 

the cash-like assets (or liquidity buffer) may force funds 

to sell their less liquid assets. When money markets 

are strained, funds may not be able to obtain full value 

(that is, amortized cost) for such assets in secondary 

markets and may incur losses. Investors thus have an 

incentive to redeem shares before a fund has depleted 

its cash-like liquidity buffer.

Low Risk Tolerance

Risk-averse investors are attracted to MMFs because 

they offer yield above that of a risk-free asset yet 

have a history of maintaining stable value and 

meeting all withdrawal requests on demand. These 

investors are prone to flight when losses appear 

possible. In particular, institutional investors, which 

currently account for about two-thirds of assets under 

management in MMFs, exhibit extreme aversion to 

absorbing even small losses. Institutional investors tend 

50 2011 FSOC Annual Report
Box D: Money Market Funds

to be less tolerant of fluctuations in share prices, have 

larger amounts at stake, and are quicker to respond to 

events that may threaten the stable NAV.

Expectation of Sponsor Support

MMFs invest in assets that may lose value, but funds 

have no formal capital buffers or insurance to absorb 

loss and maintain their stable NAV. When losses do 

occur, MMFs have historically relied on discretionary 

sponsor support to maintain a stable NAV and preserve 

the franchise value of fund management businesses 

(Chart D.2). That support may come in the form of 

capital contributions or the purchase of assets that have 

lost value, for example.

Chart D.2 Money Market Fund Sponsor Support

Sponsors do not commit to support an MMF in 

advance, however, because an explicit commitment 

may require the sponsor to consolidate the fund on 

its balance sheet. Thus, although investors ostensibly 

bear the risk of an MMF breaking the buck, sponsors 

have in the past borne that risk themselves, fostering 

the perceived safety of MMF investments. Moreover, 

the uncertainty about the availability and sufficiency 

of such support during crises, and the fact that many 

MMFs lack deep-pocketed sponsors, contribute to their 

susceptibility to runs. 

Expectation of Government Support

Given the unprecedented government support of 

MMFs during the crisis in 2008 and 2009, even 

sophisticated institutional investors and fund managers 

may have the impression that the government would 

be ready to support the industry again with the same 

tools. This expectation may give fund managers 

incentives to take greater risks than are prudent and 

may reduce sponsors’ incentives to support funds in 

times of stress. Such expectations may be particularly 

misaligned given that Congress has since prohibited 

the Treasury from using the fund that it used to 

support the MMFs for this purpose.

In February 2010, the SEC adopted new rules for 

MMFs to make these funds more resilient to market 

volatility and to credit and liquidity risk. First, the SEC 

introduced new risk-limiting restrictions, including 

increased liquidity requirements, restrictions on the 

ability of MMFs to purchase lower quality securities, and 

maturity restrictions that reduce the maximum allowable 

weighted average maturity of funds’ portfolios. Funds 

also are required to stress test their ability to maintain a 

stable NAV. Second, the SEC’s new rules permit a fund’s 

board—if it determines that the fund’s NAV per share is 

at imminent risk of falling, or has fallen, below $1—to 

suspend redemptions promptly and liquidate its portfolio 

in an orderly manner to limit contagion effects on other 

funds. Finally, the new rules impose requirements to 

disclose portfolio holdings and mark-to-market (shadow) 

NAV, which gives the SEC a window on MMF activity 

and helps investors impose strong market discipline. 

Although these new rules are a positive first step, the 

SEC recognizes that they address only some of the 

features that make MMFs susceptible to runs, and that 

more should be done to address systemic risks posed by 

MMFs and their structural vulnerabilities.

Financial Developments 51
investor confidence; it expired in September 

2009 without any claims. 

5.1.3 Capital Support

Government capital injections were required 

to stabilize regulated financial entities at 

the peak of the crisis. Many U.S. financial 

institutions were able to replace government 

capital with private sources as investors 

gained confidence from the Supervisory 

Capital Assessment Program (SCAP), financial 

conditions normalized, and the economy 

began to recover. 

During the financial panic in September 2008, 

market participants became acutely concerned 

about the solvency of the nation’s regulated 

banking institutions, particularly after the failure 

of the largest thrift institution and the acquisition 

of the fourth-largest bank holding company 

(BHC) by the fifth-largest BHC. One measure 

of the extent of concern is the behavior of 

the LIBOR-OIS spread, which captures the 

premium that banks require to lend to each 

other in the short-term money market (Chart 

5.1.14). This spread jumped from under 100 

basis points to over 350 basis points. With wellfunctioning secondary markets and the absence 

of counterparty solvency fears, this spread is 

typically under 25 basis points (Chart 5.0.1).

To restore confidence and directly bolster 

the capital base of the banking system, the 

Treasury Department drew on the $700 billion 

that Congress had made available through 

the Troubled Asset Relief Program (TARP) to 

address the market dislocation. It immediately 

injected $125 billion of capital into nine 

institutions. Over the next few months, the 

Treasury Department injected a total of $204.9 

billion of capital through the Capital Purchase 

Program and invested $40 billion through the 

Targeted Investment Program. Despite the 

massive government intervention to support the 

banking system, access to private capital was 

severely limited. Many large banks had market 

capitalizations well below their book value 

(Chart 5.1.15), and measures of default risk 

were exceptionally high (Chart 5.1.16).

Chart 5.1.13 Prime Money Market Fund Assets 5.1.13 Prime Money Market Fund Assets

Chart 5.1.14 The Financial Panic in the Interbank Market

5.1.14 The Financial Panic in the Interbank Market

Chart 5.1.15 5.1.15 Price-to-Book Ratio of 6 Large Complex BHCs Price-to-Book Ratio of 6 Large Complex BHCs

52 2011 FSOC Annual Report
In 2009, the SCAP provided an assessment of 

the capital needs of the 19 largest BHCs under 

alternative macroeconomic scenarios to ensure 

that they could continue to provide key financial 

services, even if the recession was longer and 

deeper than the consensus forecast. Ten of the 

19 BHCs were told that they needed to raise 

additional capital of $75 billion in the aggregate. 

The presence of an additional government 

backstop of capital to banks and the 

confidence-enhancing clarity produced by the 

SCAP assessment reopened the equity market 

for most of the large banks. As of first quarter 

2011, banks had raised over $300 billion in 

equity from the market and conversions and 

returned $220 billion of their TARP funds to the 

Treasury (Chart 5.1.17).

5.1.4 Housing Finance Support

The housing finance market was the first 

and biggest market to lose liquidity during 

the financial crisis. Substantial government 

intervention sustained the market during the 

crisis and remains in place today. 

Mortgage-related losses led to capital shortfalls 

at the two government-sponsored enterprises 

(GSEs), Fannie Mae and Freddie Mac, and 

a sharp decline in net income at the Federal 

Home Loan Bank System (FHLB). The federal 

government injected capital into Fannie Mae 

and Freddie Mac to stabilize the mortgage 

market, and the FHFA placed restrictions on 

capital distributions at several Federal Home 

Loan Banks.

Fannie Mae and Freddie Mac reported a $109 

billion combined net loss in 2008 owing to rising 

defaults on loans underlying the mortgagebacked securities (MBS) they had guaranteed 

in their securitization businesses (agency MBS) 

and to losses on their direct investments in 

MBS. These losses eroded the two companies’ 

capital and led to a steep widening of spreads 

in the MBS market relative to Treasury yields, 

which in turn increased the cost of new 

mortgage loans to homeowners. 

Chart 5.1.16 CDS Spreads of 6 Large Complex BHCs 5.1.16 CDS Spreads of 6 Large Complex BHCs

Chart 5.1.17 Aggregate Large BHC Total Equity Capital 5.1.17 Aggregate Large BHC Total Equity Capital

Financial Developments 53
To stabilize the mortgage market, FHFA 

placed Fannie Mae and Freddie Mac into 

conservatorship, and Treasury entered into a 

senior preferred stock purchase agreement 

in September 2008 to ensure that these 

two GSEs would have a positive net worth. 

Joint action by the FHFA and the Treasury 

Department, coupled with large purchases in 

the agency MBS market by Treasury and the 

Federal Reserve, stabilized the agency MBS 

market. These combined actions resulted in a 

sharp improvement in spreads and restored a 

measure of calm to the agency MBS market 

(Chart 5.1.18).

Treasury and FHFA increased the funding 

commitment to $200 billion for each GSE in 

May 2009, then amended the agreement again 

in December 2009. The December amendment 

added flexibility to the funding commitment by 

setting it at $200 billion plus any cumulative 

deficiency amount determined for quarters in 

calendar years 2010, 2011, and 2012, less 

any amount by which assets exceed liabilities 

at December 31, 2012, and less any existing 

amount of funding under the commitment. This 

ensured that the GSEs would have a positive 

net worth as losses continued to mount. 

Treasury holdings of GSE preferred stock as of 

first quarter 2011 totaled $162.4 billion at a net 

cost after dividend payments of $138.2 billion. 

The funding commitment will become fixed 

again on December 31, 2012 (Chart 5.1.19).

The FHLBs fared better than Fannie Mae 

and Freddie Mac, and became an important 

source of funding for many struggling financial 

institutions during the crisis. Since peaking 

at the end of 2008, FHLB advances have 

declined sharply (Chart 5.1.20). Despite the 

increase in advances in 2008, net income 

for the consolidated system declined by 57 

percent in 2008 compared with 2007, primarily 

because of losses on private-label securities 

at 6 of the 12 banks. Net losses were reported 

by three Federal Home Loan Banks in 2008 

and four in 2009. Several of the banks became 

subject to restrictions on dividends and capital 

because of their weakened financial condition.

Chart 5.1.18 Fannie Mae Option-Adjusted Spreads 5.1.18 Fannie Mae Option-Adjusted Spreads

Chart 5.1.19 GSE: Net Income and Losses

Chart 5.1.20 5.1.20 FHLB Bank Advances FHLB Bank Advances

54 2011 FSOC Annual Report
5.2 Evolution of the Financial 

System

Over the past 30 years, market-based 

intermediation of credit, such as securitization, 

increased relative to bank-based intermediation, 

such as direct lending (Chart 5.2.1). Many of 

these market-based intermediation channels 

became severely disrupted during the financial 

crisis and shrank in size (Chart 5.2.2).

Meanwhile, the crisis reinforced the secular 

increase in the concentration of the banking 

sector and changes in its business model.

Economic growth, demographics, and financial 

innovation have been factors behind the large 

increases in the financial asset holdings of 

U.S. households and businesses. While most 

asset management firms, pension funds, and 

insurance institutions were only indirectly 

affected by the crisis, the crisis highlighted their 

importance in providing both short-term and 

long-term funding to the financial sector.

Technological advances, changes in regulation, 

and globalization have produced dramatic 

changes in trading and market-making 

practices. The greater complexity of the 

financial system has been supported in part 

by developments in financial infrastructure and 

the increasing use of electronic payments and 

computerized record keeping.

Part I. Institutions

5.2.1 Bank Holding Companies

The financial crisis has changed the landscape 

for the largest BHCs. While the income of 

BHCs has improved significantly over the past 

two years, it remains substantially below the 

pre-crisis level. Assets held by foreign banking 

organizations (FBOs) in the United States have 

increased notably since the crisis. 

Most commercial banks in the United States 

are owned by a BHC, which can own other 

subsidiaries, such as a broker-dealer. Bank 

holding companies are regulated by the Federal 

Reserve on a consolidated basis and are 

subject to capital standards similar to those 

of banks. There are nearly 5,000 BHCs in the 

United States, with aggregate assets of about 

Chart 5.2.1 Origin of Private Nonfinancial Debt Outstanding

Chart 5.2.2 Bank vs. Market Intermediated Credit Outstanding

5.2.2 Bank vs. Market Intermediated Credit Outstanding

Financial Developments 55
$17 trillion. Most of these companies own only 

one commercial bank. There are 75 companies 

with assets over $10 billion which, combined, 

account for over 85 percent of all BHC assets.

Pretax net income across all BHCs totaled 

$116.7 billion in 2010 (Chart 5.2.3). While 

this was a significant improvement over the 

previous two years, it was nearly 40 percent 

below the 2006 level. Net revenue (net interest 

income plus noninterest income) held up fairly 

well through the crisis. However, as asset 

quality deteriorated, provisions for loan losses 

increased sharply. 

The financial crisis had a profound effect on 

large complex financial institutions (LCFIs). 

Several large banking organizations were 

acquired by LCFIs as a result of mergers or 

FDIC-assisted transactions. Additionally, four 

of the five largest independent broker-dealers 

were either acquired by or converted to BHCs 

in 2008 (Chart 5.2.4). These developments 

added more than $2 trillion to total BHC assets 

and had implications for the business models of 

the largest BHCs, as they now derive a higher 

share of income from investment banking and 

trading activities (Chart 5.2.5).

The assets held by FBOs in the United States 

have increased notably since the financial 

crisis (Chart 5.2.6). The percentage of U.S. 

commercial banking deposits held by FBOs has 

been relatively constant over the past decade.

Primarily through acquisitions, they expanded 

their presence in activities less dependent on 

deposit financing, such as repo, securities and 

derivatives trading, prime brokerage, and other 

investment banking activities. FBOs hold a large 

and increasing percentage of their U.S. assets 

outside of domestically chartered BHCs.

5.2.2 Insured Depository Institutions

The commercial banking industry has become 

increasingly concentrated over recent 

decades among fewer, larger institutions, a 

trend that has accelerated since the financial 

crisis. While revenue held up fairly well, the 

industry set aside nearly one-third of revenue 

in loan loss provisions over the past two years. 

Chart 5.2.3 Large Bank Holding Company Pre-Tax Income

Chart 5.2.4 5.2.4 Independent Broker-Dealer Assets Independent Broker-Dealer Assets

Chart 5.2.5 SCAP Bank Noninterest Income

56 2011 FSOC Annual Report
Commercial Banks and Thrifts

The banking industry is composed of more than 

7,500 commercial bank and thrift institutions. 

Of these, more than 6,900 institutions have 

assets less than $1 billion, while 88 institutions 

have assets between $10 billion and $100 

billion, and 19 institutions have assets over 

$100 billion (Chart 5.2.7). Over the past few 

decades, the industry has become increasingly 

concentrated among fewer, larger institutions as 

they expanded to achieve economies of scale 

and branched across state lines, and as federal 

legislation enabled them to conduct trading and 

other investment banking activities. Failures, 

mergers, and subdued new chartering activity 

during and after the crisis have contributed to 

further consolidation. Over the past decade, the 

number of institutions has fallen by 25 percent, 

and the 10 largest institutions now hold 

approximately 50 percent of industry assets 

(Chart 5.2.8). Overall, there has been a steady, 

long-term increase in assets at commercial 

banks and thrifts as population and wealth rose. 

Over the past decade, industry assets have 

risen from 75 percent of GDP to 90 percent.

Despite the rising concentration over recent 

years, the U.S. banking industry remains much 

less concentrated than banking in many other 

countries, and the size of the largest banks 

relative to GDP is still low when compared to 

other countries (Chart 5.2.9). Small banks 

and credit unions remain an important source 

of financing for consumers and businesses, 

particularly small businesses, in communities 

across the country. 

Pretax net income for the U.S. banking industry 

totaled $122.5 billion in 2010 (Chart 5.2.10).

While this was a significant improvement over 

the previous two years, it was 44 percent 

below the 2006 level. Industry net revenue 

held up fairly well throughout the crisis, rising 

each year from 2006 to 2010, but provisions 

for loan losses increased sharply beginning in 

2007 and peaked in 2009, when they absorbed 

103 percent of the industry’s net revenue. The 

industry set aside nearly $625 billion in loan loss 

provisions between 2008 and 2010, which was 

nearly one-third of industry net revenue. 

Chart 5.2.6 Assets of Foreign Bank Branches and Agencies 5.2.6 Assets of Foreign Bank Branches and Agencies

Chart 5.2.7 5.2.7 Asset Distribution of FDIC Insured Institutions Asset Distribution of FDIC-Insured Institutions

Chart 5.2.8 Assets of the Ten Largest Depository Institutions

Financial Developments 57
As the crisis has unfolded, 370 bank and 

thrift failures have occurred through June 30, 

2011, or 4.5 percent of institutions operating 

at the beginning of 2008. While the level of 

bank and thrift failures remains elevated, the 

rate is beginning to decline. Although fewer 

institutions have failed since the beginning 

of the financial crisis compared with failures 

during the savings and loan crisis of the late 

1980s and early 1990s, the value of failed-bank 

assets has been much higher this time (Chart 

5.2.11). At the end of first quarter 2011, the 

number of institutions on the FDIC’s “problem” 

list (institutions with financial, operational, or 

managerial weaknesses that threaten their 

continued financial viability) was 888, nearly 12 

percent of all institutions.

The nation’s largest banking institutions (those 

with over $100 billion in assets) have recovered 

from the financial crisis to a greater extent than 

community banks (institutions with less than 

$1 billion in assets). Pretax net income is down 

nearly 75 percent at community banks from 

the 2006 level, while it is down by 12 percent 

at the largest institutions (Charts 5.2.12 and

5.2.13). Although both the largest institutions 

and community banks have benefited from 

reductions in loan loss provisions, community 

banks have experienced a smaller increase 

in net revenue than large banks. In addition, 

community banks continue to deal with credit 

problems associated with their still-sizable 

commercial real estate portfolios. 

Credit Unions

Credit unions are nonprofit, cooperative 

financial institutions. Members pool their funds, 

and these funds are then lent to members. 

Credit unions differ from commercial banks 

and thrifts in that the members are also the 

owners. Currently, there are nearly 7,300 retail 

credit unions with approximately $940 billion in 

assets and 26 corporate credit unions, which 

are organized to provide services to the retail 

credit unions. 

The credit union experience was similar to that 

of commercial banks: the system experienced 

a deterioration of asset quality during the 

financial crisis, although delinquency rates and 

Chart 5.2.9 Largest 4 Banking Institutions as Percent of GDP

Chart 5.2.10 Commercial Bank and Thrift Pre-Tax Income

Chart 5.2.11 5.2.11 FDIC-Insured Failed Institutions FDIC-Insured Failed Institutions

58 2011 FSOC Annual Report
provisions have been less severe than those 

in the banking industry (Chart 5.2.14). Credit 

union net revenue totaled $4.6 billion in 2010, 

up significantly from the previous two years but 

20 percent below the 2006 level. Net income 

rose by 33 percent from 2006 to 2010, while 

provisions for loan losses peaked in 2009, when 

they absorbed nearly 20 percent of net income.

As in the banking industry, assets in the credit 

union system have increased and the system 

has become more concentrated, although less 

so than commercial banking (Chart 5.2.15).

Assets of the credit union system rose from 4.4 

percent of GDP to 6.2 percent over the past 

decade. The number of credit unions has fallen 

by nearly 30 percent over the same period, 

with the 10 largest institutions now holding 

nearly 15 percent of system assets. The severe 

economic downturn led to losses at retail 

credit unions and the failure of several large 

corporate credit unions, as a result of declines 

in the value of mortgage-related assets held by 

these institutions. To address these failures and 

reform the corporate credit union system, key 

regulatory reforms have been implemented to 

improve capital, restrict investments, enhance 

asset-liability management, and enhance 

corporate governance provisions. 

5.2.3 Specialty Lenders

Specialty lenders are important providers of 

credit to a number of markets that have not 

been fully served by the traditional banking 

industry. Specialty lenders struggled through 

the financial crisis because of their heavy 

reliance on the capital funding markets, but 

they have recovered to a large extent and are 

continuing to serve their customer base. 

The specialty lending sector, which plays a 

significant role in market-based intermediation, 

grew dramatically before the crisis as marketbased intermediation expanded. Much of the 

growth was in mortgage lending backed by 

Fannie Mae and Freddie Mac, the two large 

GSEs. Finance companies and real estate 

investment trusts (REITs)—tax-advantaged legal 

entities that are required to hold 75 percent of 

their assets in and generate 75 percent of their 

income from mortgages and mortgage-related 

Chart 5.2.12 Large Bank Pre-Tax Income

Chart 5.2.13 Community Bank Pre-Tax Income

Chart 5.2.14 5.2.14 Federally Insured Credit Union Income Federally Insured Credit Union Income

Financial Developments 59
holdings—played an increasing role (Charts 

5.2.16 and 5.2.17). Mortgage lending by these 

firms contracted sharply following the collapse 

of the securitization business model. Recently, 

however, REITs have attracted private capital 

for agency MBS investment because of the high 

dividend yields they offer, facilitated by the lowrate environment and steep yield curve. 

With the government’s conservatorship of 

the two large GSEs, the remaining specialty 

lending sector can be split into three broad 

types: small niche firms, finance entities that 

are captive to a manufacturer, and large 

diversified firms. Specialty lenders remain an 

important provider of credit to households and 

businesses for the purchase and leasing of a 

wide variety of goods and services, including 

automobiles, household durables, education, 

office equipment, and commercial aircraft. 

At year-end 2010, finance companies owned 

or managed approximately $600 billion in 

nonmortgage consumer loans and leases and 

approximately $500 billion in business loans 

and leases (Charts 5.2.18 and 5.2.19).

The sector is concentrated; for example, 

approximately three-quarters of consumer 

receivables on the balance sheet of finance 

companies at the end of 2010 were held by 

only 10 companies. The larger specialty lenders 

generally are either captive subsidiaries of major 

manufacturing firms that provide financing 

for the purchase of the parents’ products 

or diversified entities involved in a variety of 

consumer and commercial business lines. 

Captives and diversified specialty lenders’ 

businesses are generally global in scope. 

Specialty lenders have traditionally relied heavily 

on the debt markets for funding, because they 

have only limited deposit offerings, usually 

through a wholly owned thrift subsidiary or 

an industrial loan corporation. The traditional 

business model for many of the large finance 

companies depends on access to markets 

for secured and unsecured debt, as well as 

support from parent manufacturing companies 

(Chart 5.2.20). During the financial crisis, 

certain specialty nonmortgage lenders adopted 

a BHC structure, which made them eligible to 

receive government assistance under the TARP.

Chart 5.2.15 Assets of the Ten Largest Credit Unions

Chart 5.2.16 Finance Company Mortgage Assets

Chart 5.2.17 Real Estate Investment Trust (REIT) Assets 5.2.17 Real Estate Investment Trust (REIT) Assets

60 2011 FSOC Annual Report
Small specialty lenders, numbering in the 

thousands, are primarily focused on a specific 

industry niche or geographic area. These firms 

obtain financing mainly through bank loans and 

equity capital; therefore, they may be vulnerable 

to changes in bank underwriting standards as 

well as the creditworthiness of their customers. 

In general, these lenders serve higher risk 

segments of the economy.

5.2.4 Insurance

The insurance industry is an important source 

of long-term funding to the economy through 

its investment of premium income. Insurance 

companies, with some notable exceptions, 

generally withstood the financial crisis and 

have since strengthened their balance sheets. 

Their investment portfolios have improved 

along with general financial market conditions. 

The segment of the industry that provided 

financial guarantees on mortgages and 

mortgage-related assets experienced severe 

difficulties. 

Insurance companies are broadly classified into 

two primary groups: life insurance companies, 

which sell life insurance, annuities, and other 

retirement products; and property/casualty 

insurance companies, which sell personal, 

professional, and commercial liability insurance. 

In order to meet future insurance payouts, 

all insurers invest their premium income in 

a wide range of assets, thereby providing 

important long-term funding to the economy. 

The different asset and capital composition of 

the life and property/casualty industries reflects 

distinct claim and benefit payment patterns. In 

particular, property/casualty companies tend 

to hold higher credit quality instruments and 

have greater liquidity needs than life insurance 

companies (Charts 5.2.21 and 5.2.22).

Insurers faced challenges during the financial 

crisis as asset prices fell sharply and some 

noncore activities such as securities lending 

produced large losses. However, the industry 

withstood the financial crisis quite well in terms 

of providing insurance services to consumers 

and businesses. Only 28 of approximately 8,000 

insurers became insolvent in 2008 and 2009, 

Chart 5.2.18 Consumer Loans Outstanding

Chart 5.2.19 Business Loans Outstanding

Chart 5.2.20 Finance Company Liabilities

Financial Developments 61
and those insurers are being resolved pursuant 

to applicable state law. The improvement 

in financial markets has strengthened the 

insurance sector’s balance sheet and the sector 

generally is financially healthy. 

The property/casualty industry has been in 

a soft market cycle for the past few years, 

characterized by highly competitive markets and 

reduced insurer pricing power. The industry as a 

whole realized positive net income in 2009 and 

2010 (Chart 5.2.23), and net investment income 

has remained relatively stable. The industry faced 

higher than usual claims exposure for the first six 

months of 2011 due to severe weather in parts 

of the United States. Similarly to the property/

casualty industry, the life insurance sector has 

experienced reduced premium volumes along 

with an increase in both policyholder claims 

and administrative expenses (Chart 5.2.24).

However, these effects were somewhat offset by 

increases in investment income. 

During 2010, general financial market conditions 

improved and were reflected in insurance 

company investment portfolios in several 

ways. Valuation concerns have diminished. 

Comparisons of fair value to carrying value are 

less negative, reducing the pressure to take 

impairments. Improved market conditions also 

led to more flexibility in managing portfolios 

without the negative impact of realized losses. 

However, insurers, state regulators, and 

the FIO are carefully monitoring exposures 

to commercial real estate, residential MBS 

(RMBS), municipal bonds, securities lending, 

euro area exposures, and derivatives.

The financial guaranty and mortgage guaranty 

segments of the industry, which are a relatively 

small portion of the industry as measured by 

premium income, experienced severe difficulties 

associated with the decline in house prices 

and market activity, the increased volume in 

residential real estate foreclosures, and the 

impairment in the RMBS market. In particular, 

due to severe losses, the future viability of the 

financial guaranty segment (monoline insurers) 

remains uncertain, with only one monoline 

group actively writing insurance.

Chart 5.2.21 Property and Casualty Insurance: Assets

Chart 5.2.22 Life Insurance: Assets

Chart 5.2.23 Property and Casualty Insurance: Capital and Income

62 2011 FSOC Annual Report
5.2.5 Asset Management 

The U.S. asset management industry, with 

more than $35 trillion under management, 

is an integral part of the financial system. It 

has grown with the long-run increase in U.S. 

household financial assets. A wide range of 

asset management vehicles, including pension 

funds and hedge funds, play an important role 

in the financial system as providers of capital. 

The U.S. household sector has built a large 

stock of financial assets over the past three 

decades (Chart 5.2.25). Equity holdings 

increased over this period and now make up 

a sizable percentage of both financial assets 

and GDP (Chart 5.2.26). Demographic trends 

should continue to support asset growth, as the 

baby-boom generation, with its increasing life 

expectancy, continues to accumulate assets for 

retirement over the next few years. The aging of 

the population eventually may have implications 

for asset allocations. 

Savers have access to a wide array of 

investment products through many types of 

asset managers and vehicles, including money 

market funds and mutual funds, insurance and 

retirement funds, and private equity and hedge 

funds (Chart 5.2.27).

Mutual Funds and Closed-End Funds

Mutual funds are open-end investment 

companies, registered and regulated under the 

Investment Company Act of 1940. According 

to the Federal Reserve’s Flow of Funds report, 

mutual fund assets under management as of 

first quarter 2011 were about $11 trillion, with 

approximately $2.7 trillion in MMFs and $8.3 

trillion in other mutual funds. Among nonmoney-market funds, 65 percent of assets are 

in equity funds and 35 percent are in bond or 

hybrid funds. 

The MMF sector has grown significantly in 

recent decades and now plays a dominant role 

in some short-term credit markets (see Box 

D: Money Market Funds). While total assets 

under management have declined since their 

peak in 2009, MMFs continue to purchase a 

large share of private short-term debt issuance. 

Chart 5.2.24 Life and Other Insurance: Capital and Income

Chart 5.2.25 Household Financial Assets

Chart 5.2.26 Household Equity Holdings 5.2.26 Household Equity Holdings

t

Financial Developments 63
Other mutual fund assets, excluding MMFs, 

have increased 60 percent since year-end 2008, 

driven more by increases in the value of assets 

than by fund flows. Over this period, there have 

been large net inflows to emerging market 

equity funds, while net flows to domestic and 

other advanced country equity funds have been 

flat. Bond funds have seen net inflows over 

recent years: $900 billion has flowed into bond 

and hybrid funds since May 2008.

Mutual funds are liquid, holding at least 85 

percent of their assets in liquid securities, and 

are required to redeem investors’ shares for 

cash within seven days of an investor’s request 

for redemption. Exchange traded funds (ETFs), 

shares of which can be bought and sold on an 

intraday basis in secondary markets, have taken 

market share from mutual funds (see Chart 

5.2.28 and Box E: Exchange Traded Funds).

The use of leverage by mutual funds is 

generally constrained by statutory restrictions. 

Specifically, mutual funds’ explicit leverage 

is limited by an applicable asset coverage 

ratio of 300 percent. Mutual funds may take 

on additional implicit leverage via derivatives, 

although the SEC places limits on this activity.

The closed-end fund sector is much smaller, 

with assets under management of $250 billion 

as of the end of first quarter 2011. These funds 

issue nonredeemable equity securities that are 

traded on an exchange; thus, unlike mutual 

fund investors, closed-end fund shareholders 

look to the secondary market for liquidity in 

their shares. Under their regulations, closed-end 

funds are able to undertake greater leverage 

than mutual funds.

Retirement Funds

Retirement funds constitute an important 

category of U.S. household financial assets 

and are a source of long-term funds for the 

financial system. As of year-end 2010, the 

combined assets under management of private 

and public pensions stood at over $14.0 trillion. 

Government-managed pension plans make up 

just over one-quarter of total retirement funds 

(Chart 5.2.29). There are three main types of 

retirement funds: funds privately managed by 

Chart 5.2.27 Investment Management Industry

Chart 5.2.28 U.S. Mutual Fund and ETF Assets

Chart 5.2.29 5.2.29 Retirement Funds by Retirement Funds by Type Type

64 2011 FSOC Annual Report
individuals (for example, IRAs); defined benefit 

pension plans, in which certain future benefits 

are promised to beneficiaries; and defined 

contribution plans, which do not guarantee 

future benefits. 

Retirement funds have traditionally divided their 

assets among fixed-income securities (whose 

cash flows are managed to match the likely 

schedule of payouts in retirement), mutual 

funds, and equities (which offer the benefit of 

higher expected return). Between 1990 and 

2006, the allocation to equities increased in 

state and local government defined benefit 

plans as well as private ones. Since the crisis, 

private defined benefit plans have sharply 

decreased their allocation to equities, while 

state and local government funds, which 

are typically defined benefit plans, have not 

adjusted their allocation (Chart 5.2.30).

The declines in equity market valuations from 

2007 levels led to substantial investment losses 

across retirement fund types (Charts 5.2.31,

5.2.32, and 5.2.33). As a result of these losses 

and the decline in the assumed discount rates 

for these plans, the market value of assets 

fell significantly below the present value of 

liabilities for many private and public defined 

benefit plans. Public pension funds face more 

significant funding shortfalls than their corporate 

counterparts owing to their larger, longer term

liabilities, lower sponsor contributions in recent 

years, and the challenges facing state and local 

sponsors in making adequate plan contributions 

in the current fiscal environment (Chart 5.2.34). 

Investment Managers

Investment managers oversee approximately 

$8 trillion in separately managed accounts. This 

number has rebounded from $6 trillion at the 

end of 2008 but is still below the peak of $8.6 

trillion in 2007.

In separately managed accounts, investment 

losses fall solely on the account owner, 

so these accounts generally do not raise 

direct financial stability concerns. However, 

investment managers who pursue similar 

strategies across accounts and in associated 

managed funds (in part to capture economies 

Chart 5.2.30 Pension Fund Assets Allocated to Equities

Chart 5.2.31 State and Local Government Pension Plans

Chart 5.2.32 Private Defined Benefit Pension Plans

Financial Developments 65
Box E: Exchange Traded Funds

Exchange traded funds (ETFs) have grown to account for an increased share of the fund management sector. 

While regulations restrict synthetic-based ETFs in the United States, they are an important part of the European 

ETF market.

ETFs are generally passively managed, index-tracking 

funds traded on an exchange. While ETFs are relatively 

low-margin products for fund sponsors and market 

makers, they are rapidly gaining popularity as a means 

of achieving low-cost exposure to nearly any market

index, including emerging markets and commodities. 

Additionally, unlike traditional open-end mutual funds, 

ETF shares can be bought and sold on an intraday 

basis in liquid secondary markets. Since their inception 

in the 1990s, ETFs have grown to account for more 

than $1 trillion in assets, or approximately 13 percent of 

the long-term mutual funds industry (Chart E.1).

Chart E.1 U.S. Exchange Traded Funds (ETFs)

The U.S. ETF market generally provides long, 

unleveraged exposure to an underlying asset or 

asset class. Some ETFs enter into securities lending 

transactions to supplement returns and lower fees, 

which may somewhat increase their leverage and 

liquidity risk.

About 3 percent of total U.S.-domiciled ETF assets 

are synthetic, offering 2–3 times leverage through the 

use of derivatives. Synthetic ETFs have experienced 

limited growth in the United States, partly because 

strict regulatory standards limit the use of derivatives 

to replicate underlying indexes. These standards are 

applicable to the roughly 90 percent of ETFs registered 

under the Investment Company Act of 1940 (40 Act). 

For example, in March 2010, pending a review of 

current practices, the SEC froze the ability of new ETF 

sponsors to introduce 40 Act ETFs that would make 

significant investments in derivatives. U.S. rules require 

that a 40 Act ETF sponsor be separate from its ETF 

market maker, and that domestic ETFs must hold at 

least 85 percent of their portfolios in liquid assets. 

Together, these rules have limited flexibility to engage 

in derivatives-based activity and have rendered many 

synthetic structures uneconomical. 

E.1 U.S. Exchange Traded Funds (ETFs)

U.S.-domiciled funds make up approximately twothirds of global offerings. About 97 percent of total net 

assets of U.S.-domiciled ETFs are passively managed, 

seeking to mimic market or sector indexes such as the 

S&P 500. For the most part, these index funds hold a 

portfolio of underlying securities that replicate the return 

of the index, though they may exhibit small divergences 

from their net asset value (NAV) as a result of cash 

management or portfolio sampling issues (Chart E.2).

While tracking errors may be small, such deviations 

could lead to inefficiencies for institutional investors that 

are using ETFs to put on large hedged positions. 

Chart E.2 Major ETF Divergence From Net Asset Value (NAV)

E.2 Major ETF Divergence From Net Asset Value (NAV)

66 2011 FSOC Annual Report
Box E: Exchange Traded Funds 

In contrast, nearly half of European-domiciled ETFs 

synthetically replicate the underlying index using 

swaps and other derivatives. This increased complexity 

may lead to decreased ETF liquidity during times 

of heightened market volatility. Additionally, market 

participants—including banks providing swaps—might 

take on increased funding risk if ETFs suffered from a 

sudden loss of liquidity. U.S. investors and regulators 

should be alert to the possibility of liquidity or 

counterparty exposure risks emanating from foreigndomiciled ETFs spilling over to domestic institutions 

and markets. 

ETFs differ from another type of synthetic security: 

exchange traded notes (ETNs). ETNs are similar to ETFs 

in that they are traded on an exchange and provide 

returns based on an underlying benchmark or strategy. 

However, ETNs are actually structured notes that 

represent unsecured claims on the issuer rather than 

a claim on the underlying reference asset. (Structured 

notes are discussed in Section 5.2.8.) 

The rise of ETFs has been driven, in part, by the 

perception that liquidity is unavailable in traditional 

open-ended mutual funds. ETF shares are traded 

on exchanges like ordinary stocks, which enhances 

the ability of investors to quickly take on and shed 

risk. ETF sponsors do not restrict the daily creation 

or redemption of ETF shares by authorized liquidity 

providers. These authorized participants may be brokerdealers executing client orders or arbitragers exploiting 

and eliminating departures of ETF prices from their 

underlying portfolios. In contrast, mutual funds can only 

be bought or redeemed with the sponsor at the close of 

each day and may be subject to redemption fees. 

However, while these sources of liquidity generally 

benefit investors, they may also imply avenues through 

which liquidity could become constrained. For example, 

if a sponsoring broker-dealer were unable or unwilling 

to provide liquidity, the bid-ask spread could widen, 

leading to heightened price volatility. A departure of 

arbitragers from the market could result in ETF shares 

trading at a persistent discount or premium relative to 

their NAV, thus increasing tracking errors. 

Indeed, illiquid trading conditions triggered extreme 

volatility in the pricing of ETFs during the May 6, 2010, 

flash crash (see Section 5.3). 

Financial Developments 67 
of scale) could pose broader risks to financial 

markets by increasing the volume, and thus 

impact, of managers’ trading. Investment 

managers, along with mutual and pension 

funds, are generally not overtly leveraged. 

Alternative Investments: Private Equity

Private equity—investments in a company’s 

nonlisted equity capital—is an alternative form 

of financing to public equity and debt for firms 

that are unable to secure traditional funding or 

as a supplement to other capital. Private equity 

offers investment returns that are potentially 

enhanced by active ownership and strategic 

management, with investments taking the 

form of venture capital or buyouts of public 

shareholders. Characterized by long-term 

investment horizons with locked-up capital 

and high risk-return profiles, private equity 

has become a component of many diversified 

portfolios. Many private equity investments saw 

substantial losses in the crisis, and the number 

of private equity funds has fallen, along with the 

capital raised by these funds (Chart 5.2.35).

Alternative Investments: Hedge Funds

Assets managed by hedge funds increased 

19 percent in 2010 and currently stand at 

approximately $2 trillion, near the pre-crisis 

peak level reached in early 2008. Hedge funds 

continue to draw institutional investor interest, 

in part because of the perception that hedge 

funds are relatively less correlated to broad 

asset class movements. Industry growth 

has resumed despite somewhat lackluster 

performance in recent quarters (Charts 5.2.36 

and 5.2.37).

Following the crisis, institutional investor 

preferences for larger, more established funds 

with longer track records led to a greater 

concentration of industry assets at larger firms 

(Chart 5.2.38). However, flows have recently 

shifted toward medium-sized firms. 

Leverage in the industry remains below precrisis levels, with factors related to both the 

demand for and supply of leverage playing 

important roles. The forced liquidations and 

large redemptions some funds experienced 

during the financial crisis have prompted 

Chart 5.2.33 Private Defined Contribution Pension Plans

Chart 5.2.34 Public and Private Pension Funding Level

Chart 5.2.35 Private Equity

68 2011 FSOC Annual Report
less demand for leverage, with many funds 

preferring a liquidity cushion in the event of 

adverse market moves. Stricter regulatory 

capital requirements and internal changes to 

prime brokers’ financing practices have also led 

to a reduced supply of leverage. Nonetheless, 

both the demand for and supply of leverage are 

above the lows of early 2009, especially among 

fixed-income arbitrage, credit trading, and 

global-macro funds.

Historically, regulators have had little reliable, 

detailed information regarding the activities 

of any particular hedge fund or hedge funds 

in general, which is of concern because of 

their increased role in the financial system. 

For example, hedge fund lenders may be 

increasingly important sources of funding for 

middle-market companies that have little access 

to public capital markets. Having information 

on hedge funds could be helpful for monitoring 

emerging financial market vulnerabilities that 

could affect hedge funds and the parties with 

whom they trade or from whom they obtain 

leverage (such as prime brokers). In January 

2011, the SEC and the CFTC jointly proposed 

a new data collection form that would gather 

detailed information from hedge funds. 

Part II. Markets and Infrastructure

5.2.6 Short-Term Wholesale Funding

Short-term wholesale funding markets 

play a central role in the financial system 

by providing financial intermediaries with 

funding to support their activities. However, 

these markets are inherently fragile owing to 

the frequent need to roll over maturing debt 

and the sensitivity of institutional investors 

to perceptions of risk. The larger footprint 

of short-term wholesale debt markets in 

the financial system before the crisis likely 

reduced market and institutional resiliency.

Like retail bank deposits, short-term wholesale 

funding markets play an important role in 

the financial system by providing financial 

intermediaries with liquidity to support 

their activities. On the other side of these 

transactions, short-term wholesale debt—

which includes large time and checking 

Chart 5.2.36 Change in Hedge Fund AUM

Chart 5.2.37 5.2.37 Hedge Fund Performance By Strategy Hedge Fund Performance By Strategy

.

Chart 5.2.38 5.2.38 Distribution of Net Asset Flows by Size of Fund Distribution of Net Asset Flows by Size of Fund

Financial Developments 69
deposits, repos, and CP—meets the demand 

of institutional cash managers, such as large 

corporations, for liquid investments. Growth in 

these markets outpaced that of retail deposits 

in recent decades, driven by technological, 

regulatory, economic, and other factors 

that have changed financial institution and 

investment management practices (Chart 

5.2.39). In particular, institutional cash 

managers once kept most of their liquid funds 

in checkable or time deposit accounts at 

banks. Since the 1970s, however, they have 

placed a large and increasing portion of their 

liquid funds in MMFs and other intermediaries, 

which, in turn, invest heavily in repos, CP, and 

other short-term debt markets that do not 

have access to the FDIC’s deposit insurance 

(Chart 5.2.40).

The proportion of short-term wholesale U.S. 

dollar debt issued by foreign banks increased 

markedly before the crisis and remains 

elevated. Many foreign banks have large U.S. 

dollar funding needs because of their holdings 

of U.S. assets and because of the increasingly 

global nature of banking. Rather than incur 

the restrictions and costs associated with 

establishing a U.S.-chartered commercial 

bank, many foreign institutions meet dollar 

funding needs by issuing large time deposits 

from foreign branches located in the United 

States or through funding subsidiaries that 

issue commercial paper. Even though foreign 

branches have access to the Federal Reserve’s 

discount window, they are not allowed to issue 

insured deposits. By the end of 2006, foreign 

banks issued 45 percent of unsecured financial 

CP, sponsored 60 percent of ABCP conduits, 

and issued 42 percent of commercial bank large 

time deposits. Although sponsorship of ABCP 

conduits has declined, foreign banks constitute 

an even larger share of unsecured CP and large 

time deposits (Chart 5.2.41).

The growth of different forms of short-term 

debt instruments also corresponds with the 

broader trends of nonbank credit intermediation 

and the heightened importance of capital 

markets. Credit intermediation involving entities 

outside the banking system—so-called shadow 

banking—increased substantially leading up 

Chart 5.2.39 Retail Deposits vs. Short-Term Wholesale Funding

Chart 5.2.40 Composition of Short-Term Wholesale Funding

5.2.40 Composition of Short-Term Wholesale Funding

Chart 5.2.41 FBO Share of US$ Short-Term Wholesale Debt

70 2011 FSOC Annual Report
to the crisis. Significant reliance on short-term 

wholesale funding made these entities and the 

complex web of activities they supported more 

vulnerable to shocks than insured depository 

institutions. 

These entities also became a source of 

vulnerability to the commercial banking 

system. For example, banks and other financial 

institutions implicitly and explicitly supported a 

large volume of short-term wholesale funding 

instruments, including ABCP conduits and a 

variety of other short-term collateralized debt

(Chart 5.2.42). Before recent accounting 

reforms (see Box F: Improvements in 

Regulatory Capital and Accounting 

Measures of Assets), assets underlying these

funding arrangements were generally offbalance sheet. This kind of accounting allowed 

for favorable capital treatment, bolstered 

equity returns of the sponsoring institution, 

and reduced perceptions of the risk associated 

with these arrangements. However, investors’ 

concerns regarding the quality of ABCP 

collateral, the viability of financial guarantors, 

and the ability of financial institutions to provide 

the promised liquidity support prompted a sharp 

contraction in demand for these instruments 

beginning in mid-2007. Banks and other 

financial institutions purchased the underlying 

assets out of implicit or explicit obligation, 

placing significant strain on their funding and 

capital positions. 

A major portion of the pre-crisis increase in 

the short-term wholesale funding markets was 

associated with the repo market. By using 

securities as collateral, repurchase agreements 

facilitate the extension of low-cost short-term 

financing to holders of high-quality securities. 

While the size of the repo market is difficult to 

estimate because of netting and accounting 

conventions, it had clearly grown rapidly leading 

up to the crisis and had become a key funding 

source for broker-dealers and hedge funds

(Chart 5.2.43). Changes to bankruptcy laws 

that allowed lenders to take possession and 

liquidate repo collateral—notwithstanding the 

automatic stay otherwise applicable in the 

bankruptcy process—likely reduced the cost of 

securities financing, increased securities market

Chart 5.2.42 Short-Term Collateralized Debt

Chart 5.2.43 Estimated Size of Repo Market

Financial Developments 71
Box F: Improvements in Regulatory Capital and 

Accounting Measures of Assets

A firm’s capital allows it to absorb unexpected losses on its assets. For regulators to enforce appropriate capital 

standards, they need a comprehensive measure of the firm’s total risk exposure. Before the crisis, many financial 

institutions avoided higher capital charges relating to particular assets by holding them in off-balance-sheet 

vehicles. In addition, some capital risk charges did not appropriately reflect the risk of certain asset classes. 

Regulatory changes and accounting rules have been implemented to address these issues, and more changes 

are planned.

Consolidating Assets on Balance Sheet 

In June 2009, the U.S. Financial Accounting Standards 

Board (FASB) introduced two amendments to financial 

accounting standards that change the way companies 

account for transfers of financial assets and specialpurpose entities. The amendments, which took 

effect for most financial institutions in January 2010, 

addressed the weakness that financial statements did 

not fully reflect material assets and liabilities associated 

with certain securitizations in which the securitizers 

retained an interest but did not have to record them on 

their balance sheets.

Amendments to Accounting Standards Codification 

(ASC) Topic 860, “Transfers and Servicing,” revised the 

requirements for derecognizing assets. Among other 

changes, the amendments eliminated the concept of a 

“qualifying special-purpose entity,” thereby subjecting 

more mortgage- and asset-backed securitizations to 

consolidation on the balance sheet. An institution that 

sells certain loan participations is required to retain 

those interests on its balance sheet unless it transfers 

those participations on a strictly pro- rata basis as to 

both payment and default risk. 

Similarly, ASC Topic 810, “Consolidation,” requires 

that a bank consolidate on its balance sheet certain 

“variable interest entities” that previously were permitted 

to remain off the balance sheet. Specifically, ASC 810 

may require consolidation if an affiliate of the bank 

retains control over the financial assets and retains 

certain economic rights or obligations with respect to 

the assets. 

ASC 860 and ASC 810 require additional disclosures 

regarding holdings of variable interests, transfers of 

financial assets, and continuing involvement with 

transferred assets. Securitization requirements 

introduced by the Dodd-Frank Act, mandating the 

retention of an economic interest in the credit risk 

of assets that an entity securitizes, could lead to 

consolidation of newly securitized assets under these 

requirements.

Leverage Ratio

U.S. regulators also require insured commercial banks 

and savings institutions to satisfy a leverage ratio 

requirement. A leverage ratio provides for a base of 

capital relative to assets and thus constrains the extent 

to which institutions can lever themselves. The ratio 

provides a backstop against the possibility of model 

risk or other mis-measurement of risk in the risk-based 

capital rules. For many years, the U.S. leverage ratio 

did not incorporate off-balance-sheet exposures, on the 

theory that those are captured by the risk-based capital 

requirements. Among other changes, the new Basel 

III agreement includes a leverage ratio standard that 

applies to both on- and off-balance-sheet exposures, 

including an add-on for potential future exposure for 

over-the-counter derivatives. Section 171 of the DoddFrank Act establishes the risk-based and leverage 

capital requirements that are generally applicable to 

insured banks as a floor for certain regulatory capital 

rules. 

Risk-Based Capital

The basis of risk-based capital is an assessment of 

how much risk a given class of exposure contains. 

The standards for performing this assessment have 

changed over time. Both insurance and banking 

regulators use risk-based capital measures as one tool 

in their assessment of the safety and soundness of 

supervised institutions.

72 2011 FSOC Annual Report
Box F: Improvements in Regulatory Capital and Accounting Measures of Assets 

Banks and Savings Institutions

The original Basel capital standards used fixed weights 

for particular types of credit risk exposure. For example, 

certain single-family residential mortgage loans received 

a risk weight of 50 percent, while commercial loans 

received a weight of 100 percent. For institutions with 

large exposures to market risk, risk weights are derived 

from value-at-risk calculations for general market risk 

and either a standardized approach or value-at-risk 

approach for idiosyncratic risks. In addition, risk weights 

are applied to off-balance-sheet exposures, including 

counterparty credit risk arising from derivatives and 

some lending commitments.

In 2007, the U.S. regulators issued a rule implementing 

Basel II for internationally active banks and bank 

holding companies (BHCs). Basel II incorporates 

operational risk exposure and relies more on firms’ 

internal data regarding the riskiness of exposures. The 

rule requires a banking organization to demonstrate 

the rigor of its internal risk measurement systems to 

its supervisor for at least one year before using those 

systems for risk-based capital purposes. Currently 

a number of BHCs (representing the majority of U.S. 

banking system assets) are in this “parallel run” stage 

and are making the necessary systems refinements to 

exit the parallel run.

The new Basel III agreement enhances the coverage 

of market risk. Certain high-risk positions, such as 

structured credit, will now face much higher capital 

charges. Basel III also introduces explicit charges 

for the mark-to-market losses (also known as credit 

valuation adjustments) of counterparty credit risk and 

makes it more costly to extend credit to other financial 

institutions. These new requirements will make it more 

expensive for institutions to engage in activities that 

were destabilizing during the financial crisis.

Insurance Companies

A significant component of risk-based capital for U.S. 

insurance companies is based on an assessment of 

credit quality of (and hence the risk of loss on) an 

insurer’s investment portfolio. For bonds rated by at 

least one of the nationally recognized statistical rating 

organizations (NRSROs), state insurance regulators 

for many years relied on a formulaic approach to 

translating NRSRO ratings into NAIC designations. 

Beginning in 2009 for residential mortgage-backed 

securities (RMBS) and 2010 for commercial mortgagebacked securities (CMBS), the state insurance 

regulators changed the process by which individual 

holdings of insurers are assigned designations of 

creditworthiness. This change was made because of 

volatility and risk in the residential and commercial 

mortgage markets. The new approach focuses on 

modeling each security and developing expected 

recovery values assuming the securities are held to 

maturity. Significantly, the expected recovery values 

are compared with individual companies’ carrying 

values, reflecting the different risk profile of securities 

held at significant discounts to par value. NRSRO 

ratings assume holding at par, but in a volatile 

marketplace securities are frequently purchased at 

deep discounts. In an economic environment that 

has seen extreme stress, conservative valuation rules 

under statutory accounting principles require an 

insurer to take capital impairments. The new process 

of evaluating and designating the creditworthiness of 

insurer-held RMBS and CMBS more accurately reflects 

the risk of loss.

Financial Developments 73
liquidity, and facilitated the growth of parts 

of the asset management industry. However, 

the use of the repo market as an important 

source of short-term leverage increased 

funding vulnerabilities among key investors and 

intermediaries during the crisis. 

Repos can be transacted either bilaterally 

between two market participants or through an 

intermediary, such as a clearing bank, which 

administers the exchange of cash and collateral 

between dealers and lenders (Chart 5.2.44).

Initially smaller and limited to U.S. Treasury and 

agency collateral, the tri-party market grew to 

$2.7 trillion in 2008 (Charts 5.2.45), fueled by 

increases in securities issuance (which boosted 

the secured financing need of market makers), 

large inflows of funds into MMFs, and cost 

reductions associated with centralized collateral 

management at the clearing bank. Despite the 

decline in the size of the market, tri-party repo 

remains a key source of financing for brokerdealers and other financial market participants 

(Charts 5.2.46 and 5.2.47).

The providers of funds in short-term 

wholesale markets are institutional investors 

such as corporations and asset managers 

motivated primarily by liquidity and safety 

of principal. Strong growth in the cash and 

liquid asset holdings of the corporate and 

asset management sectors in the years 

before the crisis supported the issuance 

of short-term wholesale debt. These cash 

investors often use money market funds and 

other intermediaries to diversify counterparty 

exposures and centralize risk management 

and operations. The growing prevalence of 

short-term wholesale debt—as well as the size 

and risk sensitivity of the institutional investor 

base—likely reduced market and institutional 

resiliency before the crisis. 

Growth in liquid asset and cash holdings was 

particularly pronounced in the corporate and 

securities lending sectors in the pre-crisis 

period (Chart 5.2.48). Cash and related 

investments among corporations have 

increased at rates exceeding GDP, and they are 

a larger share of total assets than in the early 

1990s. In addition, the growth in the securities 

Chart 5.2.44 5.2.44 Bilateral vs. Tri-party Repo Market Bilateral vs. Tri-party Repo Market

Chart 5.2.45 5.2.45 Estimated Value of the Estimated Value of the Tri-party Repo Market Tri-party Repo Market

Chart 5.2.46 5.2.46 Tri-party Repo Collateral Tri-party Repo Collateral

74 2011 FSOC Annual Report
lending industry—which supplies securities 

to broker-dealers, hedge funds, and others in 

exchange for cash collateral—has prompted 

a substantial increase in related short-term 

investing. Cash collateral reinvestment from 

securities lenders grew from about $300 billion 

in 1999 to about $1.2 trillion in 2007. During 

this period, large broker-dealers expanded 

their prime brokerage business with leveraged 

hedge funds that engaged in fee-generating 

activities such as securities lending. However, 

lower demand for securities among brokerdealers and hedge funds, as well as heightened 

counterparty concerns among securities 

lenders, prompted a sharp decline in securities 

lending and related cash reinvestment volumes 

(Chart 5.2.49). In addition, the weighted 

average duration of cash reinvestment declined 

as cash management agents reduced risk in 

response to the crisis. 

5.2.7 Financial Infrastructure

Advances in technology and improvements 

to infrastructure—such as exchanges, central 

counterparties, and data repositories—have 

altered the landscape significantly, providing 

financial markets with improvements to 

efficiency and transparency.

Exchanges and Electronic Trading Platforms

Changes in technology and trading practices 

have affected exchanges, encouraging a 

migration of trading from exchange floors to 

electronic trading platforms. For example, 

electronic trading accounted for approximately 

83 percent of volume in U.S. futures markets 

in 2010 (Chart 5.2.50). There has also been 

a notable increase in the use of algorithmic 

trading. Extraordinarily high-speed computer 

programs facilitate both large-block trading 

on the part of professional investors seeking 

to minimize their impact on prices (execution 

algorithms), and proprietary trading strategies 

that can rapidly buy and sell the same 

security or future many times per second 

(high-frequency trading). The latter type of 

computerized trading is believed to account for 

50 percent or more of total volume. 

Chart 5.2.47 Tri-party Repo Collateral Distribution 5.2.47 Tri-party Repo Collateral Distribution 

Chart 5.2.48 Wholesale Cash Investors

Chart 5.2.49 Securities Lending Cash Reinvestment

Financial Developments 75
Additionally, these types of trading venues have 

become more fragmented. Over the past 18 

months, the market share of reported trading 

volume executed on undisplayed venues 

(composed of “dark pools” and broker-dealers 

executing trades internally) has increased to 

more than 30 percent (Chart 5.2.51). As of 

May 2011, no single publicly quoting exchange 

platform had more than one-fifth of market share. 

Infrastructure Supporting Derivatives Markets

Infrastructure supporting derivatives markets is 

also undergoing significant change, with certain 

asset classes—such as the interest rate swap 

market—driving these developments. Trading, 

central clearing, and reporting in OTC derivative 

trades are likely to undergo significant changes 

as regulators begin finalizing, adopting, and 

enforcing rules that further strengthen OTC 

markets through organized platform trading, 

central clearing of standardized products, and 

mandatory trade reporting. 

Historically, because OTC derivatives instruments 

are designed to allow market participants 

flexibility in customizing transactions, they have 

been significantly less standardized and less 

liquid than their listed (or exchange traded) 

counterparts. The proportion of OTC relative 

to exchange traded derivatives varies widely 

by asset class. For example, virtually all credit 

derivatives are traded OTC, while in equities, 

there is significant liquidity in exchange traded 

futures and options globally (Charts 5.2.52,

5.2.53, and 5.2.54). For this reason, many 

OTC derivatives trading and risk management 

functions were conducted in a bilateral and 

distributed manner, without the use of organized 

trading platforms or centralized clearing 

arrangements. This made it difficult to quantify 

and characterize global activity and manage 

counterparty credit risk exposures. 

Trends toward organized platform trading and 

central clearing are helping to address these 

challenges. In conjunction with increases in 

organized platform trading, the use of central 

counterparties in the United States, as well as 

the different types and volumes of derivatives 

cleared by them, is increasing (Chart 

5.2.55). A central counterparty clearinghouse 

Chart 5.2.50 U.S. Futures and Options Trading

Chart 5.2.51 Trading Venues for U.S. Equities by Market Share 5.2.51 Trading Venues for U.S. Equities by Market Share

Chart 5.2.52 OTC and Exchange Traded Derivatives Growth

76 2011 FSOC Annual Report
serves principally to ensure performance of 

the contractual obligations of the original 

counterparties to derivatives transactions and 

to manage the day-to-day risks and default 

risk associated with these obligations and 

counterparties, each of whom is a member of 

the clearinghouse. This is accomplished by 

interposing the central counterparty between 

bilateral participants, so that it becomes the 

buyer to every seller and the seller to every 

buyer (Charts 5.2.56 and 5.2.57). This 

arrangement allows the central counterparty 

to hold little or no net market exposure and to 

provide its core function of centrally managing 

the credit and operational risks arising from the 

obligations incurred by its members. 

Efforts to enhance market transparency in the 

derivatives markets are also benefiting from 

advances in trade reporting. Three major OTC 

derivatives trade repositories currently operate 

and support credit, interest rate, and equity 

derivatives markets. In other asset classes, 

including commodity and foreign exchange 

markets, industry efforts to develop centralized 

trade repositories are under way, including the 

issuance of public requests for proposals. 

Outside derivative markets, participants in fixedincome markets are also increasingly using 

trade reporting systems to track transactions 

as they occur. For example, since 2005, the 

Financial Industry Regulatory Authority, the 

self-regulatory organization for securities firms 

(formerly the National Association of Securities 

Dealers), has required that broker-dealers report 

virtually all secondary market transactions in 

U.S. corporate bonds to the Trade Reporting 

and Compliance Engine. 

Payment and Settlement Systems

Wholesale financial infrastructure in the United 

States handles, on a daily basis, over $13 

trillion in U.S. payment, settlement, and clearing 

activity—nearly the amount in dollar terms of 

the goods and services that the U.S. economy 

produces annually (Chart 5.2.58). This activity 

includes many types of transactions, such as 

multinational companies borrowing foreign 

currency to support international trade, brokers 

Chart 5.2.53 OTC and Exchange Traded Derivatives

Chart 5.2.54 Exchange Traded Derivatives

Chart 5.2.55 U.S. Regulated Derivatives Central Counterparties

5.2.55 U.S. Regulated OTC Derivatives Central 

Counterparties

Financial Developments 77
buying stocks or bonds on behalf of clients, 

and large financial institutions accessing shortterm funding markets to borrow billions of 

dollars overnight to cover daily funding needs. 

The smooth functioning of these complex and 

interconnected systems, both privately and 

publicly run, is vital to the financial stability of 

the U.S. economy (Chart 5.2.59).

The settlement of money can occur on the 

books of a central bank, a commercial bank, or 

a private sector financial infrastructure. Fedwire 

Funds is a dedicated funds transfer network 

operated by the Federal Reserve Banks; it 

allows commercial banks to settle payment 

obligations for their own business purposes 

and on behalf of their clients on the books of 

the central bank. It is also a cash settlement 

agent for many other private sector systems 

to facilitate their payment, clearing, and 

settlement activity. Fedwire Securities Service, 

which allows for the transfer of securities, 

was implemented by the Federal Reserve to 

reduce risk, expense, and delay in the transfer 

of securities; it also plays a role in the clearing 

and settlement of U.S. Treasuries and other 

government-related securities. The Clearing 

House Interbank Payments System (CHIPS) 

is the largest private wholesale payment 

system for settling large payments between 

financial institutions (Charts 5.2.60 and

5.2.61). New private systems have emerged 

to meet the growth of cross-border payments. 

For example, CLS Bank International (CLS), 

which virtually eliminates the settlement risk 

associated with foreign exchange transactions, 

is the largest multicurrency cash settlement 

system in the world.

Since the 1990s, payment and settlement 

systems have gone through significant 

changes with the introduction of risk-reducing 

features such as real-time gross settlement 

(RTGS) for large-value payment systems and 

delivery versus payment (DVP) for securities 

settlement systems. Before this, most largevalue payment systems operated as deferred 

net settlement systems, which settle at the 

end of the day. RTGS systems, which settle 

on a continuous basis, allow for payments to 

Chart 5.2.56 Bilateral Execution

5.2.56 Bilateral Execution

Chart 5.2.57 Execution Through Central Clearing 5.2.57 Execution Through Central Clearing 

Chart 5.2.58 5.2.58 Average Daily USD Payment Flows in 2010 Average Daily US$ Payment Flows in 2010

. 

78 2011 FSOC Annual Report
be finalized throughout the day. This reduces 

the buildup of potential intraday exposures, 

lowering the amount of liquidity used (mainly 

central bank money) while reducing costs. 

Similarly, DVP systems—which allow for the 

gross, simultaneous settlement of securities 

and funds—ensure that delivery occurs if, and 

only if, payment occurs. These changes were 

largely driven by advances in information and 

communication technology and have resulted in 

the immediate, final, and irrevocable settlement 

of funds and securities. 

5.2.8 New and Emerging Financial Products

The introduction and growth of new products 

is partly driven by firms and markets seeking 

new avenues of funding and trading liquidity. 

Against a backdrop of a slowdown in credit 

growth, the dominance of the GSEs in 

securitized mortgages, and uncertainty over new 

regulations, the introduction of new financial 

products has been limited. Nonetheless, 

innovation is already occurring in response to 

regulatory pressures designed to increase the 

strength and resilience of the system. 

For example, prudential regulators are 

setting standards that will require banks 

and financial institutions to extend the 

maturity of their liabilities, while the SEC is 

requiring MMFs to shorten the term of the 

assets they hold. These new requirements 

have led to the introduction of collateralized 

commercial paper, which meets the liquidity 

requirements for investments by MMFs and 

satisfies the need for financial institutions 

to extend funding beyond one month 

to meet the new stressed funding ratio 

requirements. Collateralized CP is intended 

to expand funding sources for a variety of 

debt and equity securities currently funded 

via tri-party repo. The bank sets up a special 

purpose vehicle (SPV) to face the bank on 

repo transactions. The SPV funds itself with 

proceeds from CP issuance to cash investors, 

using the proceeds to enter into traditional 

repo agreements rather than to buy term 

assets, as an ABCP conduit would (Chart 

5.2.62).

Chart 5.2.59 U.S. Financial Infrastructure 5.2.59 U.S. Financial Infrastructure

Source: Federal Reserve Chart 5.2.60 Annual Payment Clearing Volumes 5.2.60 Annual Payment Clearing Volumes

Chart 5.2.61 Annual Payment Clearing Values

5.2.61 Annual Payment Clearing Values

Financial Developments 79
For issues of collateralized CP to date, 

accounting treatment of the SPV limits the 

opportunity for regulatory capital arbitrage. 

Ratings of the structures are pegged to the 

rating of the sponsoring bank and do not 

receive a “ratings uplift” above the bank’s 

rating based on support from potentially illiquid, 

difficult-to-price collateral or other structural 

features. Although collateralized CP issuance 

has been negligible, increased activity could 

give rise to potential vulnerabilities, particularly 

as the products evolve.

Financial innovation can also involve the 

evolution of existing products in new forms. 

Two examples are exchange traded funds 

(ETFs) and structured notes. ETFs have 

experienced rapid growth and offer an 

increasing diversity of fund types (see Box E: 

Exchange Traded Funds).

Structured notes, issued primarily by banking 

entities, are an important source of funding 

for some institutions. These notes are senior 

unsecured debt instruments that have a 

derivative element. The return on structured 

notes is based in part on the performance of 

one or more underlying reference assets, such 

as equities, commodities, or interest rates. 

While the return on a structured note depends 

on that of a reference asset, the structured note 

remains a recourse obligation of the issuer and 

is subject to default risk. 

Unlike many other structured products, 

issuance of structured notes has been broadly 

maintained around pre-crisis levels (Chart 

5.2.63). U.S. dollar-denominated structured 

notes are concentrated in interest-rate-linked 

and equity-linked products to a slightly greater 

extent than non-U.S. dollar-denominated notes 

(Charts 5.2.64 and 5.2.65).

For financial institutions, structured notes offer 

an alternative source of unsecured funding, 

fee income from design and distribution, and 

a potentially economical way to distribute 

trading book risk. Structured note designs 

are very heterogeneous and can embody 

a high degree of complexity, leverage, or 

optionality, presenting challenges for issuing 

Chart 5.2.62 Collateralized Commercial Paper Market 5.2.62 Collateralized Commercial Paper Market

Chart 5.2.63 Global Structured Note Issuance

Chart 5.2.64 US$ Structured Notes by Asset Class

80 2011 FSOC Annual Report
firms’ market and liquidity risk management. 

Also, the embedded derivatives require firms 

to dynamically hedge most structured notes, 

exposing the issuer to gap risk—the potential 

of losses owing to a sudden and sustained 

movement in underlying prices. Firms may 

therefore need to rely on consistent access to 

liquid markets.

5.3 Resilience of the Financial 

System

Many parts of the financial system were not 

sufficiently resilient to function through the 

financial crisis without government support. 

Interconnections among financial institutions 

were complex and poorly understood. 

Improvements in capital, funding structures, 

transparency, and regulatory and accounting 

standards have been undertaken to enhance 

the resilience of the financial system, but further 

improvement is necessary in a number of areas. 

5.3.1 Capital

Capital levels and the capital quality 

of financial institutions have increased 

significantly since the financial crisis owing 

to a return to profitability, capital raising, 

regulatory changes, and a dramatic drop in 

distributions to shareholders.

For leveraged financial institutions, capital 

acts as a shock absorber for unexpected 

losses. Because the financial system is highly 

interconnected, low capital of institutions in one 

part of the system can have adverse effects on 

other parts of the system. Financial institutions 

have significant obligations to each other: the 

U.S. financial sector had gross liabilities of 

about $61.7 trillion at the end of first quarter 

2011, almost twice the gross liabilities of the 

nonfinancial private sector (Chart 5.3.1). The 

gross liabilities of the financial sector, which 

were about one-and-a-half times GDP in the 

early 1980s, have been more than four times 

GDP in recent years (Chart 5.3.2).

As a result of the interconnections in the 

financial sector, the disorderly insolvency of 

a financial institution—or the fear of such an 

event—can impair the ability of the entire 

Chart 5.2.65 Non-US$ Structured Notes by Asset Class

Chart 5.3.1 Financial to Private Sector Gross Liabilities

Chart 5.3.2 Financial Sector Gross Liabilities to GDP

Financial Developments 81
financial system to provide its services to the 

real economy, which in turn can adversely 

affect the real economy. Therefore, a financial 

institution’s insolvency can potentially have 

a more severe impact than the insolvency 

of a nonfinancial business. Consequently, 

because capital acts as a shock absorber for 

unexpected losses, it is central to the financial 

system’s resilience to adverse developments 

and the resilience of the entire economy.

The crisis illustrated that many parts of the 

U.S. financial system were undercapitalized 

relative to the risk posed by unexpected 

losses in their assets (Chart 5.3.3). For 

example, a number of asset classes that had 

some of the lowest risk weights according to 

regulatory capital requirements experienced 

severe losses in the crisis (see Box F: 

Improvements in Regulatory Capital and 

Accounting Measures of Assets). These 

classes included residential mortgages, highly 

rated MBS and structured securities, and 

trading activities. Further, the crisis showed 

that some of the capital instruments held 

by banks to meet regulatory requirements 

were less able than anticipated to absorb the 

losses during this period. 

The overall U.S. financial system now has a 

much higher level and quality of capital than 

it did in 2007 for several reasons. One source 

of improvement is the exigent assistance 

provided by the government to Fannie Mae 

and Freddie Mac. Another temporary source 

of the improvement was the preferred capital 

provided through the TARP, most of which 

has since been repaid to the government. 

A permanent source of improvement is the 

increase in privately sourced high-quality 

capital at regulated banking institutions 

(Chart 5.1.17). Many banks also lowered 

or suspended capital distributions during 

the crisis, some in response to government 

insistence (Chart 5.3.4). The rise in capital 

ratios for the system also partly reflects the 

failure of weak specialty mortgage finance 

institutions, which removes undercapitalized 

firms from the aggregate. The remaining 

specialty finance companies primarily are 

Chart 5.3.3 Change in Tier 1 Common Ratios for Large BHCs

Chart 5.3.4 Large BHC Dividends and Repurchases

82 2011 FSOC Annual Report
stronger, better-capitalized institutions focused 

on secured business and consumer lending. 

The SCAP focused on the level of common 

equity of the 19 banking firms assessed using 

a measure based on common equity that was 

consistent with existing regulatory rules, referred 

to as tier 1 common, relative to risk-weighted 

assets. Tier 1 common is higher quality than 

other forms of capital. Under the SCAP, some 

firms were required to raise additional capital 

in 2009 so that their tier 1 common ratio would 

remain above 4 percent in a hypothetical, more 

adverse macroeconomic scenario. 

The aggregate dollar amount of tier 1 common 

equity at BHCs increased by $333 billion to 

$912 billion from first quarter 2009 through 

first quarter 2011, and the tier 1 common ratio 

increased by 4.1 percentage points to 10.1 

percent. These increases were due to private 

capital raising, conversion of preferred equity to 

common equity, and retained earnings (Chart 

5.3.5). In addition, reserves for expected loan 

losses increased by $22 billion to $200 billion 

over this period. Consequently, as of first 

quarter 2011, the banking system had $1.11 

trillion of tier 1 common equity plus loan loss 

reserves to absorb losses. 

The vast majority of the top 100 U.S. BHCs 

now hold sufficient amounts of high quality 

tier 1 common equity, to easily exceed 

regulatory minimums for all forms of capital 

(Charts 5.3.6 and 5.3.7).

Stronger bank capital and liquidity standards 

have been a key element of the G-20 financial 

sector reform objectives, and the United 

States has been significantly involved with the 

Basel Committee on Banking Supervision and 

its oversight body, the Group of Governors

and Heads of Supervision, to help this work 

progress. This global regulatory framework for 

bank capital (often referred to as “Basel III”) 

was published on December 16, 2010. The 

new framework strengthens the resilience of the 

banking system through a number of prudential 

measures (see Box G: Analytical Basis for 

Basel III Capital Standards). Staff at the 

federal banking agencies are currently working 

Chart 5.3.5 Change in Tier 1 Common Ratios for Large BHCs 5.3.5 Change in Tier 1 Common Ratios for Large BHCs

Chart 5.3.6 Aggregate Large BHC Capital Ratios

Chart 5.3.7 Tier 1 Common at the 100 Largest BHCs

Financial Developments 83
Box G: Analytical Basis for Basel III Capital Standards 

Capital—the excess of assets over liabilities—is the most important measure of a bank’s viability. Banks need 

to hold sufficient capital to handle financial stress, since the owners of a bank’s capital must bear unexpected 

losses. Determining the appropriate level of capital is a challenging task for banks and their supervisors. Since 

the global financial crisis, international supervisors have introduced new standards that will lead to much higher 

capital levels.

Highlighting the importance of capital and the need 

for consistency, international supervisors on the Basel 

Committee on Banking Supervision have agreed to

an international standard since 1988 (Basel I). The 

standard was revised significantly in 2004 (Basel II). 

During the financial crisis, many banks and other large 

financial institutions did not have sufficient capital 

to reassure creditors and other counterparties that 

they would survive as going concerns. Supervisors 

launched a range of analytical projects to determine the 

appropriate level for a new capital standard.

The result of those efforts was the Basel III accord, 

which was agreed to in late 2010. The new standard 

includes a higher minimum capital requirement of 

4.5 percent of risk-weighted assets, which is the 

amount of capital that a bank would generally need 

to be regarded as a viable concern; a new “capital 

conservation buffer” of 2.5 percent to provide a 

cushion during financial shocks and enable banks to 

remain above the 4.5 percent minimum; and more 

stringent risk-weights on certain types of risky assets, 

particularly securities and derivatives. 

Crucially, Basel III also defines capital more narrowly 

than the previous Basel agreements. The new tier 1 

common capital measure is limited mainly to common 

equity, because common stockholders are the only 

investors who are reliably available to absorb losses 

during a financial crisis. 

Banks will be significantly more resilient to financial 

shocks under the new standard.

To determine the 2.5 percent conservation buffer, 

supervisors examined stress test results from several 

jurisdictions as well as historical data on the experience 

of banks during the recent financial crisis and earlier 

stress episodes. The buffer is designed to partly 

mitigate the impact of pro-cyclicality on bank balance 

sheets: building capital in good times and shrinking 

during periods of stress.

To determine the 4.5 percent minimum standard, 

supervisors analyzed the historical distribution of net 

income in the banking industry relative to risk-weighted 

assets. Unlike the calibration of the conservation 

buffer, which was based on periods of stress, the 

calibration of the minimum was meant to apply across 

all points in time.

The analysis provided important insights into the scale 

of losses experienced historically by banks in various 

countries. The chart illustrates the 99th percentile of 

losses experienced by banks in the countries that 

participated in the Basel discussions. In other words, 99 

percent of the time, banks performed better than these 

levels (Chart G.1). The assumption underlying this 

Chart G.1 Return on Risk-Weighted Assets: 99th Percentile

84 2011 FSOC Annual Report
Box G: Analytical Basis for Basel III Capital Standards

analysis is that if capital were set at a level that could 

absorb a high-percentile net loss realization during a 

period of stress, creditors and counterparties would 

view the bank as a viable concern. The table shows the 

same calculations for U.S. bank holding companies, 

looking at different periods, samples of banks, and 

percentiles (Chart G.2).

There are some reasons to treat these numbers with 

caution as to the true extent of possible losses. First, 

if a bank failed, its last quarters of (presumably) very 

large losses might not be captured in the data. In 

addition, any losses that were avoided as the result of 

interventions—including actions such as guarantees, 

loss-sharing arrangements, and resolution funds—

would not be reflected in these data.

According to these results, the 99th percentile 

experience for net income relative to risk-weighted 

assets ranged from a 1 percent gain to a loss of more 

than 8 percent. The median value across all countries 

was a loss of 4 percent. Taking various adjustments into 

account (under the new standard, risk-weighted assets 

will generally be higher than under the old standard), the 

committee viewed these results as confirming the new 

4.5 percent regulatory minimum. 

Chart G.2 Percentile of the Distribution of After-Tax Net Income to RWA for U.S. BHCs

G.2 Percentile of the Distribution of After-Tax Net Income to RWA for US BHCs

Financial Developments 85
together to implement Basel III standards in the 

United States.

As bank balance sheets have improved, 

regulators have been assessing requests 

by banks to resume or increase capital 

distributions to shareholders. The Federal 

Reserve evaluated these requests as part of its 

efforts to ensure that large complex banking 

institutions improve their capital planning (see 

Box H: Improving Capital Planning).

5.3.2 Liquidity

Since the financial crisis, financial institutions 

have taken steps to manage their liquidity 

more conservatively. Banks and other financial 

institutions have reduced their reliance on 

short-term wholesale funding markets and 

have extended the maturity of their liabilities.

The liquidity risk faced by a financial institution 

is a function of the liquidity of its assets relative 

to the term and reliability of its funding. A 

greater reliance on wholesale funding markets, 

particularly those for short-term debt (see 

Section 5.2.6), can potentially place significant 

strains on financial intermediaries during 

periods of market stress. If liquid assets are not 

sufficient to meet an abrupt withdrawal of less 

stable short-term liabilities, then an institution 

may be forced to sell less-liquid assets at a 

discount. Losses from such asset “fire sales” 

and broader price declines can undermine the 

financial condition of even healthy institutions, 

potentially leading to contagion effects that 

are quickly transmitted to the broader financial 

system.

One of the key factors that contributed to the 

financial crisis was insufficient analysis and 

management of liquidity risk by participants 

in short-term money markets. During the 

crisis, weaknesses in the liquidity risk profiles 

of financial institutions became evident and 

required a significant expansion of government 

support that went well beyond the traditional 

safety net extended to regulated depository 

institutions (see Section 5.1). Exposure 

of these weaknesses has given financial 

institutions and market participants a better 

Chart 5.3.8 Core Deposits as a Percent of Total Liabilities

86 2011 FSOC Annual Report
understanding of the vulnerabilities in these 

markets and, in particular, of the importance of 

liquidity risk management.

Liquidity risk in the U.S. financial sector has 

fallen since the crisis, as financial institutions 

have more liquid assets and more stable 

liabilities on their balance sheets. On the liability 

side, short-term wholesale debt outstanding 

has declined since the crisis while retail 

deposits have increased. Indeed, core deposits 

now make up a larger percentage of the total 

liabilities of FDIC-insured institutions and 

support a greater portion of their less liquid loan 

assets (Chart 5.3.8). The reduced reliance on 

short-term wholesale debt for funding also has 

been notable among larger U.S. institutions 

(Chart 5.3.9). This shift has been driven in 

part by a general “flight-to-quality” away from 

riskier investments as well as higher levels of 

deposit insurance coverage. In addition, the low 

short-term interest rate environment of recent 

years has lowered incentives for nonfinancial 

corporations to sweep their cash balances out 

of banks into overnight investments. 

The long-term debt profile of U.S. financial 

institutions has also improved, in part because 

longer term funding needs have been modest 

given strong deposit inflows and subdued 

private nonfinancial credit growth. New 

issuance of longer term debt by financial 

institutions has been low despite the large 

volumes of maturing government-guaranteed 

and nonguaranteed debt (Charts 5.3.10 

and 5.1.12). On the asset side, U.S. financial 

institutions have enhanced their liquidity 

profile by increasing balances of highly liquid 

securities such as Treasuries, agency debt, 

and agency MBS on their balance sheets.

In contrast to domestic institutions, foreign 

financial institutions continue to have elevated 

levels of short-term wholesale debt outstanding 

(Chart 5.3.11). Their issuance of long-term 

U.S. dollar denominated debt also remains 

elevated. Outside of a decline in foreign-bank 

support of ABCP conduits, the composition of 

foreign bank short- and long-term wholesale 

U.S. dollar-denominated debt appears to 

Chart 5.3.9 Short-Term Wholesale Funding at Large BHCs

Chart 5.3.10 5.3.10 Domestic vs. Foreign U Domestic vs. Foreign US$ Bank Debt Issuance S$ Bank Debt Issuance

Chart 5.3.11 Foreign Bank Issuance of US$ Short-Term Debt

.

Financial Developments 87
Box H: Improving Capital Planning 

Financial institutions’ processes for managing and allocating their capital resources are critical to their individual 

health and performance, and to the stability and effective functioning of the U.S. financial system. In the 

recent Comprehensive Capital Analysis and Review (CCAR), the Federal Reserve conducted a forward-looking 

evaluation of the internal capital planning processes of large complex bank holding companies (BHCs). The 

evaluation found that all of the large firms needed to bolster their capital planning. 

The CCAR was the first in-depth and cross-sectional 

investigation of the capital planning process of 

large U.S. financial institutions ever conducted. 

Nineteen large U.S. BHCs were required to submit 

comprehensive capital plans and additional supervisory 

information, and these submissions were evaluated 

across five areas:

1. Capital assessment and planning processes

2. Capital distribution policy

3. Plans to repay any government investment

4. Ability to absorb losses under several scenarios 

5. Plans for addressing the expected impact of Basel III 

and the Dodd-Frank Act

The CCAR was a substantial strengthening of previous 

approaches to ensure that large BHCs have thorough 

and robust processes for managing and allocating their 

capital resources. The CCAR built on lessons regulators 

learned during the financial crisis about the importance 

of a forward-looking and comprehensive approach 

to capital adequacy. This includes an assessment of 

the level and composition of a banking organization’s 

capital resources under stressed economic and financial 

market conditions. The CCAR’s forward-looking 

evaluation encompassed both quantitative assessments 

and qualitative reviews of large BHC’s processes for 

assessing, and strategies for managing, their capital 

resources. This analysis complements comparisons of 

current capital amounts relative to regulatory minimum 

requirements, internal management targets, and capital 

levels at peer institutions. In addition, while traditional 

approaches have tended to evaluate individual capital 

actions in isolation, the CCAR took a longer run, holistic 

view of a firm’s strategy and management of its capital 

resources over a two-year period. Finally, the CCAR 

expanded on traditional practices by undertaking this 

assessment of the largest BHCs simultaneously, thus 

allowing the process to be informed by a horizontal 

perspective of the financial condition of and outlook for 

these firms.

An important innovation in the CCAR is the expectation 

that large BHCs will submit annual comprehensive 

capital plans to the Federal Reserve. These plans will 

describe their strategies for managing their capital over 

a minimum 24-month forward-planning horizon. While 

the specific elements of the plan may evolve over time, 

the following are some of the key components:

•	 A description of the firm’s current regulatory capital

base, including key contractual terms of its capital 

instruments and any plans to retire, refinance, or 

replace the instruments over the planning horizon.

•	 A description of all planned capital actions (e.g.,

dividends, share repurchases, and issuance), as 

well as anticipated changes in the firm’s risk profile, 

business strategy, or corporate structure over the 

planning horizon.

•	 A description of the firm’s processes and policies for

determining the size of dividend and common stock 

repurchase programs under various conditions.

•	 The firm’s assessment of potential losses, earnings,

and other resources available to absorb such 

losses in stressed economic and financial market 

environments, and the resulting impact on a firm’s 

capital adequacy and capital needs over the 

planning horizon.

•	 An assessment, accompanied by supporting

analysis, of the post-stress capital needed by the firm 

to continue operations, including its functions as a 

credit intermediary.

88 2011 FSOC Annual Report
Box H: Improving Capital Planning

The CCAR is a key method through which the Federal 

Reserve will hold BHCs—and their boards—to high 

standards in the critically important areas of assessing 

capital needs on the basis of all a firm’s activities 

and firm-wide risk exposures, and ensuring that the 

firm uses strong capital planning and management 

practices to make decisions that can affect capital. 

While many of the firms have made significant 

progress in enhancing their capital planning practices 

over the past 18 to 24 months, the evaluation found 

that all of the large firms needed to continue efforts to 

bolster their capital planning. 

A large majority of the 19 firms that participated in 

the CCAR proposed some form of capital distribution 

in 2011; most of the proposals involved a common 

dividend increase at some point in 2011. Some of the 

proposed increases were extremely modest, while 

others were more substantial. In nearly all cases, 

however, the levels of proposed dividend payments 

remained well below the levels that prevailed before 

the recent crisis. A number of firms proposed common 

share repurchase programs; in many cases, these 

repurchase programs were accompanied by proposed 

dividend increases. Several firms also requested 

the early redemption or retirement of trust-preferred 

securities that currently qualify as tier 1 capital but will 

be phased out as a result of the Dodd-Frank Act. 

Each of the participating firms that requested increased 

capital distributions in 2011 was informed in March 

2011 whether the Federal Reserve had any objection 

to the proposed increases. If the Federal Reserve did 

not object to the distributions proposed in a firm’s plan, 

the firm was free to make the distributions, subject 

to ongoing monitoring of its financial condition and 

operating environment. 

In the case of an objection, the firm had the option of 

submitting a revised plan for consideration as early as 

second quarter 2011. BHCs are expected to address 

any supervisory concerns with the initial plans as part of 

their resubmissions. 

Consistent with the overall supervisory goals of the 

CCAR, the focus of the stress scenario used in the 

evaluation was on assessing the sensitivity of the 

firms’ own projections of capital under both baseline 

and stress scenarios to alternative assumptions and 

estimates. The Federal Reserve’s development of 

independent supervisory estimates for losses and 

available resources was central to the evaluation of 

the firms’ capital plans. However, the intensity and 

comprehensiveness of the analysis was tailored to 

each firm and portfolio, depending on several factors. 

These included the materiality of the estimate to the 

firm’s post-stress capital position, the Federal Reserve’s 

assessment of the reliability of the firm’s internally 

generated estimates, and the width of the margin by 

which the firm’s estimates indicated it would meet the 

CCAR’s quantitative criteria. 

Financial Developments 89
have changed little in the past couple of 

years. However, the liquidity risks from these 

institutions may be mitigated because of greater 

asset liquidity on their balance sheets. Indeed, 

at the end of first quarter 2011, FBOs held 

nearly 30 percent of their assets in the form of 

reserves at the Federal Reserve (Chart 5.3.12).

While somewhat elevated, spot and forwardlooking indicators of dollar funding market 

stress remain well below levels reached during 

the crisis and mid-2010.

A number of reforms will strengthen the 

liquidity profiles of financial institutions and 

thus enhance their ability to withstand a severe 

stress scenario without government support. 

The Basel III agreement includes new liquidity 

standards for banks and BHCs—the latter 

encompassing the largest U.S. broker-dealers—

that will require financial firms to finance more 

of their assets and activities with more stable 

sources of funding. 

This new liquidity framework has two new 

minimum requirements. First, the Liquidity 

Coverage Ratio (LCR) seeks to promote the 

short-term resilience of a bank’s liquidity risk 

profile through a standard for high-quality 

liquid resources sufficient to survive an acute 

stress scenario lasting 30 days. Second, the 

Net Stable Funding Ratio (NSFR) addresses 

resilience over a longer, one-year horizon 

by setting a minimum level of stable funding 

sources relative to the liquidity profile of a 

bank’s assets, taking into account contingent 

liquidity needs associated with, for example, 

off-balance sheet commitments. After an 

observation period, the LCR is scheduled to be 

introduced in 2015 and the NSFR is scheduled 

to be introduced by the start of 2018.

In their oversight of BHCs and broker-dealers, 

supervisors are reviewing the dedicated 

liquidity facilities of each business line. In 

addition, accounting standards have been 

revised so that financial institutions can 

no longer treat certain short-term funding 

structures as off-balance sheet. These 

changes should limit the possibility that these 

structures will receive “favorable” regulatory 

and financial statement treatment that 

Chart 5.3.12 Reserves Held by Foreign Bank Branches

90 2011 FSOC Annual Report
obscures the risks posed to the institution 

and the financial system (see Box F: 

Improvements in Regulatory Capital and 

Accounting Measures of Assets).

5.3.3 Financial Infrastructure

Financial infrastructure functioned relatively 

well during the crisis, although the crisis 

revealed weaknesses and potential stresses, 

notably in tri-party repo and mortgage 

servicing, that a number of public- and 

private-sector initiatives have begun to 

address. While these initiatives should 

improve efficiency and market functioning, 

they also could increase the concentration 

and interconnectedness of financial markets in 

the global economy.

Large-value payment, clearing, and 

settlement systems were tested by the 

significant disruptions and shocks in financial 

markets during the crisis and its aftermath, 

but they generally continued to operate 

smoothly throughout this period. Robust risk 

management helped to ensure that market 

infrastructure operated both safely and 

efficiently. In addition, the government’s support 

for financial firms and markets, especially the 

Federal Reserve’s liquidity provisions, also 

indirectly eased liquidity pressures faced by 

financial infrastructure. 

A good example of the smooth operation 

of financial infrastructure was in the global 

foreign exchange market. CLS, a system that 

began operating in 2002 with the purpose 

of addressing settlement risk in the foreign 

exchange market, is widely credited with 

maintaining confidence for continued interbank 

trading and settlement of foreign exchange. 

In fact, CLS was able to handle successfully 

heightened values and volumes of transactions 

during the 2008 financial crisis as well as during 

the 2010 peripheral European sovereign debt 

crisis (Charts 5.3.13 and 5.3.14).

Many of the new developments and trends in 

infrastructure are expected to help mitigate 

pre-settlement risk, while enhancing efficiency 

as well as market and regulatory transparency. 

One such development is the use of central 

Chart 5.3.13 Average Daily Value of CLS Transfers

Chart 5.3.14 Average Daily Volume of CLS Transfers

Financial Developments 91
counterparty clearinghouses for facilitating 

trades in various derivatives and other financial 

products. In such arrangements, a central 

counterparty clearinghouse acts as a guarantor 

while providing multilateral netting efficiencies 

to reduce the counterparty credit and liquidity 

risks faced by market participants. Although 

central counterparties are principals to the 

transactions they clear, they do not stand to 

profit from changes in the market value of those 

transactions, and thus have stronger incentives 

to develop effective risk management measures 

and to monitor their members for potential 

stress. Central counterparties also can play an 

important role in safely managing a default of a 

major counterparty. 

Mandatory reporting requirements, which apply 

to both exchange traded and centrally cleared 

derivatives as well as OTC derivatives, are 

expected to help increase the transparency 

of open positions in these markets. Pre-trade 

transparency will be enhanced through the 

publication of quotes and pre-trade interest 

for transactions; post-trade transparency will 

be improved through detailed reporting to 

regulators and the release of basic transaction 

information to the public. 

Among its other potential benefits, electronic 

trading allows for wider participation and 

reduced costs for many financial intermediaries 

and other market participants. Also, through 

established standards for trading procedures 

and record keeping, electronic trading reduces 

the opportunities for market manipulation. 

However, electronic and complex trading 

practices also can increase the likelihood of 

operational failures and malicious attacks 

that could threaten the stability of financial 

markets. In one case of an operational error, 

on September 13, 2010, data intended to 

be placed into the Globex test environment 

as part of the CME Group’s normal testing 

regimen was inadvertently introduced into the 

live trading system. This mistake resulted in a 

large number of erroneous trades in a sixminute period, with additional errors occurring 

subsequently (Chart 5.3.15). These erroneous 

orders moved prices by a significant amount 

92 2011 FSOC Annual Report
in six of the eight energy and metals markets 

that had significant trading volume, highlighting 

the potential for operational errors to affect 

market behavior. The potential for a malicious 

attack was illustrated when, on February 5, 

2011, suspicious files were detected on the 

U.S. servers hosting a NASDAQ OMX webfacing application. While these suspicious 

files were removed immediately and there was 

no evidence that customer information was 

accessed or acquired by unauthorized parties, 

the incident serves as an important reminder 

that trading and clearing infrastructures are 

susceptible to intentional disruption and must 

be safeguarded accordingly. 

The advent of global trade repositories 

and central clearing in OTC markets along 

with trends in consolidation among existing 

clearinghouses and exchanges is likely to 

increase the concentration in financial markets 

and the interdependencies across multiple 

systems and markets. For example, the 

financial environment that once had numerous 

independent clearinghouses now has fewer 

and larger clearinghouses, each with a 

global footprint. Many of the same globallyactive banks participate in all of the major 

clearinghouses, or act as agent banks and 

liquidity providers to these clearinghouses. 

As a result of these developments, financial 

infrastructure is becoming more interconnected, 

highlighting the need for careful supervision. 

In the international arena, G-20 leaders agreed to 

reforms of the derivatives regulatory frameworks, 

including requiring standardized derivatives to be 

centrally cleared and, where appropriate, traded 

on regulated platforms. U.S. regulators have also 

been key participants in revising CPSS-IOSCO 

standards on financial market infrastructures to 

enhance standards for payment, clearing, and 

settlement systems supporting global financial 

markets. These proposed principles will help 

to address the potential risks resulting from 

increased use of infrastructure such as central 

counterparties. In addition, the United States 

is leading a global effort to develop minimum 

standards for margins on derivatives that are not 

centrally cleared. 

Chart 5.3.15 Globex CME September 13, 2010 Incident

Financial Developments 93
Tri-party Repo 

A notable exception to the smooth operation 

of payment, clearing, and settlement systems 

through the financial crisis was the tri-party 

repo market. The weaknesses in the settlement 

infrastructure in this market and the attendant 

flaws in the risk management practices of 

borrowers, lenders, and the two clearing banks 

significantly amplified market instability. These 

weaknesses, if they are not addressed, will 

continue to have the potential to exacerbate 

volatility in the overall financial system during 

times of stress.

Currently, all tri-party repo contracts, including 

those that are not scheduled to mature that 

day, are “unwound” each morning. This process 

returns cash to the repo buyers (lenders) and 

allows the repo sellers (borrowers, who are 

typically broker-dealers) to use the securities 

in their portfolios to settle other trades outside 

the tri-party repo market during the trading day. 

New repo contracts are not settled until the 

early evening. Under these arrangements, for 

most of each business day, the clearing banks 

extend hundreds of billions of dollars of intraday 

credit to individual dealers between the morning 

contract unwind and the evening settlement, 

at which time lender funds from the new repo 

contracts can be credited to the borrowers’ 

accounts. Thus, there is an ongoing handoff of 

dealer exposure between lenders who bear it 

overnight and clearing banks that bear it during 

the business day (Chart 5.3.16).

This arrangement proved to be extremely 

destabilizing during the crisis, particularly in 

light of the significant concentrations of dealer 

collateral being financed (Chart 5.3.17). 

As the financial condition of some major 

securities dealers deteriorated, large lenders 

to these institutions began to withdraw their 

cash. Lender withdrawals thus contributed to 

an adverse feedback loop that exacerbated 

counterparty credit risk and asset price volatility, 

and eroded the capital and funding capacity of 

many financial institutions. 

Within the tri-party repo market infrastructure, 

the role of the two clearing banks further 

intensified these dynamics. As some major 

Chart 5.3.16 5.3.16 Current Current Tri-party Repo High Level Process Flow Tri-party Repo High Level Process Flow 

Chart 5.3.17 Tri-party Concentration by Asset Class 5.3.17 Tri-party Concentration by Asset Class

94 2011 FSOC Annual Report
securities dealers faced greater difficulty 

financing their securities portfolios overnight, 

clearing banks became more concerned 

about assuming exposure to these dealers by 

unwinding their trades and providing intraday 

credit to them. Many market participants had 

assumed that the clearing bank would always 

be available to unwind repo contracts, return 

cash to lenders, and finance dealers during 

each trading day. They were not prepared for 

the possibility that it would refuse to do so. This 

belief, and the market’s reliance on clearing 

bank intraday credit to fund 100 percent 

of market activity during the trading day, 

obscured the credit and liquidity risks faced by 

participants in these transactions. Dealers were 

exposed to significant rollover risk because 

of their heavy reliance on short-term funding, 

which translated to a large concentration of 

repos maturing on any given day that needed 

to be replaced by new borrowings. And 

because these risks were not well understood 

beforehand, neither lenders nor clearing banks 

were well prepared to dispose of the collateral 

they would have to take on in the case of a 

dealer default. Given the severe strains at 

that time and the lack of preparedness, many 

cash lenders behaved like unsecured investors 

and rapidly closed out their repo books with 

troubled dealers rather than managing the credit 

risk exposure by raising haircuts, narrowing 

eligible collateral, and decreasing counterparty 

limits (Charts 5.3.18, 5.3.19, and 5.3.20).

The Tri-Party Repo Infrastructure Reform Task 

Force was launched to address some of these 

vulnerabilities in the tri-party repo market. The 

Task Force is an industry working group formed 

under the auspices of the Payments Risk 

Committee, a private-sector body sponsored 

by the Federal Reserve Bank of New York. The 

group includes representatives from institutions 

that are significant participants in the tri-party 

market, including lenders, borrowers, and the 

two clearing banks. 

Since the Task Force issued initial 

recommendations in May 2010, the industry has 

made significant progress in improving market 

transparency through its monthly reporting of 

market volume, collateral composition, and 

Chart 5.3.18 Tri-party Repo Aggregate Median Haircut

Chart 5.3.19 Lehman Tri-party Repo Assets in 2008 5.3.19 Lehman Tri-party Repo Assets in 2008 

Chart 5.3.20 Lehman Tri-party Repo Cash Investors in 2008 5.3.20 Lehman Tri-party Repo Cash Investors in 2008

Financial Developments 95
margin ranges charged by tri-party repo lenders 

for each type of collateral, which should help 

lay the groundwork for additional reforms. 

On June 27, 2011, the two clearing banks 

implemented collateral substitution functionality. 

Allowing dealers access to collateral needed 

to settle trades without requiring an unwind 

of all tri-party repo transactions each morning 

represents an important prerequisite for 

a meaningful reduction in the market’s 

dependence on intraday credit. 

Additionally, the Task Force is on track to shorten 

the daily period during which clearing banks are 

providing intraday credit: the settlement time was 

moved back from 8:30 am to 10:00 am on July 

25 and will be moved back further to 3:30 pm on 

August 22. It will also require three-way posttrade confirmation of deal details such as trade 

tenor as a prerequisite for settlement, starting on 

August 29. 

However, much work remains to implement 

other recommendations, particularly moving 

market participants away from relying on clearing 

banks for extensions of intraday credit. The 

complications in addressing these issues reflect 

the complexities associated with compressing 

an end-of-day settlement process to one hour, 

implementing technology to support collateral 

substitution, and enforcing a cap on intraday 

credit provided by clearing banks. Consequently, 

the Task Force recently acknowledged that it 

will need time beyond 2012 to achieve these 

objectives. In addition to technological and 

infrastructure challenges, the Task Force’s 

composition, which spans a diverse array 

of market participants with varied economic 

interests, likely has affected its timetable. 

Mortgage Servicing

Another weakness in the financial infrastructure 

revealed during the financial crisis and 

after was in the systems that handled the 

servicing of residential mortgages. As the 

rate of foreclosure originations increased, 

disclosures of widespread irregularities in 

foreclosure paperwork prompted an interagency 

investigation (Chart 5.3.21). Evidence 

emerged during lawsuits brought by borrowers 

96 2011 FSOC Annual Report
facing foreclosure that critical paperwork was 

deficient. For example, reports surfaced of 

foreclosure affidavits sworn without document 

review and of improper notarizations, coupled 

with allegations of falsified documents used in 

foreclosure proceedings. The matter became 

known as “robosigning” for the rapid, seemingly 

automated, manner in which flawed paperwork 

was generated by some mortgage servicers 

initiating foreclosures. 

Some of the nation’s largest servicers conceded 

possible flaws in their foreclosure procedures 

and, by mid-October 2010, had instituted selfimposed moratoriums on foreclosures while 

they conducted reviews. The federal banking 

regulatory agencies examine the banks’ 

internal assessments, compliance with state 

foreclosure laws, and adequacy of controls 

and governance. Subsequently, some agencies 

took enforcement action against a number 

of servicers. Additionally, state mortgage 

regulators are conducting examinations of state 

licensed mortgage servicers.

Questions also arose from borrowers facing 

foreclosure about whether the parties seeking 

foreclosure actually owned the loans and if 

they had legal standing to pursue foreclosure. 

Issues related to the transfer of ownership of 

a mortgage, either as a whole loan or as part 

of the securitization process, and procedures 

for recording such transfers were factors 

contributing to these questions.

An additional risk is that mortgage security 

investors could challenge whether mortgages 

were transferred to securitization trusts 

in accordance with contractual and legal 

requirements. The primary concern is that 

document custody and transfer issues with 

notes and mortgages could render many private 

securitizations invalid. 

Another ongoing issue is that many loans 

underlying securitizations might not meet the 

representations and warranties made at the 

time the mortgages were initially securitized 

or sold. This has led to requirements that 

mortgage originators or their successors 

repurchase mortgages from investors in MBS 

Chart 5.3.21 Residential Mortgage Foreclosure Starts Rate

Financial Developments 97
or from Fannie Mae and Freddie Mac. This 

risk has risen significantly as a result of high 

mortgage delinquencies (Chart 5.3.22). A few 

banks have reached settlements with the GSEs 

but mortgage repurchases are likely to remain 

elevated in the years to come. 

5.3.4 Market Functioning

When markets function well, the pricing of 

risks and flows of funds occur unimpeded. 

Overall, since the major market dislocations 

experienced in late 2008, most markets have 

facilitated orderly trading and price discovery. 

However, certain markets have exhibited 

short-term dislocations, in part owing to a 

variety of factors pertaining to technological 

change and interconnectedness. 

Technology has significantly altered the 

landscape of financial markets over recent 

years, with implications for the resilience of 

market functioning. Electronic trading, which 

enables extremely fast execution of orders, 

has led to a sizable shift in market structure, 

allowing for wider participation, reduced trading 

costs, and very short-term trading strategies 

that take advantage of arbitrage opportunities. 

In a normal market environment, and for an 

investor seeking to execute a small order, the 

result of increased electronic trading is nearimmediate execution. However, even though 

technology leads to fast trade execution, it can 

also contribute to shrinking liquidity in times of 

market dislocation. A number of these market 

developments were featured prominently 

during a period of extreme market volatility on 

May 6, 2010.

The Flash Crash

On May 6, 2010, between 2:40 pm and 

3:00 pm, major indexes in both the futures 

and equities markets plummeted more than 

5 percent in a matter of minutes before 

rebounding almost as quickly (Chart 5.3.23).

Approximately two billion shares traded 

during this time with a total volume exceeding 

$56 billion. Over 98 percent of all shares 

were executed at prices within 10 percent 

of their 2:40 p.m. value. However, some 

equities experienced more severe upward and 

Chart 5.3.22 Residential Mortgage Delinquency Rate

98 2011 FSOC Annual Report
downward price movements. In particular, 

more than 20,000 trades in more than 300 

securities were executed at prices more than 

60 percent away from their values just before 

the onset of the flash crash. These trades 

were subsequently labeled erroneous and 

thus cancelled by the exchanges and Financial 

Industry Regulatory Authority. 

The rapid decline in major market indexes 

initially began in the Chicago Mercantile 

Exchange S&P 500 E-mini futures contracts 

(S&P 500 E-mini), as a large sell order coupled 

with subsequent selling pressure from highspeed algorithms overwhelmed the immediately 

available demand. Cross-market arbitragers 

who bought the S&P E-mini as it declined offset 

their exposures through sales of individual 

equities or ETFs, thereby transmitting the selling 

pressure to other markets. With selling pressure 

increasing in many markets and prices dropping 

rapidly, many electronic market makers who 

were simultaneously active in several markets 

either widened their spreads or withdrew from 

trading entirely, leading to an evaporation of 

liquidity in many securities. Issues with data 

feeds resulting from delays at some exchanges 

also prompted participants to withdraw from 

markets, reducing potential purchasers and 

helping to allow the price declines to accelerate. 

ETFs accounted for 70 percent of the 326 

securities for which trades were reversed, 

meaning their share prices fell by at least 60 

percent from the previous day’s close. Bidoffer quotes from dealers widened significantly 

and market makers were unable to transact 

efficiently in the underlying basket and maintain 

the price of an ETF share close to the net asset 

value of its underlying securities. This highlights 

the importance of liquid markets for the efficient 

operation of this product.

A number of points pertaining to the functioning 

of markets can be drawn from this incident. 

First, under stressed market conditions, the 

automated execution of a large sell (or buy) 

order can trigger extreme price movements. 

Second, the interaction between automated 

execution programs and algorithmic trading 

strategies, which ordinarily would reduce 

Chart 5.3.23 S&P 500 and VIX on May 6, 2010

Financial Developments 99
asset mispricing through exploiting temporary 

arbitrage opportunities, can under some 

circumstances quickly erode liquidity and result 

in disorderly markets. In particular, during the 

flash crash, high-speed trading algorithms 

chased market orders to the level of stub 

quotes—bids to buy or offers to sell a stock at a 

price so far away from the prevailing market that 

it is not intended to be executed, such as a bid 

to buy at $0.01 or an offer to sell at $100,000. 

Such transactions, clearly outside the scope 

of rational pricing, were later canceled, and 

the SEC later approved rules to eliminate stub 

quotes. In another response to the flash crash, 

regulators added new circuit breakers to halt 

trading under disorderly market conditions, 

with the aim of restoring investor confidence 

by helping to ensure that markets operate only 

when they can effectively carry out their critical 

price-discovery functions.

Heightened Correlations Across Assets

Tighter linkages between some markets were 

evident during the crisis. For example, on many 

occasions investors pulled away from assets 

perceived to be risky, such as equities, in favor 

of U.S. Treasuries and other assets perceived to 

provide a safe haven. Beyond the developments 

associated with the financial crisis, there have 

been a number of developments that potentially 

could lead to stronger linkages and higher 

correlation between assets and across markets. 

These developments include the rapid spread 

of information, economic integration, and 

globalization of capital flows. 

As one example of stronger linkages across 

financial markets, correlations across equity 

markets and currencies generally remain at 

elevated levels relative to those of the mid-2000s 

(Chart 5.3.24). Even so, another measure 

shows that correlations among equities have 

declined since mid-2010 (Chart 5.3.25).

Chart 5.3.24 Citi FX/Equity Realized Correlation Index 5.3.24 Citi FX/Equity Realized Correlation Index

Chart 5.3.25 S&P 500 Implied Correlation Index 5.3.25 S&P 500 Implied Correlation Index

100 2011 FSOC Annual Report
5.4 Prices and Incentives

Appropriate pricing of financial assets and 

instruments, along with proper incentives 

to take on risk, are central to maintaining 

financial stability. For example, the two large 

GSEs encouraged housing purchases and real 

estate investment over other sectors, which 

misaligned incentives in the financial system. 

Currently, the pricing of risk in a number 

of important markets—including corporate 

equities, corporate bonds, and real estate—

appears to be in line with historical averages. 

Compensation for risk in the market for loans 

to low-rated, high-yield corporate borrowers 

remains in the range experienced in the last 

credit cycle. While the values of commodities 

and agricultural land are at long-run highs, there 

does not appear to be substantial leverage in 

those markets. 

5.4.1 Securities Markets

Prices of securities reflect a variety of factors, 

including investors’ outlook for future cash 

flows from a particular asset and the premium 

they demand to compensate for the risks 

associated with that asset. When the price of 

an asset rises, it could be because investors 

raised their forecast of future cash flows 

or because they lowered the risk premium. 

Distinguishing between these two reasons 

is empirically challenging. When an asset’s 

valuation is high, it may be vulnerable to 

reduced investor willingness to hold risk or to 

a decline in investors’ evaluation of the asset’s 

future outlook.

Equities

Equity market values have rebounded 

considerably from their March 2009 lows 

(Chart 5.4.1). A valuation measure of 

corporate equities typically used by analysts 

is the ratio of a stock’s price to the earnings 

of the corporation. This measure can be 

computed using realized current operating 

earnings, forward-looking estimates of future 

earnings, or trailing earnings. The price-toearnings (P/E) ratios for the S&P 500 index 

appear in line with their average over the 

past 20 years (Chart 5.4.2). Investors also 

Chart 5.4.1 Dow Jones U.S. Total Stock Market Index

Chart 5.4.2 Price-to-Earnings Ratio for Corporate Equities

Financial Developments 101
compare the return on a risky investment asset 

such as stocks to a low-risk asset such as 

Treasury bonds to determine the risk premium. 

With interest rates currently very low, this 

second measure suggests that the valuation 

of corporate equities could still be somewhat 

below historical norms.

Corporate Bonds

In corporate credit markets, the high-yield 

credit risk premium can be viewed as a proxy 

for risk appetite. The premium rises when 

investors are less willing to take on risk and 

demand higher compensation for a given 

level of risk; conversely, the premium declines 

when investors are more willing to take on 

risk. Calculation of the credit risk premium 

using estimates of the consensus default 

rate, which in early 2011 was approximately 2 

percent, reveals that the credit risk premium is 

below its historical average but within recent 

ranges (Chart 5.4.3). As discussed in Section 

4.2, there are several reasons why corporate 

defaults have been lower than expected since 

the beginning of the financial crisis, including 

improved fundamentals of high-yield companies 

and the ability of companies to refinance nearterm maturing debt in capital markets.

U.S. Treasuries

Investors in long-term Treasuries must consider 

the risk associated with movements in nominal 

interest rates over the life of the security. In 

particular, if nominal rates rise, the secondary 

market price of the security will fall. Because 

this interest rate risk is greater for longer 

maturity bonds, investors generally require 

additional compensation to hold longer-maturity 

debt. That compensation is often referred to as 

the “term premium.” 

Investors have tended to increase their 

investment in U.S. Treasuries in periods of 

financial stress because they see Treasuries as 

relatively safe and liquid—in other words, a safehaven investment. In these periods, investors 

appear to be more willing to accept a lower risk 

premium for longer maturity Treasuries. The 

correlation between stock prices and Treasury 

returns—a measure of this safe-haven demand—

Chart 5.4.3 High-Yield Credit Risk Premium

102 2011 FSOC Annual Report
turned sharply negative as the financial crisis 

started to unfold in 2007. The correlation turned 

sharply negative again in early 2010 and in early 

2011, periods when European sovereign debt 

problems escalated, also suggesting safe-haven 

demands (Chart 5.4.4).

5.4.2 Real Estate Markets

Rapid growth in credit for real estate purchase 

and investment can produce large imbalances. 

Assessments of valuations are challenged by 

the illiquidity inherent in real estate and the 

lack of comparability among property types. 

Residential Real Estate

In evaluating residential real estate prices, the 

ratio between the price of a single-family house 

and the rent it could obtain is analogous to the 

P/E ratio for stocks. However, calculating this 

ratio in the case of real estate is more difficult 

because, unlike stocks, residential property 

is very illiquid, real estate provides significant 

nonmonetary returns to households, and 

properties are seldom exactly comparable. 

Moreover, aggregate indexes of home prices 

and rents probably measure the prices and 

rents of different properties. Despite these 

qualifications, indexes based on price-to-rent 

ratios for residential real estate can still provide 

information about broad trends in the valuation 

of housing. One such index reached a record 

high in 2006, at the peak of the housing boom, 

but has since reversed essentially all of the 

increase between the late 1990s and 2006. 

The most recent readings put this residential 

real estate valuation metric about in line with its 

average over the 1990s (Chart 5.4.5).

Commercial Real Estate

Notwithstanding that commercial real estate 

(CRE) values have broadly declined, it is useful 

to observe trends in capitalization rates—the 

ratio of income produced by a property to the 

property value—on newly originated loans 

(Chart 4.1.15). Capitalization rates broadly 

fell over the course of 2010 and the first part 

of 2011, signaling higher CRE valuations. 

The bulk of recent commerical property sales 

have involved higher quality properties in 

major cities, where valuations have increased 

Chart 5.4.4 Correlation of Stock Prices and Treasury Returns 5.4.4 Correlation of Stock Prices and Treasury Returns

Chart 5.4.5 Price-to-Rent Ratio for Residential Property

Financial Developments 103
relative to the rest of the market. Valuations 

in these markets have also benefited from a 

lower interest rate environment, which has 

contributed to the decline in capitalization 

rates. However, the spread between the 

capitalization rate and the risk-free rate 

remains elevated compared with pre-crisis 

levels, signaling that investors are currently 

applying a higher risk premium (Chart 5.4.6).

Agricultural Land

Agricultural land values have increased, driven 

by rising commodity prices, favorable export 

conditions, and low interest rates. On an 

inflation-adjusted basis, agricultural land values 

are now near the highest levels of the past 50 

years (Chart 5.4.7). Currently, in the aggregate, 

incomes in the U.S. farm sector are performing 

well, forecasts for production and demand 

are positive, and debt levels in general do not 

appear excessive. However, if farm incomes fall 

owing to a decline in either domestic or export 

demand, or an increase in operating costs, then 

agricultural land values may be susceptible to a 

decline.

Adjusting for inflation, current agricultural real 

estate debt levels remain significantly below 

the levels of the late 1970s (Chart 5.4.8). The 

Farm Credit System and community banks that 

specialize in agriculture lending have the bulk of 

exposures to agricultural land. While the extent 

to which high agricultural land prices reflect 

their underlying fundamentals is uncertain, a 

sizable decline in land values could have an 

adverse impact on the financial institutions that 

hold farm loans. These institutions will need to 

maintain prudent lending standards in the face 

of high and rising land values. 

5.4.3 Loans

During a prolonged period of low interest 

rates, some institutions may reach for yield 

by increasing duration, lending to lower rated 

borrowers, or employing more leverage. Such 

concerns today are focused in the market for 

low-rated corporate credits, referred to as the 

leveraged loan market. 

Leveraged loans—a form of floating rate 

instrument that would provide protection 

Chart 5.4.6 5.4.6 Capitalization Rate and Spread Capitalization Rate and Spread

Chart 5.4.7 Farm Land Prices

Chart 5.4.8 Agricultural Real Estate Debt Outstanding

104 2011 FSOC Annual Report
against interest rate risk relative to fixed rate 

instruments in a rising rate environment—have 

attracted strong investor interest. Bank loan 

funds, for example, have experienced record 

high inflows, bolstering secondary market prices 

and filling the gap left by maturing collateralized 

loan obligation vehicles (Chart 5.4.9). Most 

leveraged loans are not retained by bank 

arrangers; rather, they are increasingly sold to 

institutional investors (Chart 5.4.10). Unlike the 

peak of the market in 2006–07, little evidence 

exists that leverage is being employed on any 

significant scale in the funding of loans through 

repos or total return swaps, suggesting that the 

potential for a rapid and disorderly deleveraging 

in this market is limited. 

The all-in cost of leveraged loans has been 

driven lower by the low-rate environment, 

although the average spread required by 

investors is higher (Chart 5.4.11). The lower 

cost has facilitated heavy loan refinancing: 

nearly three-quarters of issuance in early 2011 

and more than half of issuance in 2010 was 

for this purpose. While issuance of leveraged 

loans has been robust, outstanding loans have 

declined, in part reflecting paydowns from 

robust bond issuance (Chart 4.1.3).

Most metrics for leveraged loan and high-yield 

bond deals remain in the middle of the range 

experienced through the last credit cycle, from 

2002 to 2010 (Chart 5.4.12). Issuance by the 

lowest rated borrowers (for example, those 

rated CCC by S&P) remains muted compared 

with levels seen during 2006 and 2007. 

Relative to overall total loan issuance, there is 

less issuance of loans for leveraged buyouts, 

and those issued tend to require higher equity 

contributions. However, issuance of certain 

loan structures has been increasing since 2009. 

Loan issuance for the purpose of financing 

a dividend or shareholder buyback, also 

known as a dividend recapitalization, reached 

historically high levels in early 2011 owing to 

low interest rates and strong demand for loan 

assets. Additionally, covenant-lite loans—those 

that do not provide investors with the traditional 

protection of maintenance covenants—have 

recently made up a high percentage of issuance 

Chart 5.4.9 Syndicated Leveraged Loan Market 5.4.9 Syndicated Leveraged Loan Market 

Chart 5.4.10 Composition of Leveraged Loan Investors

Chart 5.4.11 All in Cost of Leveraged Loans

Financial Developments 105
(Chart 5.4.13). While neither of these issuance 

types may be indicative of a new vulnerability, 

they do reflect an increase in investor risk 

appetite as well as the dynamics of market 

competition, including pressures on fund 

managers to invest inflows and on arranging 

banks to maintain market share. 

Mitigating these trends, bank underwriters have 

lower warehouse risk, that is, the risk of losses 

on assets that they are holding prior to sale. 

This is partly because deals are smaller than 

they were before the financial crisis. Also, unlike 

the fully committed transactions seen during 

2006 and 2007, banks report that financings 

are currently arranged on a “best efforts” basis, 

in which underwriters do not commit to take 

on the risk of the entire loan before syndication 

but maintain contractual flexibility after the 

commitment to adjust the pricing and structure 

of loans (at the expense of borrowers) to 

market-clearing levels if necessary. 

5.4.4 Commodities

Commodities prices are subject to standard 

demand and supply factors. Additionally, 

financial instruments that track commodities 

play an increasing role in the market. 

Commodity prices rose in 2010 and early 2011. 

Energy prices rose strongly in the first half of 

2011, but they have not reached the levels seen 

in mid-2008. Prices for a number of agricultural 

and industrial commodities have reached 

record levels in nominal terms (Chart 5.4.14).

The global economic recovery, particularly the 

robust growth in many major emerging market 

economies, has been a major factor behind the 

recent strength in commodity prices.

Oil prices generally have tracked the improving 

world economy, with the spot price of Brent 

crude oil, a standard for world oil prices, 

rising from a low of just under $34 per barrel 

in December 2008 to over $120 per barrel 

in spring 2011 before falling a little more 

recently. The price of West Texas Intermediate, 

a standard in the United States, has followed 

a similar pattern. Demand growth since the 

recession has come largely from emerging 

economies, as consumption in the Organisation 

for Economic Co-operation and Development 

Chart 5.4.12 5.4.12 Leveraged Loan New Issuance Metrics Leveraged Loan New Issuance Metrics

Chart 5.4.13 Leveraged Loan New Issuance Characteristics 5.4.13 Leveraged Loan New Issuance Characteristics

Chart 5.4.14 Commodity Prices 5.4.14 Commodity Prices

106 2011 FSOC Annual Report
countries has grown very little during this 

period. Price movements in early 2011 reflected 

events in Libya and elsewhere in the Middle 

East and North Africa. While Libya accounted 

for only 2 percent of global supply in 2010, 

concerns focus on the uncertainty regarding 

the long-term damage to Libya’s production 

infrastructure and to further supply impacts 

from the political unrest across the region. 

The lack of spare capacity among foreign oil 

producers and concerns about future long-run 

production growth have also added to price 

pressures (Chart 5.4.15).

The increased financialization or trading of 

liquid, synthetic financial products based on 

less liquid physical commodities is evidenced 

by the growth in commodity ETFs (Chart 

E.1). Additionally, the liquidity of commodity 

futures markets, which provide a critical pricediscovery function for physical markets, is 

supported by speculative market makers. A 

rapid sell-off and spike in volatility in crude oil, 

refined energy, and silver markets in May 2011 

coincided with an unwinding of speculative 

positions, which had reached record levels in 

a number of commodities (Chart 5.4.16). In a 

dynamic similar to that of the flash crash, the 

speed and magnitude of price declines in these 

markets revealed that the automatic liquidation 

of positions may have contributed to reduced 

liquidity and downward price pressure. 

5.4.5 Incentives

Programs and policies can affect incentives 

for risk taking in financial markets. It is crucial 

that programs and policies are designed 

with appropriate safeguards, such as with 

deposit insurance, to provide financial system 

participants with proper incentives to help 

maintain a well-functioning financial system. 

Deposit Insurance

Congress created federal deposit insurance 

in 1933 in response to the thousands of bank 

failures that occurred in the 1920s and early 

1930s. Deposit insurance promotes financial 

stability by maintaining public confidence in 

the banking system, ensuring that depositors 

continue to place their money in the system, 

and limiting the incentives for depositors to 

Chart 5.4.15 Middle East Producers: Production and Capacity

Chart 5.4.16 Oil Market Price and Net Long Positions

Financial Developments 107
quickly withdraw their money when banks 

become troubled. During the most recent 

crisis, depositors remained confident that their 

money was safe and insured deposits provided 

a stable source of funding for individual banks 

and the banking system as a whole. 

Still, government-provided deposit insurance 

has the potential to lead to excessive risk-taking 

at banks. Insured depositors do not have an 

incentive to monitor the decisions management 

makes on behalf of the equity holders, who reap 

the gains on the upside but have limited liability 

on the downside. To address this moral hazard, 

banks are subject to prudential supervision, 

capital regulation, activity restrictions, and riskbased pricing of deposit insurance. 

The enactment of the Dodd-Frank Act has led 

to a number of significant changes to FDIC 

deposit insurance and, to a lesser extent, NCUA 

share insurance. The Act permanently raised 

the deposit insurance limit from $100,000 to 

$250,000 and temporarily extended deposit 

insurance coverage to the full balance of noninterest-bearing transaction accounts through 

the end of 2012. 

The Dodd-Frank Act made a number of other 

significant changes to FDIC deposit insurance. 

First, it changed the basis for calculating 

the assessment that insured depository 

institutions pay the FDIC from domestic 

deposits to a measure of total assets less 

shareholder equity. This change generally 

will shift the overall assessment burden away 

from community banks and toward the largest 

banks, which rely less on domestic deposits 

for their funding. This change will better align 

an institution’s deposit insurance assessment 

with the impact that its failure would have 

on the FDIC’s Deposit Insurance Fund (DIF). 

Second, the Dodd-Frank Act raised the 

minimum reserve ratio for the DIF balance 

from 1.15 percent to 1.35 percent of insured 

deposits and requires the FDIC to achieve 

the minimum reserve ratio by September 30, 

2020. Third, the Act provided new flexibility to 

the FDIC in setting a long-run target reserve 

ratio for the DIF, which the FDIC has set at 2 

percent. This should enable the FDIC to build 

Chart 5.4.17 BHC Systemic Uplift

Chart 5.4.18 S&P Current Actual & Market Implied Rating

Chart 5.4.19 Current Long-Term Ratings and Uplift

108 2011 FSOC Annual Report

5.4.19 Current Long-Term Ratings and Uplift
up a larger balance during better economic 

times, maintain a positive balance during 

periods of stress, and establish more stable 

assessment rates over the economic cycle.

Large Complex Financial Institutions

Some large complex financial institutions can 

derive benefits from the perception that they are 

“too big to fail.” Institutions that are perceived 

to be difficult to resolve in an orderly manner if 

they fail can undermine market discipline. The 

distortions induced by “too big to fail” may be 

evident in the creditworthiness assigned to 

these firms by credit rating agencies and more 

directly in their funding costs. 

Credit rating agencies factor an explicit “uplift” 

into the ratings of certain financial institutions 

over their stand-alone credit ratings on the 

basis of perceived government support. The 

support embedded in firms’ uplifted ratings 

increased dramatically in 2008 and persists. 

However, analysis based on credit default 

swap pricing for these large complex financial 

institutions suggests that markets are not 

factoring the ratings uplift into their evaluation 

of these companies’ long-term debt (Charts 

5.4.17, 5.4.18, and 5.4.19). The uplift does 

have a direct benefit for the short-term funding 

rating for these firms, which is currently the top 

tier A-1/P-1 rating (Chart 5.4.20). This rating 

allows these firms to access certain short-term 

wholesale funding markets that they would not

be able to access with a lower rating.

Large banks with over $100 billion in assets 

have greater access to market funding and a 

lower total funding cost than smaller institutions, 

as measured by the interest expense on total 

liabilities (Chart 5.4.21). The lower funding cost 

for larger banks is partly due to their greater 

ability to bundle a range of services to attract 

low-cost deposits; larger banks have also 

benefitted from the full guarantee on transaction 

accounts (Chart 5.4.22). Market-based factors 

also play a role. Larger institutions have access 

to market-based short-term sources of funding, 

such as through MMFs, which are currently 

providing funding at historically low rates. 

Chart 5.4.20 Current Short-Term Ratings 5.4.20 Current Short-Term Ratings

Chart 5.4.21 Interest Expense as a Percent of Total Liabilities

Chart 5.4.22 Noninterest-Bearing Liabilities to Total Liabilities 5.4.22 Noninterest-Bearing Liabilities to Total Liabilities

Financial Developments 109
Credit rating agencies have said they will review 

their U.S. bank support assumptions in the 

coming year on the basis of the enhanced 

resolution authority established under the 

Dodd-Frank Act (see Box I: Addressing 

Issues Related to Large Complex Financial 

Institutions and Section 6.1.2). As credit 

rating agencies consider the likelihood and 

potential impacts of a reduction in official 

support, they have placed certain firms’ ratings 

on review for potential downgrade.

Compensation

As the financial system became more complex 

and globalized, the contribution of the financial 

sector to U.S. output increased by about 60 

percent from 1980 to 2000 (Chart 5.4.23). 

This increased contribution was achieved with 

little change in the share of employment in the 

financial sector (Chart 5.4.24). Since 2000, its 

share of GDP has remained around 8 percent 

and its employment share just above 5 percent. 

With the exception of the recent recession, 

finance accounted for 25 percent to 50 percent 

of all corporate profits over the past decade 

(Chart 5.4.25).

Labor compensation in the financial sector is 

considerably higher than in many other industries 

and also tends to depend more heavily on 

complicated incentive structures. Average annual 

compensation in finance between 2001 and 

2010 was 70 percent to 90 percent higher than 

in other industries (Chart 5.4.26). Specifically, 

average compensation in investment banking 

and securities dealing was 300 percent to 

450 percent higher (Chart 5.4.27). The labor 

compensation share of value added in finance 

has fallen abruptly as many firms have made 

substantial changes to their compensation 

structures, partly to increase capital buffers 

through retained earnings (Chart 5.4.28).

Compensation has grown dramatically for 

senior executives at the largest, most complex 

financial institutions. For example, in 1989, 

the chief executives at the seven largest 

BHCs earned an average of $2.8 million, or 

97 times the median U.S. household income 

of $28,906 for that year. In 2007, the CEOs at 

the six largest BHCs earned an average of $26 

Chart 5.4.23 Value Added Share of Financial Sector

Chart 5.4.24 Financial Sector Share of Nonfarm Payroll

Chart 5.4.25 Financial Sector Share of Corporate Profits

110 2011 FSOC Annual Report
million, or 516 times the median household 

income of $50,233 for that year. In 2007, 

these CEOs earned 2.3 times the average 

total compensation of the CEOs at the top 50 

nonbank companies. 

Because they affect the incentives of current 

and prospective employees, compensation 

programs are critical tools that can contribute 

to the success of financial institutions. If they 

are properly structured, they can help to attract 

and retain qualified staff and to align employee 

performance with organizational objectives. 

However, if they are not properly structured, 

compensation practices can lead to excessive 

risk taking by an institution’s employees and 

have the potential to undermine the safety and 

soundness of the financial institution as well 

as that of the financial system itself. The G-20 

leaders called for reform of compensation 

and endorsed the Principles for Sound 

Compensation Practices issued by the Financial 

Stability Board (FSB) in April 2009. Since then, 

many financial institutions have reexamined their 

compensation practices and are reevaluating 

possible links between incentive compensation 

and risk-taking behavior. 

In June, 2010, the U.S. federal bank regulatory 

agencies issued supervisory guidance to ensure 

that incentive compensation arrangements at 

banking organizations take risk into account 

and are consistent with safe and sound 

practices. The guidance stated that incentive 

compensation programs should provide 

employees incentives that appropriately 

balance risk and financial results; they should 

be compatible with effective controls and riskmanagement; and they should be supported by 

strong corporate governance. 

Subsequently, on March 30, 2011, as required 

by the Dodd-Frank Act, a broader set of 

financial regulatory agencies issued a proposed 

rule on incentive compensation that will apply to 

investment advisers, broker-dealers, and other 

entities, as well as banking organizations. The 

proposed rule, which is discussed more fully in 

Section 6.3.5, would apply to certain financial 

institutions with more than $1 billion in assets 

and would prohibit compensation arrangements 

that could encourage inappropriate risks. 

Chart 5.4.26 Financial Sector Wages to All Wages

5.4.27 Investment Banking Wages to All Wages

5.4.28 Compensation Share of Industry Value Added

Financial Developments 111
Box I: Addressing Issues Related to 

Large Complex Financial Institutions 

Large complex financial institutions (LCFIs) can be an efficient means of providing financial services to the 

economy. However, in the absence of an appropriate regulatory structure and robust risk management practices, 

the benefits of LCFIs can be outweighed by the risk they pose to the stability of the financial system, especially 

in times of severe market stress. The Dodd-Frank Act puts in place a number of measures to mitigate this risk.

In the years preceding the crisis, the structure of many 

commercial banks, investment banks, and insurers 

had become increasingly complex, with numerous 

subsidiaries that spanned the globe (Chart I.1).

Chart I.1 Complex Financial Institutions in 2007

The LCFIs at the center of the 2008 crisis could not be 

wound down in an orderly manner when they became 

nonviable. Major segments of these companies’ 

operations were subject to the U.S. Bankruptcy Code, 

as opposed to bank receivership or other specialized 

insolvency laws, or they were located abroad and 

therefore outside U.S. jurisdiction for insolvency 

purposes. In the midst of the crisis, policymakers in 

several instances provided government assistance 

instead of letting these companies file for bankruptcy. 

They were concerned that creditor losses and other 

uncertainty associated with the bankruptcy process 

would cascade through the global financial system. 

These concerns were realized when the prime 

brokerage assets of Lehman Brothers in the U.K. were 

frozen following that firm’s bankruptcy.

Among the goals of the Dodd-Frank Act are to work 

toward ensuring that the risks posed by LCFIs are 

prudently managed and subject to adequate oversight, 

and eliminating the “too big to fail” risk and the 

necessity for government assistance to nonviable 

financial companies. The law, including provisions in 

Title I and Title II, uses the following tools to accomplish 

these goals.

Designation of Nonbank Financial Companies

The Council is authorized to designate nonbank 

financial companies as subject to enhanced prudential 

standards and supervision by the Federal Reserve. The 

Council must consider various factors in determining 

whether to make this designation, including leverage; 

off-balance-sheet exposures; and the nature, scope, 

size, scale, concentration, interconnectedness, and mix 

of activities of the company.

Enhanced Prudential Standards and 

Supervision

Major financial companies—bank holding companies 

with assets over $50 billion and designated nonbank 

financial companies—will be subject to enhanced 

prudential standards and supervision by the Federal 

Reserve to ensure that they have sufficient buffers to 

withstand severe financial stress. Strengthened capital 

and liquidity requirements will be core elements of these 

enhanced standards. 

The Dodd-Frank Act also requires regulators to 

establish remedial actions to be taken when a financial 

company that is subject to enhanced prudential 

standards is experiencing increased financial distress. 

These remedial actions are intended to minimize the 

probability that such a company will become insolvent 

and harm the stability of financial markets.

I.1 Complex U.S. Financial Institutions in 2007

112 2011 FSOC Annual Report
Box I: Addressing Issues Related to Large Complex Financial Institutions

Concentration Limits

The Dodd-Frank Act establishes a financial sector 

concentration limit. This limit generally prohibits 

a financial company from merging or acquiring 

another company if the total consolidated liabilities 

of the combined entity would exceed 10 percent of 

the aggregate consolidated liabilities of all financial 

companies. This limit should help avoid a financial 

system that is over-reliant on any particular firm, as well 

as acquisition-driven growth that is not accompanied by 

appropriate risk management systems and processes.

Detailed Resolution Plans

Financial companies subject to enhanced prudential 

standards are required to maintain detailed resolution 

plans that would facilitate a resolution under the 

Bankruptcy Code. The Dodd-Frank Act also requires, if 

necessary, changes in the structure or activities of these 

companies to ensure that they meet the standard of 

being resolvable in a crisis. 

Orderly Liquidation Authority

Enhanced prudential standards and supervision by 

the Federal Reserve will help mitigate the risks posed 

by LCFIs. However, if such an institution fails, the 

orderly liquidation authority—under which company 

shareholders and unsecured creditors bear the losses 

of failure—provides the government with the tools 

and authority to resolve a failed institution in a manner 

that limits broader systemic impact and taxpayer 

cost during times of severe market stress. This new 

framework should help strengthen market discipline and 

discourage the subsidization of excessive risk taking 

that occurred before the crisis.

These provisions, together with other elements of 

regulatory reform, such as regulation of the over-thecounter derivatives market and the implementation of 

international Basel III capital standards, are aimed at 

achieving a more resilient financial system that is better 

able to withstand the level of stress that occurred 

during the financial crisis. 

Financial Developments 113

6 Progress in the Implementation of the 

Dodd-Frank Act; Council Activities

The regulatory implementation of the Dodd-Frank Act has included introducing stronger 

supervision, risk management, and disclosure standards; establishing orderly resolution 

plans and an orderly liquidation regime to prevent firms from being perceived as too 

big to fail; regulating the derivatives markets to reduce risk and increase transparency; 

reforming the securitization markets; enhancing standards for hedge fund advisers; 

creating the new Federal Insurance Office (FIO); strengthening the oversight program for 

credit rating agencies; establishing the Office of Financial Research (OFR); consolidating 

federal banking regulators; and implementing measures to enhance consumer and 

investor protection. 

In addition, in its first year, the Council laid the groundwork for determining which nonbank 

financial companies will be supervised by the Federal Reserve and subject to heightened 

prudential standards, and for designating systemically important financial market utilities 

that will be subject to risk management standards. The Council also initiated monitoring of 

potential risks to U.S. financial stability; fulfilled explicit statutory requirements, including 

the completion of several studies; served as a forum for discussion and coordination 

among the member agencies implementing the Dodd-Frank Act; and built its basic 

organizational framework.

The following is a discussion of the significant implementation progress the Council and 

its member agencies have achieved since enactment of the Dodd-Frank Act.

6.1 Safety and Soundness

6.1.1 Capital Adequacy Rules

In June 2011, the federal banking agencies adopted 

a rule to implement portions of Section 171 of the 

Dodd-Frank Act, which is generally referred to as 

the Collins Amendment. Section 171 addresses 

several issues regarding financial institutions’ capital 

adequacy.

One issue was to eliminate the possibility that 

adoption by the largest institutions of advanced 

Basel II approaches to calculating regulatory capital 

could result in those institutions holding less capital 

than that required of smaller banks. Such a result 

would be inconsistent with the intent of the DoddFrank Act, which is that the largest institutions 

should be subject to heightened capital standards. 

Accordingly, Section 171 provides that the capital 

requirements that generally apply to insured banks 

will serve as a floor for any capital requirements 

the agencies may establish for banks, depository 

institution holding companies, and nonbank financial 

companies supervised by the Federal Reserve.

Section 171 also seeks to ensure that the 

instruments issued by depository institution holding 

companies eligible for inclusion in regulatory capital 

are equivalent or superior to those issued by insured 

banks. In general, starting January 1, 2013, for 

certain depository institution holding companies, any 

regulatory capital deductions required by Section 

171 will be phased in incrementally over three years.

Progress in the Implementation of the Dodd-Frank Act; Council Activities 115
 

6.1.2 Resolution Plans and Orderly Liquidation 

Authority 

Resolution Plans

To improve the resolvability of large financial firms 

and increase stability during times of market stress, 

Section 165(d) of the Dodd-Frank Act requires 

nonbank financial companies designated for 

enhanced supervision by the Federal Reserve and 

bank holding companies (BHCs) with $50 billion or 

more in total consolidated assets to prepare and 

maintain plans for their rapid and orderly resolution 

under the U.S. Bankruptcy Code; these plans are 

sometimes referred to as “living wills” (see Box I: 

Addressing Issues Related to Large Complex 

Financial Institutions). These resolution plans are 

not binding on bankruptcy courts or receivers. The 

Federal Reserve and the FDIC must review each 

plan. If they determine that a plan is not credible 

or would not facilitate an orderly resolution under 

the U.S. Bankruptcy Code, they may compel the 

firm to resubmit a conforming plan. If a conforming 

plan is not forthcoming, the two agencies can take 

further action, including imposing more stringent 

capital and liquidity requirements or, in consultation 

with the Council, ordering a divestiture.

Resolution plans are required to include information 

such as the following:

•	 the manner and extent to which any insured 

depository institution affiliated with the 

company is adequately protected from risks 

arising from the activities of any nonbank 

subsidiaries of the company;

•	 descriptions of the company’s ownership 

structure, assets, liabilities, and contractual 

obligations; and

•	 identification of the cross-guarantees tied 

to different securities, identification of major 

counterparties, and a process for determining 

to whom the collateral of the company is 

pledged.

In April 2011, the FDIC and the Federal Reserve 

released for public comment a joint proposed rule 

that would implement the requirement to prepare 

and maintain resolution plans. 

Orderly Liquidation Authority 

The financial crisis demonstrated that for certain 

BHCs or other financial companies near failure 

during a time of severe market stress, there may 

be only two options in the absence of a credible 

orderly liquidation authority: emergency public 

funding or bankruptcy. Neither of these options can 

accomplish the efficient and effective resolution of 

such a firm in a way that both limits the systemic 

impact and imposes costs on private investors 

rather than taxpayers. Title II of the Dodd-Frank 

Act created an orderly liquidation authority (OLA) 

that authorizes the government to address the 

potential failure of a BHC or other financial company 

when the stability of the financial system is at risk. 

The OLA is modeled on the resolution provisions 

of the Federal Deposit Insurance Act. After being 

appointed receiver under the processes described 

below, the FDIC is authorized to transfer to a third 

party assets or liabilities of a company subject to 

the OLA.1 The FDIC may also establish a temporary 

bridge financial company to hold any part of the 

company’s business with going-concern value until it 

can be sold to a third party at fair value or otherwise 

liquidated in an orderly fashion. 

To help ensure that taxpayers do not cover the costs 

of liquidation, all funds expended by the FDIC must 

be recovered through the disposition of the failed 

company’s assets, assessments on the creditors 

that stand to benefit from the process because 

of additional payments made to such creditors 

in certain limited circumstances, or assessments 

on large financial firms. In addition, under certain 

circumstances, senior executives and directors of 

a company subject to the OLA may be prohibited 

from participating in the conduct of the affairs of any 

financial company and be subject to recoupment by 

the FDIC of compensation received in the two years 

before the failure.

On the recommendation of two-thirds of the Board 

of Governors of the Federal Reserve and twothirds of the board of the FDIC (or, depending on 

the nature of the financial company, two-thirds of 

1 In the case of a failing insurance company, the company is resolved 

under the relevant state’s liquidation or rehabilitation process rather than 

under the FDIC’s receivership process. Special procedures also apply to 

the resolution of failing financial companies that are broker-dealers.

116 2011 FSOC Annual Report
the Board of Governors of the Federal Reserve 

and either two-thirds of the members of the 

SEC or the approval of the Director of the FIO, in 

consultation with the FDIC) and in consultation 

with the President, the Dodd-Frank Act authorizes 

the Treasury Secretary to appoint the FDIC as 

receiver of certain financial companies if the 

Treasury Secretary makes certain findings. The 

required findings include a determination that the 

failure of the financial company and its resolution 

under otherwise applicable insolvency law would 

have serious adverse effects on financial stability 

in the United States; that no viable private sector 

alternative is available to prevent the default of the 

financial company; and that the use of the OLA 

would avoid or mitigate the adverse effects that 

would result from resolving the financial company 

under otherwise applicable insolvency law. 

The OLA is a remedy of last resort, to be used 

only if the other tools provided by the DoddFrank Act—including the increased informational 

and supervisory powers—are unable to stave off 

a failure that could threaten financial stability. In 

particular, it is expected that the mere knowledge 

of the consequences of resolution under the OLA, 

including the understanding that financial assistance 

is no longer an option, would encourage a troubled 

financial company to find an acquirer or a strategic 

partner on its own well in advance of failure.

Title II of the Dodd-Frank Act authorizes the FDIC, 

in consultation with the Council, to adopt rules to 

implement the OLA process. The FDIC adopted 

a final rule to implement the OLA after notice and 

comment. As discussed more fully below, these 

rules seek to clarify procedural and substantive 

matters under the OLA. The FDIC intends to propose 

additional rules to implement the OLA, including 

rules governing receivership termination, receivership 

purchaser eligibility requirements, and recordretention requirements. The FDIC and SEC, after 

consultation with the Securities Investor Protection 

Corporation, will jointly propose rules governing the 

orderly resolution of certain broker-dealers.

The first OLA rule the FDIC adopted was an interim 

final rule that addressed OLA procedures, including 

payment of similarly situated creditors (which 

includes the treatment of holders of long-term 

senior debt); honoring personal services contracts; 

recognition of contingent claims; treatment of 

any remaining shareholder value in the case of a 

financial company subject to FDIC receivership (a 

covered financial company) that is a subsidiary of an 

insurance company; and limitations on liens that the 

FDIC may take on the assets of a covered financial 

company that is (1) an insurance company or (2) a 

covered subsidiary of an insurance company (other 

than an insured depository institution, an insurance 

company, or certain broker-dealers).

In March 2011, the FDIC issued a proposed rule for 

public comment. This rule provides clarity regarding 

the implementation of the OLA and helps ensure 

that the OLA process reflects the Dodd-Frank 

Act’s mandate of transparency in the liquidation of 

covered financial companies. Among the significant 

issues addressed in this rule are the priority for the 

payment of claims, the process for the determination 

of claims by the receiver, and the process for 

seeking a judicial review of any claims disallowed in 

whole or in part. 

The FDIC issued a final rule in July 2011 that 

amends and makes final the interim final rule and 

the proposed rule issued in March 2011. The final 

rule establishes a more comprehensive framework 

for the implementation of the OLA and provides 

greater transparency to the process for the orderly 

liquidation of covered financial companies under 

the Dodd-Frank Act. The rule also includes specific 

provisions setting forth the priority of payments to 

creditors, and the administrative claims process and 

the processes for resolving contingent and secured 

claims.

Secured Creditor Haircut Study

The Dodd-Frank Act requires the Council to study, 

and issue a report regarding, the importance of 

maximizing U.S. taxpayer protections and promoting 

market discipline with respect to the treatment of 

fully secured creditors in the use of the OLA. The 

Council approved the report for submission to 

Congress on July 18, 2011. The report is discussed 

further in Section 6.4.

Progress in the Implementation of the Dodd-Frank Act; Council Activities 117
6.2 Financial Infrastructure, 

Markets, and Oversight

6.2.1 Over-the-Counter Derivatives Reform

A lack of transparency in pricing or market 

exposures of derivatives and a lack of regulatory 

oversight created risks that contributed to 

the vulnerabilities of the financial system’s 

largest institutions. Title VII of the Dodd-Frank 

Act establishes a comprehensive regulatory 

framework for the over-the-counter (OTC) 

derivatives marketplace. The regulatory structure 

for derivatives set forth in the Dodd-Frank Act 

is intended to promote exchange trading and 

centralized clearing of swaps and security-based 

swaps, helping increase regulatory and public 

transparency, reduce counterparty risk, and 

enhance the resiliency of the swaps markets. 

The reforms under Title VII should also enhance 

investor protection by increasing disclosure, 

helping mitigate conflicts of interest involving 

swaps and security-based swaps, and establishing 

comparable standards for initial and variation 

margin posted to swap dealers in connection with 

noncleared swaps.

The CFTC and SEC have proposed numerous 

rules pursuant to the standard public notice and 

comment process, and have engaged in extensive 

public outreach and interagency coordination, 

including the following: 

•	 public roundtables with agency staff, market 

participants, and other concerned members of 

the public;

•	 meetings involving staff from multiple 

regulators, both domestic and international; 

and

•	 agency staff meetings with members of the 

public. 

To facilitate the establishment of OTC derivatives 

markets that are more transparent, efficient, 

accessible, fair, and competitive than the previous, 

unregulated markets, the SEC and CFTC have 

proposed (or will propose) rules that govern the 

following:

•	 the operation of swap and security-based 

swap trading platforms (exchanges and swap 

and security-based swap execution facilities);

•	 conflicts of interest relating to, and the 

operation of, clearinghouses;

•	 reporting requirements to swap and securitybased swap data repositories for swap and 

security-based swap dealers, major swap and 

security-based swap market participants, and 

swap and security-based swap counterparties; 

and

•	 business conduct standards and other 

regulatory requirements for swaps and 

security-based swap dealers and major swap 

and security-based swap market participants.

The SEC and CFTC have also jointly proposed 

rules further defining the terms “swap,” “securitybased swap,” “security-based swap agreement,” 

“swap dealer,” “security-based swap dealer,” “major 

swap participant,” and “major security-based swap 

participant,” as well as rules regarding “mixed 

swaps” and books and records for “security-based 

swap agreements.” 

In addition, the CFTC and the federal banking 

agencies issued proposed rules on capital and 

margin requirements for swap and security-based 

swap dealers and major swap and security-based 

swap market participants. The proposed rules 

would impose initial margin and variation margin 

requirements for uncleared swaps held by entities 

under each agency’s jurisdiction. With respect to 

capital requirements, the federal banking agencies’ 

existing regulatory capital rules take into account 

and address the unique risks arising from derivatives 

transactions and would apply to transactions in 

swaps and security-based swaps. The CFTC has 

proposed capital requirements for entities under its 

jurisdiction.

The FDIC, the OCC, and the Federal Reserve 

have proposed rules to permit entities under their 

respective jurisdictions to engage in certain retail offexchange foreign currency transactions, including 

foreign currency futures, options on futures, and 

options and functionally or economically similar 

transactions such as “rolling spot” trades that are 

similar to futures contracts. The proposed rules 

establish requirements in six areas: disclosure, 

recordkeeping, capital and margin, reporting, 

business conduct, and documentation. Traditional 

spot and forward contracts are not covered under 

the rules.

118 2011 FSOC Annual Report
The SEC and the CFTC are considering the 

structural and systems changes market participants 

will have to make to satisfy the new derivatives 

regulatory framework. The agencies are also 

considering a phased-in approach to implementing 

the new rules. This approach is intended to mitigate 

operational risk associated with structural and 

systems changes, and to provide an opportunity for 

market participants to raise any concerns they have 

as they design and implement the required systems.

6.2.2 Financial Market Utilities

Financial market utilities (FMUs) manage or operate 

multilateral systems for the purpose of transferring, 

clearing, or settling financial transactions. FMUs 

are critical components of the U.S. financial system 

and the broader economy. Financial institutions, 

corporations, governments, and individuals rely on 

FMUs directly or indirectly to discharge a variety of 

financial and economic transactions. The market 

infrastructure supporting the millions of financial 

transactions that occur every day encompasses 

everything from smaller-value retail payment 

systems, such as credit and debit card networks, 

to large-value payment, clearing, and settlement 

systems for financial market transactions, such as 

central counterparties, securities, foreign exchange 

settlement systems, and funds transfer systems. 

Title VIII of the Dodd-Frank Act establishes a new 

supervisory framework for systemically important 

FMUs. It authorizes the Council to designate an 

FMU as systemically important if the failure of or 

a disruption to the FMU’s operations could create 

or increase the risk of significant liquidity or credit 

problems spreading among financial institutions 

or markets and thereby threaten the stability of 

the U.S. financial system. As discussed further 

in Section 6.4, the Council approved a final rule 

outlining the criteria, processes, and procedures 

for the designation of FMUs at its July 18, 2011 

meeting.

The Federal Reserve, CFTC, and SEC, in 

consultation with each other and with the Council, 

have published proposed rules regarding risk 

management standards for designated FMUs 

subject to their respective supervisory authority. 

Final rules on risk management standards for 

designated FMUs are expected in 2011. 

Section 813 of Title VIII requires the CFTC and SEC 

to coordinate with the Federal Reserve to jointly 

develop risk management supervision programs for 

designated clearing entities (DCEs)—FMUs that are 

either registered derivatives clearing organizations 

or registered clearing agencies. The agencies 

transmitted a joint report to Congress on July 21, 

2011 containing recommendations for improving 

consistency of the DCE oversight programs of the 

CFTC and SEC; promoting robust risk management 

by DCEs and oversight by their regulators; and 

improving regulators’ ability to monitor the potential 

effects of DCEs’ risk management on financial 

stability.

6.2.3 Securitization 

Risk Retention

Properly structured securitization provides economic 

benefits that lower the cost of credit to households 

and businesses. However, when incentives are 

not properly aligned and the origination process 

lacks discipline, securitization can result in harm 

to investors, consumers, financial institutions, and 

the financial system. During the financial crisis, 

securitization displayed significant vulnerabilities to 

informational and incentive problems among various 

parties involved in the process. To address this 

weakness and promote prudent lending, Section 

941 of the Dodd-Frank Act requires federal agencies 

jointly to adopt so-called “skin in the game” rules 

that require a securitizer to retain credit risk for 

loans that the securitizer, through the issuance of 

an asset-backed security (ABS), transfers, sells, 

or conveys to a third party. In March 2011, the 

OCC, Federal Reserve, FDIC, SEC, FHFA, and the 

Department of Housing and Urban Development 

jointly proposed rules to implement this risk retention 

requirement. The Chairperson of the Council 

coordinated the rulemaking effort.

The proposed rules would require securitizers 

of ABS to retain at least 5 percent of the credit 

risk of the assets underlying the securities. 

Securitizers would not be permitted to transfer or 

hedge that credit risk. The proposed rule provides 

exemptions for qualified residential mortgages 

and ABS collateralized exclusively by commercial 

loans, commercial mortgages, or automobile 

loans that meet certain underwriting standards. 

The definition of “qualified residential mortgages,” 

Progress in the Implementation of the Dodd-Frank Act; Council Activities 119
which represent a portion but not all of the market 

for mortgage loans, is an important aspect of the 

proposed rule: it would take into account, among 

other things, the borrower’s ability to repay and 

credit history, the loan-to-value ratio of the loan, 

the form of valuation used in underwriting the 

loan, the type of mortgage, and owner-occupancy 

status. In crafting the proposed rule, the agencies 

sought to ensure that the amount of credit risk 

retained is meaningful while reducing the potential 

for negative effects on the availability and cost of 

credit to consumers and businesses. 

Issuer Review and Representation, Warranty 

Disclosure, Conflicts

Other provisions of the Dodd-Frank Act require 

SEC rulemaking for ABS. Pursuant to Section 943 

of the Dodd-Frank Act, the SEC adopted final rules 

in January 2011. These rules require securitizers 

to disclose the history of repurchase requests 

received for assets that are believed to have violated 

representations and warranties, and repurchases 

made relating to their outstanding ABS. Pursuant 

to Section 945, the SEC adopted final rules in 

January 2011 requiring an asset-backed issuer in 

a transaction registered under the Securities Act of 

1933 to perform a review of the assets underlying 

the ABS and disclose the nature of such review. At a 

minimum, the review must be designed and effected 

to provide reasonable assurance that the prospectus 

disclosure on the assets is accurate in all material 

respects.

6.2.4 Hedge Fund Adviser Registration and 

Oversight

Title IV of the Dodd-Frank Act closes a regulatory 

gap by making numerous changes to the 

registration, reporting, and recordkeeping 

requirements of the Investment Advisers Act of 

1940 (Advisers Act). These provisions are intended 

to provide the SEC with oversight authority over 

previously unregistered investment advisers to 

hedge funds and private equity funds, and the 

authority to require recordkeeping and reporting by 

advisers to venture capital funds. 

In June 2011, the SEC adopted a rule that would 

facilitate the registration of advisers to hedge funds 

and private equity funds with the SEC. To enhance 

the SEC’s ability to oversee these advisers, 

the SEC will require them to provide additional 

information about the private funds they manage, 

including information about the amount of assets 

held by the fund and identification of fund service 

providers, including auditors, prime brokers, 

custodians, administrators, and marketers. In 

addition, the SEC will require all advisers to provide 

further information about an adviser’s clients, 

employees, and advisory activities.

The SEC also adopted rules relating to several new 

exemptions from the investment adviser registration 

requirements for advisers that exclusively advise 

venture capital funds; advisers solely to private 

funds with less than $150 million in assets under 

management in the United States; and foreign 

private advisers with less than $25 million in assets 

under management in the United States. Although 

advisers are relieved from SEC registration, they 

may be subject to a registration requirement with the 

appropriate state securities regulator.

Section 404 of the Dodd-Frank Act also authorizes 

the SEC to collect data from investment advisers 

about their private funds to enable the Council to 

assess systemic risk. In January 2011, the SEC 

proposed a rule under this authority that would 

require registered investment advisers to a private 

fund to report certain systemic risk information 

to the SEC. Private fund advisers that are also 

registered with the CFTC as commodity pool 

operators or commodity trading advisers would 

satisfy systemic risk reporting requirements of the 

CFTC by filing with the SEC. 

6.2.5 Insurance

Establishment of the FIO

The financial crisis highlighted the lack of expertise 

within the federal government regarding the 

insurance industry. In response, the Dodd-Frank Act 

established the FIO to provide expertise regarding 

the insurance business, marketplace and regulatory 

environment. The following are among the FIO’s 

authorities:

•	 to monitor all aspects of the insurance 

industry, including identifying issues or gaps in 

the regulation of insurers that could contribute 

to a systemic crisis in the insurance industry or 

the U.S. financial system;

120 2011 FSOC Annual Report
•	 to monitor the extent to which traditionally 

underserved communities and consumers, 

minorities, and low- and moderate-income 

persons have access to affordable insurance, 

except health insurance;

•	 to recommend that the Council designate 

an insurer as a nonbank financial company 

that should be subject to supervision by the 

Federal Reserve;

•	 to coordinate federal efforts and develop 

federal policy on prudential aspects of 

international insurance matters; and

•	 to recommend and approve the resolution of 

certain troubled insurance companies under 

the OLA.

The FIO is led by a Director who serves in an 

advisory capacity as a nonvoting member of the 

Council. The states remain the primary functional 

regulators, and the FIO will consult with the states 

regarding insurance matters of national and 

international importance.

6.2.6 Credit Ratings 

Following the onset of the financial crisis, it 

became apparent that credit rating agencies 

had systematically underestimated the risks of 

many RMBS, CDOs, and other structured finance 

instruments. Faulty assumptions underlying rating 

methodologies and the subsequent reevaluations 

by credit rating agencies led to a significant number 

of downgrades of these securities. The number and 

severity of these negative ratings actions caused 

investors to lose confidence in the accuracy of the 

ratings of a wide range of securitized products, 

thereby contributing to the market turmoil and 

revealing the extent to which investors and others 

had become overly reliant on credit ratings. The 

Dodd-Frank Act includes two sections that remove 

references to credit ratings in certain statutes and 

direct federal agencies to remove any references to 

or requirements of reliance on credit ratings from 

regulations.

Subtitle C of Title IX of the Dodd-Frank Act 

strengthened the SEC’s oversight authority 

regarding, and mandated a number of rulemakings 

in connection with the SEC’s oversight and 

regulation of, credit rating agencies registered as 

nationally recognized statistical rating organizations. 

The SEC issued proposed rules under this authority 

in May 2011. In addition, Section 939 of the DoddFrank Act removed references to credit ratings in 

certain statutes, while Section 939A requires each 

federal agency to review any rules that require 

the use of an assessment of creditworthiness of 

a security or money market instrument and any 

references to or requirements in such rules regarding 

credit ratings. Each agency must modify those rules 

to remove references to or requirements of reliance 

on credit ratings and to substitute appropriate 

standards of creditworthiness. Numerous federal 

agencies have proposed or finalized rules that would 

modify their regulations and forms to comply with 

these requirements. Among others, the federal 

banking regulators sought initial public comment 

on proposed removals of references to rating 

agencies from the risk-based capital rules; the SEC 

proposed rules that would remove rating agency 

references from many of its investment company 

rules and forms, its registration statement forms, 

and its rules and forms applicable to broker-dealer 

financial responsibility, distributions of securities, 

and confirmations of transactions; the FDIC issued a 

final rule removing credit ratings from the calculation 

of deposit insurance risk-based assessments for 

large insured depository institutions; and the NCUA 

issued a proposed rule for public comment.

6.2.7 OFR

The Dodd-Frank Act also created the OFR in 

Treasury to, among other things, improve the quality 

of financial data and provide analytical support to 

the Council and its member agencies. The Director 

of the OFR must be appointed by the President and 

confirmed by the U.S. Senate. Treasury staff and 

personnel from other Council member agencies 

have worked to set up a framework for the OFR’s 

functions. The OFR has made significant progress 

in meeting its statutory mandates. It is working 

closely with Council member agencies to improve 

the research and data capabilities of the regulatory 

community. The OFR has also issued a policy 

statement regarding the establishment of a universal 

“legal entity identifier” that would allow the Council 

to aggregate measures of risk across the system; 

made progress in establishing a research network 

that includes academics from several universities; 

and initiated the planning process for creating a data 

Progress in the Implementation of the Dodd-Frank Act; Council Activities 121
center to set standards for financial reporting and 

to improve the quality of data that the Council and 

market participants rely on to manage risk. 

6.2.8 Consolidation of Federal Banking 

Regulators

The Dodd-Frank Act provides for the termination 

of the Office of Thrift Supervision (OTS), which had 

been the primary regulator of savings and loan 

holding companies and state and federally chartered 

savings associations, and for the transfer of its 

responsibilities to the Federal Reserve, the FDIC, 

and the OCC. This transfer occurred on July 21, 

2011. As of that date, in accordance with plans 

prepared by these agencies, the Federal Reserve 

assumed responsibility for regulating savings and 

loan holding companies; the FDIC for regulating 

state savings associations; and the OCC for 

regulating federal savings associations. The Director 

of the CFPB will assume the seat of the Director of 

the OTS on the board of the FDIC.

6.3 Consumer and Investor 

Protection 

6.3.1 Consumer Protection 

On July 21, 2011, most rulemaking and certain 

other authorities relating to consumer financial 

products and services transferred to the CFPB 

from seven federal agencies. The CFPB launched 

bank supervision, consumer response, and other 

functions on that date, and has issued a variety of 

required rules and reports under the Dodd-Frank 

Act. The CFPB is now the primary federal regulator 

focused on, and held accountable to Congress 

and the public for, consumer financial protection. 

The CFPB will work to ensure that consumers have 

the information they need to understand the costs 

and risks of financial products and services, so that 

they can compare products and choose the ones 

that are best for them. The CFPB also will clarify 

and streamline regulations and guidance to reduce 

unnecessary burdens on providers of consumer 

financial products and services.

Among its other duties, the CFPB will:

•	 conduct rulemakings with respect to federal 

consumer financial laws, including prohibitions 

on discrimination and unfair, deceptive, or 

abusive acts or practices, and supervise and 

enforce these laws for many financial service 

providers;

•	 take consumer complaints;

•	 promote financial education; and

•	 monitor financial markets for new risks to 

consumers.

The Dodd-Frank Act gives the Treasury Secretary 

responsibility for setting up the CFPB until the 

CFPB Director is in place. On September 17, 2010, 

President Obama appointed Professor Elizabeth 

Warren to serve as assistant to the President, and 

Secretary Geithner appointed her as special advisor 

to the Treasury Secretary on the CFPB. Professor 

Warren has led the effort to build the framework 

for the CFPB and, in consultation with other senior 

Treasury officials, helped to appoint a leadership 

team to assist with implementation. On July 18, 

2011, President Obama nominated former Ohio 

Attorney General Richard Cordray as Director of the 

CFPB. 

One of the CFPB’s highest priorities is 

consolidation of mortgage loan disclosure forms 

under the Truth in Lending Act and the Real 

Estate Settlement Procedures Act, both to make 

the information more useful to consumers and 

to reduce burdens on lenders. Existing federal 

regulators first began discussing consolidation of 

these forms a number of years ago. The DoddFrank Act consolidates rulemaking authority under 

the two statutes in the CFPB and mandates that 

the CFPB propose model forms by July 2012. 

The CFPB began testing prototype disclosure 

forms this spring through qualitative interviews 

with consumers, lenders, and brokers. The CFPB 

continues to gather input from industry, consumers, 

and other stakeholders via its website.

Also in the context of mortgages, significant 

progress has been made on a rule mandated by 

the Dodd-Frank Act requiring lenders to assess 

and verify consumers’ ability to repay mortgage 

loans as part of the underwriting process. The 

Federal Reserve proposed a rule in April 2011 for 

public comment. The CFPB will be responsible 

for finalizing a rule after considering the public 

comments on the proposal. 

122 2011 FSOC Annual Report
6.3.2 Debit Interchange

Debit card interchange fees, which are established 

by a payment card network and ultimately paid 

by merchants to card issuers, became subject to 

regulation by the Federal Reserve under Section 

1075 of the Dodd-Frank Act, referred to as the 

Durbin Amendment. The Durbin Amendment, among 

other things, requires the Federal Reserve to adopt 

a rule that sets standards for assessing whether 

the amount of an interchange fee for an electronic 

debit (but not credit) transaction is reasonable and 

proportional to the cost incurred by the issuer with 

respect to the transaction. The fee standards do not 

apply to an issuer that, together with its affiliates, 

has less than $10 billion in assets, or to transactions 

initiated using debit cards issued pursuant to 

government-administered payment programs and 

certain reloadable prepaid cards.

After requesting comment on a proposed rule in 

December 2010, the Federal Reserve received 

comments from more than 11,500 commenters. 

On June 29, 2011, the Federal Reserve approved 

a final rule providing that the amount of an 

interchange fee that a covered issuer may receive 

may not exceed the sum of 21 cents plus 5 basis 

points of the transaction’s value. The final rule 

also prohibits circumvention or evasion of the 

interchange fee standard, as well as an issuer 

receiving net compensation from a payment card 

network. The final rule exempts the statutorily 

exempt issuers and transactions from the 

interchange fee standard but does not mandate 

two-tier interchange fee structures.

The Federal Reserve also approved an interim final 

rule allowing an upward adjustment of no more 

than 1 cent to the permissible interchange fee. 

This adjustment makes allowance for an issuer’s 

debit card fraud-prevention costs, provided the 

issuer satisfies the fraud-prevention standards set 

forth in the interim final rule. Comments on the 

interim rule are due by September 30, 2011; the 

Federal Reserve has stated that it will re-evaluate 

this adjustment, as appropriate, in light of the 

comments received.

In addition, the final rule implements the payment 

card network exclusivity and routing provisions of 

the Durbin Amendment by requiring each debit 

card be enabled on no fewer than two unaffiliated 

payment card networks and prohibiting an issuer 

or network from inhibiting the ability of any person 

that accepts debit cards as a form of payment from 

directing the routing of debit card transactions for 

processing. The statutory exemptions from the 

interchange fee standards do not extend to the 

network exclusivity and routing provisions in the 

final rule.

The interchange fee standards, fraud-prevention 

adjustment, and the routing restrictions are effective 

on October 1, 2011. The network exclusivity 

provisions are effective on April 1, 2012, with 

respect to issuers, and October 1, 2011, with 

respect to payment card networks. Issuers of certain 

health-related and other benefits cards and generaluse prepaid cards have a delayed effective date of 

April 1, 2013, or later in certain circumstances.

6.3.3 Mortgage Transactions

Title XIV of the Dodd-Frank Act, the “Mortgage 

Reform and Anti-Predatory Lending Act,” contains 

several measures designed to protect consumers 

in mortgage transactions. Many of these measures 

were enacted as amendments to the Truth in 

Lending Act (TILA). Prior to the designated transfer 

date, July 21, 2011, the Federal Reserve was 

responsible for regulations implementing TILA, 

but, in general, rulemaking authority under TILA 

transferred to the CFPB on that date. 

In October 2010, the Federal Reserve issued 

an interim final rule to implement the appraisal 

independence provisions in Section 1472 of the 

Dodd-Frank Act. The interim rule seeks to ensure 

that appraisers are free to use their independent 

professional judgment. To protect the quality of 

appraisals, the rule also requires independent 

appraisers to receive customary and reasonable 

compensation for their services. Compliance with 

the rule became mandatory on April 1, 2011. 

Several regulatory agencies are jointly responsible 

for issuing permanent rules on appraisal 

independence. 

In February 2011, the Federal Reserve issued a final 

rule pursuant to Section 1461 of the Dodd-Frank Act 

to revise the escrow requirement for jumbo mortgage 

loans. As amended, the escrow requirement will 

Progress in the Implementation of the Dodd-Frank Act; Council Activities 123
apply to first-lien jumbo loans only if the loan’s annual 

percentage rate is 2.5 percentage points or more 

above the average prime offer rate. Also in February 

2011, the Federal Reserve issued a proposed rule to 

implement additional escrow account requirements 

for higher-priced loans pursuant to Sections 1461 

and 1462 of the Dodd-Frank Act. The proposed rule 

would expand the minimum period for mandatory 

escrow accounts, while providing an exemption for 

certain creditors that operate in “rural or underserved” 

counties. The proposed rule also would implement 

new disclosure requirements.

In April 2011, the Federal Reserve issued a 

proposed a rule to implement the provisions of 

Title XIV relating to the requirement for a creditor to 

determine a consumer’s ability to repay a mortgage 

loan before extending the loan. The proposed 

rule would provide four options for complying 

with the ability-to-repay requirement. A creditor 

could meet the standard by: (1) considering and 

verifying specified underwriting factors, such as the 

consumer’s income, assets, and obligations; (2) 

making a “qualified mortgage,” which is subject to 

certain limitations on loan terms and features; (3) 

making a balloon-payment qualified mortgage, for 

certain creditors operating predominantly in rural 

or underserved areas; or (4) refinancing a “nonstandard mortgage” with risky features into a more 

stable “standard mortgage” with a lower monthly 

payment. 

6.3.4 Investor Protection

The Dodd-Frank Act includes various provisions 

to strengthen investor protection, such as those 

promulgated under the regulatory actions discussed 

above and below. These provisions include 

regulation of the over-the-counter derivatives 

markets and governance and compensation reform. 

A key investor protection provision requires the SEC 

to complete a study of any gaps, shortcomings, or 

overlaps in the standard of conduct and supervision 

of broker-dealers and investment advisers that 

provide personalized investment advice about 

securities to retail customers. The SEC staff 

completed this study in January 2011. The study 

recommends that the SEC establish a uniform 

fiduciary standard for broker-dealers and investment 

advisers when providing personalized investment 

advice about securities to retail customers that is 

no less stringent than the standard currently applied 

under Sections 206(1) and (2) of the Advisers Act. In 

addition, the staff recommended that broker-dealers 

and investment advisers be subject to the same or 

substantively similar regulatory requirements when 

providing services to retail investors.

The SEC also completed a study of the need for 

enhanced examination and enforcement resources 

for investment advisers, and in particular, the 

extent to which having Congress authorize the 

SEC to designate a self-regulatory organization 

(SRO) to augment the SEC’s efforts in overseeing 

investment advisers would improve the frequency 

of examinations of investment advisers. This study 

recommended presenting Congress with three 

options:

1. Authorize the SEC to impose user fees on 

investment advisers to fund their examinations.

2. Authorize an SRO to examine investment 

advisers.

3. Authorize the Financial Industry Regulatory 

Authority to examine dual-registrants for 

compliance with the Advisers Act.

The SEC finalized rules in June 2011 that will 

implement provisions in Section 410 of the DoddFrank Act. The rules will realign the regulatory 

responsibilities of investment advisers between 

the state securities regulators and the SEC. These 

provisions increased the number of investment 

advisers that will be primarily regulated by the 

states. Estimates indicate that as a result of these 

changes, approximately 3,200 investment advisers 

will transition from SEC registration to state 

registration. That transition is scheduled to conclude 

by mid-2012.

The securities laws also were modified in a number 

of ways to facilitate SEC enforcement actions. 

These changes include enhancing the application of 

antifraud provisions and providing authority to bring 

actions against aiders and abettors. 

6.3.5 Governance and Compensation

The financial crisis showed that improperly 

structured compensation arrangements can lead 

executives and employees of financial institutions to 

124 2011 FSOC Annual Report
take imprudent risks that are not consistent with the 

long-term health of their organizations. To facilitate 

prudent risk management at financial institutions 

and to align the interests of executives and other 

employees with the long-term health of their 

organizations, Section 956 of the Dodd-Frank Act 

requires the Federal Reserve, FDIC, FHFA, NCUA, 

OCC, OTS, and SEC to jointly prescribe rules or 

guidelines that (1) require certain financial institutions 

to disclose to their appropriate federal regulator the 

structure of their incentive-based compensation 

arrangements so the regulator can determine 

whether such compensation is excessive or could 

lead to material financial loss to the firm; and (2) 

prohibit any type of incentive-based compensation 

that the regulators determine encourages 

inappropriate risks by providing excessive 

compensation or that could lead to material financial 

loss to the covered firm.

In April 2011, the agencies published a threepart proposed rule for public comment. First, 

a financial institution with $1 billion or more in 

total consolidated assets (a covered financial 

institution) would be required to file an annual 

report with its appropriate federal regulator 

describing the structure of the firm’s incentivebased compensation arrangements. Second, the 

proposed rule would prohibit a covered financial 

institution from establishing or maintaining an 

incentive-based compensation arrangement 

that could lead to material financial loss or that 

encourages inappropriate risks by providing certain 

“covered persons” (which include all executives and 

employees) with excessive compensation. Finally, 

the proposed rule would require each covered 

financial institution to adopt specific policies and 

procedures approved by its board to ensure and 

monitor compliance with the rule.

The prohibitions portion of the proposed rule would 

require larger covered financial institutions—those 

with $50 billion or more in total consolidated 

assets—to defer at least 50 percent of the incentive 

compensation of executive officers and heads of 

major business lines for at least three years, award 

such compensation no faster than on a prorata basis, and seek to ensure that the amounts 

ultimately paid over the course of the deferral period 

reflect losses or other aspects of performance over 

time. For these larger covered financial institutions, 

the prohibitions portion of the proposed rule would 

also set forth additional requirements for employees 

of the firm who might have the ability to expose 

the institution to risk of substantial loss. For these 

employees, the board of directors or a board 

committee would be charged with identifying the 

persons (other than the executive officers subject 

to deferral requirements) who individually have the 

ability to expose the firm to possible losses that 

are substantial in relation to the firm’s size, capital, 

or overall risk tolerance. Once such persons are 

identified, the board or committee would need 

to approve the incentive-based compensation 

arrangement for each person. For credit unions, 

large financial institutions would be defined as 

those with $10 billion or more in assets. The FHFA 

proposed that the income-deferral provisions apply 

to all entities it regulates, regardless of size. 

In addition, on January 25, 2011, the SEC adopted 

final rules implementing provisions of the DoddFrank Act that require public U.S. companies to 

conduct separate shareholder votes on executive 

pay (say-on-pay) and on the frequency of the 

say-on-pay vote, as well as specific disclosures 

about any agreements to offer a form of executive 

compensation (so-called golden parachutes) 

in connection with merger and acquisition 

transactions.

6.4 Council Activities 

6.4.1 Determination of Nonbank Financial 

Companies to Be Supervised by the Federal 

Reserve and Designation of Financial Market 

Utilities

Nonbank Financial Companies

One of the Council’s statutory purposes is to 

identify risks to financial stability that could arise 

from the material financial distress or failure, or 

ongoing activities, of large, interconnected BHCs, 

or nonbank financial companies. Under Section 113 

of the Dodd-Frank Act, the Council is authorized 

to determine that a nonbank financial company’s 

material financial distress—or the nature, scope, 

size, scale, concentration, interconnectedness, or 

mix of its activities—could pose a threat to U.S. 

financial stability. Such companies will be subject 

to consolidated supervision by the Federal Reserve 

and enhanced prudential standards. 

Progress in the Implementation of the Dodd-Frank Act; Council Activities 125
The Dodd-Frank Act provides a list of 10 

considerations the Council must use in making 

determinations under Section 113. In fall 2010, the 

Council began a rulemaking process to further clarify 

these statutorily mandated considerations. Seeking 

public input on the criteria, the Council issued an 

advance notice of proposed rulemaking (ANPR) in 

October 2010 and a notice of proposed rulemaking 

(NPR) in January 2011. The Council received 

significant input from market participants, nonprofits, 

academics, and members of the public about 

the need to develop an analytical framework for 

making determinations that will provide a consistent 

approach and will incorporate both quantitative and 

qualitative judgments. The Council expects to seek 

additional public comment regarding its approach 

to determinations and the considerations mandated 

by the Dodd-Frank Act, and to publish a final rule 

describing the process and guidance regarding the 

criteria for its determinations.

The Council’s proposed analytical framework 

organizes the 10 statutory considerations into 

six broad categories that reflect a company’s 

role in the financial system and potential to 

experience material financial distress. Three of 

these six categories—size, lack of substitutes for 

the financial services and products the company 

provides, and interconnectedness with other 

financial companies—seek to assess the potential 

for spillovers from one company’s financial distress 

to the broader financial system and real economy. 

The other three categories—leverage, liquidity risk 

and maturity mismatch, and existing regulatory 

scrutiny—indicate the vulnerability of a company to 

distress, whether it is an idiosyncratic or systemic 

shock. 

The Council’s commitment to a robust determination 

process goes beyond transparency during 

rulemakings. Each determination will be firmspecific. Before an initial Council vote on a 

proposed determination, the company under 

consideration will have an opportunity to submit 

written materials to the Council regarding the 

proposed determination. Council members will 

vote on a proposed determination only after they 

have reviewed that information, and the proposed 

determination will proceed only if approved by 

two-thirds of the Council, including the affirmative 

vote of the Chairperson. Upon a proposed 

determination, a company may request a hearing, 

and the determination will be finalized only after a 

subsequent two-thirds vote of the Council, including 

the affirmative vote of the Chairperson. The Council 

must submit a report to Congress detailing its final 

decision, which will be subject to judicial review.

As of the date of this report, the Council has not 

made any determinations under Section 113 of the 

Dodd-Frank Act. 

Financial Market Utilities

Financial market utilities (FMUs) exist in many 

markets to support and facilitate the payment, 

clearing, or settlement of financial transactions, 

thereby forming a critical part of the nation’s 

financial infrastructure. However, the function and 

interconnectedness of FMUs also concentrate 

risk because the systems they operate are highly 

interdependent, either directly through operational, 

contractual, or affiliation linkages, or indirectly 

through liquidity flows or common participants. 

Problems at one system could spill over to other 

systems or financial institutions in the form of 

liquidity and credit disruptions. Accordingly, the 

Dodd-Frank Act provides the Council with the ability 

to designate an FMU as systemically important if the 

Council determines that the failure of or a disruption 

to the functioning of an FMU’s operations could 

create or increase the risk of significant liquidity 

or credit problems spreading among financial 

institutions or markets and thereby threaten the 

stability of the U.S. financial system.

An FMU designated by the Council will be subject 

to enhanced prudential standards and supervisory 

requirements, such as heightened risk management 

standards beyond existing regulatory oversight 

that may otherwise be applicable. Designation 

further subjects an FMU to additional examinations, 

enforcement actions, and reporting requirements. 

Under unusual or exigent circumstances, designated 

FMUs could potentially gain access to the Federal 

Reserve’s discount window.

Following the publication of an ANPR in December 

2010 and an NPR in March 2011, and two 

corresponding rounds of public comment, the 

Council approved a final rule outlining the criteria, 

126 2011 FSOC Annual Report
processes, and procedures for the designation 

of FMUs at its July 18, 2011 meeting. As of the 

date of this report, the Council has not made any 

designations under Title VIII of the Dodd-Frank Act. 

The Council expects to address the designation 

of payment, clearing, or settlement activities in a 

separate rulemaking.

6.4.2 Risk Monitoring

One of the Council’s central purposes is the ongoing 

identification of risks to U.S. financial stability. 

To help identify risks, promote market discipline, 

and respond to emerging threats, the Council 

facilitates information sharing, coordination, and 

communication among member agencies. 

In the past year, the Council examined significant 

market developments and structural issues within 

the financial system, including topics discussed 

elsewhere in this report. The Council will continue to 

monitor potential threats to financial stability, whether 

from external shocks or structural weaknesses. 

To facilitate this risk-monitoring process, the Council 

established the Systemic Risk Committee (SRC), 

composed primarily of agency staff in supervisory, 

examination, surveillance, and policy roles. The 

SRC helps the Council identify, analyze, and 

monitor risks to financial stability, and provides 

the Council with periodic risk assessments. 

Accountable for interagency coordination, the SRC 

meets periodically to share information to assess 

risk-related issues that affect financial markets 

and institutions and financial stability. This forum 

enables member agency staff to identify and 

analyze potential risks that may extend beyond the 

jurisdiction of any one agency and to collaborate on 

regulatory responses.

6.4.3 Studies Required Under the 

Dodd-Frank Act

Section 619 Study: The Volcker Rule

Section 619 of the Dodd-Frank Act, known as the 

Volcker Rule, strengthens the financial system and 

constrains risks by generally prohibiting banking 

entities from engaging in proprietary trading and 

limiting their investment in or sponsorship of hedge 

funds and private equity funds. The Dodd-Frank 

Act requires the Council to issue a study and make 

recommendations on the implementation of the 

Volcker Rule within six months after the enactment 

of the Dodd-Frank Act. In October 2010, the 

Council sought input from the public in advance 

of the study by issuing a request for information; it 

received more than 8,000 comments. The Council 

issued the final study at its meeting on January 

18, 2011.2 The Council’s study recommends 

principles for implementing the Volcker Rule and 

suggests a comprehensive framework for identifying 

activities prohibited by the rule, including an internal 

compliance regime, quantitative analysis, and 

reporting and supervisory review.

Section 622 Study: Concentration Limits

Under the Dodd-Frank Act, the Council was 

also required to issue a study and make 

recommendations on the implementation of Section 

622 within six months of the Dodd-Frank Act’s 

enactment. Section 622 establishes a financialsector concentration limit generally prohibiting a 

financial company from merging or consolidating 

with, or acquiring the assets of or control of, another 

company if the resulting company’s consolidated 

liabilities would exceed 10 percent of the aggregate 

consolidated liabilities of all financial companies. 

This concentration limit is intended, along with a 

number of other provisions in the Dodd-Frank Act, 

to promote financial stability and prevent large 

financial institutions from becoming “too big to fail.” 

The Council issued the report at its meeting 

on January 18, 2011, meeting the statutory 

deadline. The Council’s study concludes that 

the concentration limit will reduce moral hazard, 

increase financial stability, and improve efficiency 

and competition within the U.S. financial 

system. The study also includes largely technical 

recommendations to mitigate practical difficulties 

likely to arise in the administration and enforcement 

of the concentration limit, without undermining its 

effectiveness in limiting excessive concentration 

among financial companies. 

On February 8, 2011, the Council published a notice 

and request for comment on the recommendations 

in the concentration limit study. 

2 The report and other reports cited in this section are available online at 

http://www.fsoc.gov/

Progress in the Implementation of the Dodd-Frank Act; Council Activities 127
Section 946 Study: Risk Retention

The Treasury Secretary, as Chairperson of the 

Council, issued a study on the macroeconomic 

effects of the Dodd-Frank Act’s risk-retention 

requirements for asset-backed securities, as 

required by Section 946, within 180 days of the 

Act’s enactment. This study, which is separate from 

the joint rulemaking on risk retention under Section 

941, was delivered to Congress on January 18, 

2011. The study recognizes the economic benefits 

of asset-backed securitization but notes that without 

reform, risks arising in the securitization process 

can detract from these benefits. The study provides 

several objectives that a risk-retention framework 

should seek to achieve to help promote safe and 

efficient lending. 

Section 123 Study: Economic Impact 

The Dodd-Frank Act directs the Treasury Secretary, 

as Chairperson of the Council, to carry out a study 

within 180 days of the Act’s enactment (and every 

five years thereafter) addressing the economic 

impact of possible financial services regulatory 

limitations intended to reduce systemic risk. The 

statute requires the study to estimate the benefits 

and costs of various potential regulatory limits on 

the efficiency of capital markets, on the financial 

sector, and on national economic growth, and to 

make recommendations on the optimal structure of 

those limits. 

The Council Chairperson met the statutory deadline, 

publishing the study on January 18, 2011. The 

study contains a critical review of existing research 

on the impact of the types of financial regulation 

identified in Section 123 of the Dodd-Frank Act, 

as well as recommendations for future research to 

better quantify the benefits of the Act and financial 

regulation generally. The study recommends that a 

cost-benefit analysis of other potential limitations 

on the activities or structure of large financial 

institutions be addressed in the next periodic study, 

which is due in 2016.

Section 215 Report: Secured Creditor Haircuts 

The Dodd-Frank Act also required the Council 

to issue a report within one year of the Act’s 

enactment, evaluating the importance of maximizing 

U.S. taxpayer protections and promoting market 

discipline with respect to the treatment of fully 

secured creditors in the utilization of the OLA. 

Among other topics, the study outlines how various 

secured creditors are treated in existing resolution 

regimes and examines whether a secured creditor 

haircut would be an effective means of improving 

market discipline and protecting U.S. taxpayers. 

The Council approved this report for submission to 

Congress on July 18, 2011. 

6.4.4 Rulemaking Coordination by the Council

As Chairperson of the Council, the Treasury 

Secretary is required to coordinate several major 

rulemakings by the member agencies under the 

Dodd-Frank Act. 

To facilitate the joint rulemaking on credit risk 

retention for asset-backed securities, certain 

member agencies participated in an inter agency 

working group to develop the rule text and 

preamble for an NPR for public comment. The 

Dodd-Frank Act generally requires that securitizers 

retain at least 5 percent of the credit risk of an 

asset sold to investors through the securitization 

process. It also calls for specific exemptions 

from this requirement, such as for asset-backed 

securities that are collateralized solely by qualified 

residential mortgages. The purpose of the riskretention requirement is to help address the 

misalignment of interests and deterioration of 

underwriting standards in the securitization markets 

leading up to the financial crisis. The Federal 

Reserve, FDIC, SEC, OCC, Department of Housing 

and Urban Development, and FHFA issued a joint 

NPR on March 30, 2011 that proposes rules to 

implement this requirement and represents a 

significant step toward strengthening securitization 

markets. The agencies extended the comment 

period for the proposed rule from June 10, 2011 to 

August 1, 2011.

The Chairperson of the Council is also required 

to coordinate the issuance of final regulations 

implementing the Volcker Rule, which are required 

to be issued within nine months of the publication of 

the Volcker Rule study described above. The Council 

Chairperson has played an active role in coordinating 

the agencies’ work to develop consistent and 

comparable regulations and to promote the 

consistent application of those regulations. 

128 2011 FSOC Annual Report
6.4.5 Operations of the Council

The Dodd-Frank Act requires the Council to 

convene no less than quarterly. In its first year, the 

Council’s principals met approximately every eight 

weeks.3 The meetings bring principals from member 

agencies together to discuss and analyze emerging 

market developments and financial regulatory 

issues. The Council is committed to conducting its 

business as openly and transparently as practicable, 

given the confidential supervisory and sensitive 

information at the center of its work. The Council 

opens its meetings to the public whenever possible. 

The Council held a public session at five of its 

meetings and has committed to holding at least two 

open sessions each year. 

The Council’s committee structure promotes 

accountability and coordination among the staffs 

of the member agencies. Due to the substantive 

agenda of the Council in its first year, every two 

weeks, the Deputies Committee, which is composed 

of senior officials from each of the Council’s 

member agencies, has convened to discuss the 

Council’s agenda and to direct the work of the 

SRC and the five other functional committees. As 

mentioned above, the SRC supports the Council’s 

efforts to monitor the U.S. financial system and 

identify potential threats to the health of the 

system. The other functional committees are 

organized around the Council’s ongoing statutory 

responsibilities: identifying nonbank financial firms 

and financial market utilities for designation; making 

recommendations to primary financial regulatory 

agencies regarding heightened prudential standards 

for financial firms; consulting with the FDIC on 

orderly liquidation authority and reviewing resolution 

plans for designated nonbank financial firms and the 

largest BHCs; and collecting data and improving 

data-reporting standards.

To help with the identification of emerging risks in 

the financial system, the Council may request data 

and analyses from the newly created OFR housed 

in Treasury. The OFR will support the Council 

and its member agencies by providing critical 

data and research as well as the analytical tools 

required to monitor and respond to future emerging 

3 The Council met on October 1, 2010; November 23, 2010; January 

18, 2011; March 17, 2011; May 24, 2011; July 13, 2011; and July 18, 

2011.

vulnerabilities. The OFR will also work with member 

agencies to reduce reporting burdens and increase 

market transparency.

Council Administration

In its first year of operation, the Council has worked 

to establish its institutional framework; adopted 

rules of operation4; released proposed regulations 

implementing its Freedom of Information Act 

obligations; and passed its first budget. The Council 

also adopted a transparency policy5 and has 

complied with the policy.

6.4.6 Section 119 of the Dodd-Frank Act

Section 119 of the Dodd-Frank Act provides that the 

Council may issue nonbinding recommendations to 

member agencies on disputes about the agencies’ 

respective jurisdiction over a particular BHC, 

nonbank financial company, or financial activity or 

product. (Certain consumer protection matters, 

for which another dispute mechanism is provided 

under Title X of the Act, are excluded). To date, 

no member agency has approached the Council to 

resolve a dispute under Section 119. 

4 The rules of operation are available online at http://www.fsoc.gov/

5 The transparency policy is available online at http://www.fsoc.gov/

Progress in the Implementation of the Dodd-Frank Act; Council Activities 129

7 Potential Emerging Threats to 

U.S. Financial Stability 

Financial stability requires a forward-looking assessment of the financial system’s 

propensity to generate imbalances and the system’s resilience to a range of potential 

adverse events. Misaligned incentives and inappropriate compensation can produce 

imbalances and vulnerabilities. Unanticipated events and the reversal of widely held 

beliefs create shocks that can be amplified by existing structural vulnerabilities. Threats 

to financial stability arise from a combination of imbalances, shocks, and vulnerabilities 

that impair the functioning of the financial system. The Council is focused on assessing 

and mitigating potential threats and taking reasonable steps to make the financial system 

more robust. 

Shocks and imbalances can interfere with financial 

stability through three main interconnected channels:

1. Failure of a financial institution or a market 

participant to honor a contractual obligation.

2. Deterioration in market functioning.

3. Disruptions in financial infrastructure.

When a financial firm or market participant fails to 

honor a contractual obligation, not only is it often a 

sign that the firm or market participant is failing or 

has failed as a going concern, it is also a disruption 

to the operations and income of the other party to 

the obligation. Even if the disruption is not large 

enough to threaten the counterparty, it will increase 

uncertainty and can have negative consequences for 

the market as a whole. 

A deterioration in market functioning can force 

financial institutions and market participants to 

rapidly reassess their risk profiles. Abrupt changes in 

pricing or liquidity for asset, funding, or risk transfer 

markets can disrupt the ability of financial institutions 

and market participants to manage their risks, 

forecast their financial needs, or even fulfill their 

contractual obligations. 

Disruptions in financial infrastructure can undermine 

confidence in financial transactions; without certainty 

that a payment will be delivered, or a transaction 

settled and cleared, financial institutions and 

market participants will be reluctant to engage 

in transactions, even with otherwise reliable 

counterparties. 

A key goal of the Council and its member agencies 

is to monitor threats to U.S. financial stability and 

reduce the transmission of shocks and imbalances 

through these channels. Achieving this goal requires 

not only fixing structural vulnerabilities but also 

maintaining confidence in the ability of the financial 

system to absorb a wide range of shocks.

Under market stress, financial institutions and 

market participants may react to fears about the 

amplification of potential losses by reducing their 

provision of financial services within the system 

itself and to the broader economy. For example, if 

lenders believe that a borrower may fail to honor a 

contractual obligation, they may restrain lending to 

other borrowers to conserve capital and liquidity. 

Because of the interconnectedness of the financial 

system, such preemptive reactions can destabilize 

the system.

In addition, large complex financial institutions that 

are difficult to resolve in an orderly manner can 

produce inefficiencies in the allocation of gains 

and losses across private investors that undermine 

market discipline. Perceptions that institutions are 

“too big to fail” can increase uncertainty in periods of 

market turmoil and reinforce destabilizing reactions 

Potential Emerging Threats to U.S. Financial Stability 131
 

Box J: Measuring Systemic Risk

The development of systemic risk measures and models is in an early stage. Various measures seek to estimate 

either the overall vulnerability of the financial system to shocks, or the contribution of individual firms to systemic 

risk. Generally, these measures have declined from their highs.

Although there is no one way to define systemic risk, 

all definitions attempt to capture risks to the stability 

of the financial system as a whole, as opposed to the 

risk facing individual financial institutions or market 

participants. For example, market participants may 

believe that they have insured against certain risks. 

However, if all participants act similarly to avoid those 

risks, for example, crowding into the same positions, 

their actions might amplify shocks and threaten the 

stability of the financial system.

Directly measuring systemic risk is challenging, and 

no consensus exists on the best measure of the level 

of systemic risk in the financial system. Financial 

economists have constructed various measures for 

assessing the contribution of individual firms to systemic 

risk on the basis of market prices. These measures 

can be averaged across firms to produce aggregate 

measures (Chart J.1).

Chart J.1 Average Risk Measures Across the 5 Largest BHCs

The chart shows three measures that use market data 

in different ways to estimate the covariation between 

individual financial institutions and the financial system 

in times of financial distress. The conditional valueat-risk (CoVaR) considers losses in total assets, the 

systemic expected shortfall (SES) focuses on equity 

losses, and the distressed insurance premium (DIP) 

measures risk from a creditor’s perspective. CoVaR 

estimates the potential financial system losses 

conditional on the distress of a particular institution. 

SES takes an opposite approach, estimating the 

equity loss of a particular institution conditional on a 

systemwide equity shortfall. DIP uses credit default 

swap spreads to estimate the hypothetical premium 

that a firm would have to pay to buy insurance against 

systemwide distress.

All three measures are contemporaneous, in the sense 

that they estimate the systemic risk contributions at a 

point in time. While they measure the average systemic 

risk for large financial institutions over time, systemic 

risk measures are most commonly used for gauging 

the cross-sectional differences in systemic risk. The 

measures have been shown to forecast differences 

in systemic risk across institutions, but their ability to 

forecast the risk of the financial system as a whole is 

more limited. Since the measures are based on market 

prices for individual institutions, they illustrate the level 

of concern market participants have about specific 

types of risks and how those risks interact, particularly 

with respect to the largest financial institutions. Market 

participants, whose decisions determine the direction 

of these measures, have less than perfect information 

about the activities and systemic risks collectively faced 

by large financial institutions. 

132 2011 FSOC Annual Report
within the financial system. These destabilizing 

reactions and their consequences for the economy 

are at the core of the concept of systemic risk (see 

Box J: Measuring Systemic Risk).

This section has two parts. First, it examines the 

interactions of current vulnerabilities in the financial 

system with potential shocks and imbalances that 

could be amplified into a threat to financial stability; 

for example, a further decline in real estate prices, 

an escalation of the European sovereign debt 

crisis, and a sudden increase in term premiums 

on U.S. government debt. The Council aims to 

reduce the system’s exposure to identified structural 

vulnerabilities and thereby bolster its resilience.

The second part of this section discusses some of 

the dominant forces that will drive change in the 

financial system over the next few years and their 

possible effects on the incentives of financial market 

participants and institutions. To sustain financial 

stability, these incentives must be aligned with 

society’s need for the efficient provision of financial 

services and must not lead to future imbalances.

The dominant forces are divided into three 

categories: (1) cyclical, (2) secular, and (3) 

regulatory forces. Among the important cyclical 

forces are normalization of monetary policy, fiscal 

consolidation, and recovery of real estate markets. 

For the secular forces we focus on technological 

innovation and new products that could transform 

the provision of financial services, with special 

attention to the role of globalization. The driving 

regulatory forces center around the continued 

implementation of the Dodd-Frank Act and issues 

related to large complex financial institutions.

7.1 Vulnerabilities and Shocks

The speed with which financial disruptions spread to 

the rest of the world in September 2008 showed the 

vulnerabilities of financial institutions and markets to 

certain shocks. Leveraged financial institutions that 

rely on access to market liquidity have an inherent 

fragility. Vulnerabilities increase when institutions are 

highly leveraged or when market participants do not 

have enough information about financial products 

or about their own counterparties. The crisis also 

illustrated the risks that can emerge when a large 

number of market participants and key markets rely 

on the stability and services of a particular entity.

Council members are addressing vulnerabilities 

in the financial system through the many reforms 

and recommendations described in this report. 

While it is not possible to anticipate every potential 

threat to the financial system, Council members 

are identifying and analyzing emerging threats and 

addressing them in their supervision of financial 

institutions, markets, and infrastructure. 

7.1.1 Financial Institutions

The resilience of individual financial institutions to 

stress is a key factor in the overall stability of the 

system. The financial crisis showed that regulators 

must focus not only on the safety and soundness 

of individual institutions but also on the risks 

those institutions could pose to the stability of the 

system as a whole. 

The crisis illustrated that shocks can become 

magnified when many large institutions are 

connected to each other, either directly (e.g., 

through counterparty exposure in short-term 

funding, trading, and derivatives activities) or 

indirectly (e.g., through common exposures to 

similar assets or funding sources). 

Interconnectivity as a source of risk is exacerbated 

when there is insufficient transparency to determine 

which entities are connected to each other, or 

when certain critical entities are not subject to 

robust risk management standards. The DoddFrank Act includes several measures to increase 

the amount of information market participants 

have about the aggregate risk exposure of their 

counterparties. For example, the Federal Reserve 

will perform stress tests on large financial institutions 

and report a summary of the results (see Box K: 

Stress Testing as a Forward-Looking Risk 

Mitigation Tool); private funds will be subject 

to disclosure requirements; and new trading and 

reporting requirements will enhance transparency in 

the derivatives market. Council members have also 

taken measures to improve the information available 

to both regulators and the public about individual 

financial institutions. 

Financial institutions are generally less vulnerable 

today than they were before the crisis, with stronger 

capital and liquidity buffers and a reduced reliance 

Potential Emerging Threats to U.S. Financial Stability 133
Box K: Stress Testing as a Forward-Looking Risk Mitigation Tool

Stress testing reveals important information about financial institutions’ resilience to potential adverse 

developments. It can guide supervisors and firms in their efforts to improve the overall health of the 

financial system. 

Stress testing has long been used as a risk 

management tool, but the approach gained greater 

prominence during and after the financial crisis. 

Recent supervisory initiatives build on lessons learned 

during the crisis about the importance of a forwardlooking and comprehensive perspective on a banking 

firm’s capital and liquidity. A critical component is the 

ability to evaluate both the quantity and quality of a 

firm’s capital against a range of plausible but severe 

outcomes in the economy and financial markets. Such 

evaluation can help supervisors allocate resources to 

better understand and address vulnerabilities, provide 

important feedback to firms about relative risks, and 

supply crucial information to market participants. 

Many types of stress tests are available for financial 

institutions. They range from an internally run stress 

test of an idiosyncratic exposure at one institution, 

to a supervisor-run, systemwide stress test that 

simultaneously stresses a number of financial 

institutions that, in aggregate, account for a large 

share of total financial system assets. The focus here 

is on systemwide, supervisor-initiated tests, but it 

should be emphasized that financial institutions’ own 

stress tests are a crucial component of their internal 

risk management and capital planning processes. The 

Dodd-Frank Act recognizes the importance of stress 

tests, mandating supervisory tests to be conducted 

once a year and company tests to be run twice a year 

for bank holding companies with assets greater than 

$50 billion and for all nonbank financial institutions 

supervised by the Federal Reserve. It also mandates 

annual company tests by all other federally regulated 

financial companies with consolidated assets of more 

than $10 billion.

A supervisory stress test has three key elements: (1) 

specification of the macroeconomic and financial market 

stress scenario(s); (2) a translation of the stress to 

capital and liquidity outcomes for individual institutions 

and the broader financial system; and (3) follow-ups, 

which could include public disclosure of results and 

supervisory actions. In describing the three elements, 

the main focus will be on stresses that potentially affect 

institutions’ capital cushions. 

Defining the Stress

Stress tests start out by defining one or more stressed 

macroeconomic and financial environments relative 

to a baseline scenario. The systemwide perspective 

comes from analyzing a set of the firms experiencing 

a simultaneous external stress. The definition has two 

aspects: (1) the severity of the stressed environment, 

and (2) the adverse developments that require special 

attention.

The severity of the test can be measured in 

various ways. For example, in the Supervisory 

Capital Assessment Program (SCAP), the baseline 

unemployment rate scenario was based on the Blue 

Chip consensus forecast but was set 1.5 percentage 

points higher in the “more adverse” scenario, 

consistent with a forecast error that would occur 

about 1 out of 10 times. In the Comprehensive Capital 

Analysis and Review (CCAR), the supervisor-designed 

macroeconomic stress used by the firms in parts of their 

internal analysis assumed an unemployment rate above 

11 percent. As measured by forecast errors, this was 

a highly unlikely event, but it was used to ensure that 

the projected recovery in the baseline did not lead to a 

scenario that entailed only a mild stress on the firms.

The definition of adverse developments requires 

analysis of the most salient among a large number of 

variables to identify areas that might need risk mitigation. 

In the SCAP and the CCAR, special attention was 

given to house prices, reflecting the exposure of the 

financial system to real estate (Chart 7.1.4). Recently, 

supervisors and firms have been examining scenarios in 

which the term structure of interest rates deviates in a 

variety of ways from the consensus forecast. 

134 2011 FSOC Annual Report
Box K: Stress Testing as a Forward-Looking Risk Mitigation Tool

Historical episodes of financial market stress are often 

used to assess potential losses on firms’ trading and 

derivatives activities. The SCAP and the CCAR used the 

financial market events of the second half of 2008, with 

the assumption that the changes in market prices from 

June to December 2008 would all happen in one day. 

Contagion effects from stresses in global markets have 

been another focus of attention. Supervisors and firms 

have considered a number of financial market contagion 

scenarios that could result from the sovereign debt 

crisis in peripheral Europe.

Translating the Stress to Financial Firm 

Outcomes

Supervisors typically use two basic approaches to 

translate the macroeconomic stress to outcomes 

for capital. The top-down approach uses statistical 

models estimated on systemwide aggregates to 

produce projections of losses and revenue under 

the stress. This approach has the advantage of 

incorporating a full range of data that spans the 

industry, but it can miss important firm-specific 

variation. The bottom-up approach uses detailed data 

about individual characteristics of specific institutions 

as inputs to models to produce projections of losses 

and revenue; it requires active engagement between 

firms and supervisors. 

A major advantage of systemwide tests is that they 

allow a horizontal comparison of results across 

institutions, which helps supervisors understand areas 

of particular exposure and vulnerability in the financial 

system. This information enables them to impose 

discipline on individual firms by identifying outliers. 

For example, in the SCAP, estimates of total industry 

returns on assets were used to evaluate the estimates 

of revenue for each firm.

For trading and derivatives activities, the focus is on 

profits and losses resulting from changes in the values 

of institutions’ trading and private equity positions, 

as well as potential losses stemming from changes in 

the size of counterparty exposures at the same time 

that counterparty creditworthiness is deteriorating. 

Depending on the institutions’ trading positions and 

the scenario used, it is possible that some institutions 

might profit from particular stress scenarios. But the 

breadth and severity of the global shock used in SCAP 

and CCAR generated significant stress losses across all 

firms in both exercises. 

The results for losses and revenue are then converted 

into a path for regulatory capital for each firm. Important 

considerations in constructing this path are tax liabilities 

and credits, as well as assumptions on the future 

lending and trading activity of the firms. Similarly, 

projections of the balance sheet structure of the firm are 

critical to project regulatory capital ratios. If the focus is 

on liquidity, assumptions about the behavior of liability 

holders are required. For example, one might assume 

that no short-term wholesale funding rolls over.

Disclosure and Supervisory Actions

A large amount of stress testing happens as part 

of standard firm risk management and supervisory 

oversight; thus, it is considered to be confidential 

supervisory information about the firm. These 

confidential results can lead to risk mitigation actions 

by the firms or supervisory action. However, for 

supervisor-run, systemwide stress tests, public 

disclosure can have advantages. For example, in the 

SCAP, detailed supervisory estimates were published 

for each firm, along with an extensive description of 

the methodology. This disclosure served a number of 

useful purposes: it reduced the uncertainty around 

private sector estimates of losses for individual firms; 

it provided estimates of losses across various asset 

classes that were useful to all market participants; and 

the transparency about the results and methodology 

gave credibility to the overall exercise. 

Systemwide stress tests can also be paired with 

specific sets of supervisory actions. In the SCAP, firms 

whose capital fell below the supervisory tier 1 common 

ratio of 4 percent in the hypothetical more adverse 

scenario were required to take capital actions to move 

above this projected ratio. If they were unable to attract 

private capital, the government was ready to provide 

capital as a backstop under the Troubled Asset Relief 

Program. In the CCAR, supervisors used the information 

from firm-run stress tests—along with their analysis 

of the adequacy of capital planning, dividend policies, 

and Basel III projections—to give “objections” or “no 

objections” to firms’ capital distribution requests. 

Potential Emerging Threats to U.S. Financial Stability 135
on short-term funding markets. Nonetheless, 

Council members are focusing on potential 

threats that could result from external shocks or 

changing dynamics in the financial system. The 

economic environment for financial institutions 

is challenging. Economic growth in the United 

States remains weak compared with recoveries 

from previous recessions (Chart 7.1.1), 

and real estate markets remain depressed. 

Continued deterioration in residential real 

estate markets would add additional strains to 

household balance sheets and reduce the value 

of collateral supporting residential mortgages 

(Charts 4.2.7 and 7.1.2). 

Supervisors have carefully analyzed the 

residential and commercial real estate holdings 

of U.S. financial institutions (Chart 7.1.3). In the 

Supervisory Capital Assessment Program and 

Comprehensive Capital Analysis and Review 

exercises, supervisors tested the effects of 

additional substantial declines in real estate 

prices on the capital buffers of large bank 

holding companies (BHCs) (Chart 7.1.4). While 

losses would increase with further price declines, 

the increased capital and relatively large loan 

loss reserves in the system provide some 

reassurance that large financial intermediaries 

would not have to deleverage in response 

(Charts 5.3.6 and 5.3.7). 

Council members remain alert to the potential 

for financial institutions, under pressure to 

boost returns to shareholders, to aggressively 

reduce their underwriting standards. As a 

result of the weak recovery and low overall 

loan demand, financial institutions have built up 

unprecedented cash reserves and increased 

their holdings of government securities (Chart 

7.1.5). Supervisors are carefully monitoring 

loan terms, especially for non investment-grade 

corporate loans. Leveraged loan issuance 

in early 2011 signaled some pressures on 

underwriting standards, but the potential for 

market disruptions appears low because of the 

relatively small size of the market and the limited 

use of funding leverage such as repo. 

Council members have considered the effects on 

banks of various scenarios for yield curve shifts 

in the coming quarters. Under a yield curveChart 7.1.1 Real GDP Growth in Recoveries

Chart 7.1.2 Percent of Mortgages with Negative Equity

Chart 7.1.3 Real Estate Exposure as a Percent of Assets

136 2011 FSOC Annual Report
steepening scenario, long-term rates would 

rise relative to short-term rates if, for example, 

investors were to demand higher compensation 

for long-term interest rate risk. In that scenario, 

while lenders would benefit from the higher 

returns on new loans, they would be exposed 

to losses on their current holdings of long-term 

assets. In particular, many banks have increased 

their exposures to long-term government and 

agency securities: one-quarter of large BHCs 

had exposures of 20 percent or more as of first 

quarter 2011 (Chart 7.1.6). Supervisors are 

actively analyzing banks’ management of these 

exposures. 

A steeper yield curve would have various 

implications for bank income. Statistical 

analysis for large BHCs suggests that net 

interest margins could be expected to increase 

if the yield curve steepened. However, higher 

long-term interest rates could be expected to 

dampen economic activity and loan growth, so 

the overall effect is less clear.

Globalization has increased the exposure 

of U.S. financial institutions to international 

developments. Markets have recently signaled 

heightened concern about sovereign and bank 

balance sheet risks in the peripheral euro 

area (Chart 7.1.7). Supervisory analysis and 

disclosures by large U.S. banks indicates that 

direct net exposures of U.S. banking firms 

to Greece, Ireland, and Portugal, individually 

and collectively, are very limited. Insurance 

industry exposure to peripheral Europe, which 

is also very limited, is concentrated in private 

corporations. The relatively larger holdings 

in Ireland primarily reflect exposures to large 

multinational corporations (Chart 7.1.8). 

While U.S. financial institutions’ direct claims 

on peripheral euro area borrowers are relatively 

modest, their exposures to core European 

banks in the United Kingdom, Germany, and 

France are much larger, and those European 

banks are the primary international lenders 

to peripheral European borrowers. The 

interconnectedness of financial institutions 

with sovereigns makes it difficult to precisely 

quantify all possible exposures, which in turn 

Chart 7.1.4 House Prices Under Supervisory Scenarios 7.1.4 House Prices Under Supervisory Scenarios

Chart 7.1.5 Securities and Reserves as a Percent of Assets

Chart 7.1.6 Large BHC Treasury and Agency Debt Holdings

Potential Emerging Threats to U.S. Financial Stability 137
increases the risk that a credit event could lead 

to generalized declines in investor sentiment, 

losses of liquidity, and associated disruptions of 

international financial markets.

7.1.2 Financial Markets

The crisis highlighted the vulnerabilities 

of financial markets to shocks. Member 

agencies have been developing tools to 

monitor financial markets so they can better 

understand these vulnerabilities. 

Before the crisis, maturity and risk 

transformation had extended into untested 

areas, with new and often more leveraged 

financial instruments and institutional structures. 

Much of this transformation depended on 

liquid wholesale funding markets. Because of 

the complexity and opacity of some of these 

products, investors often relied on the judgment 

of credit rating agencies in making investment 

decisions. As investors began to rethink the 

quality of some of the underlying assets and 

the soundness of their counterparties, market 

liquidity started to tighten. Tighter liquidity 

exposed funding problems for many financial 

institutions, leading to fire sales into illiquid 

markets. These sales often forced recognition of 

losses, reinforcing investor doubts and further 

constraining funding. 

Council agencies are developing tools to 

improve their understanding of potential risks 

to financial stability, particularly with respect 

to credit allocation, leverage, and maturity 

transformation (see Box L: Improvements 

in the Monitoring of Risks to Financial 

Stability). 

The U.S. financial system has significantly 

reduced its reliance on short-term wholesale 

funding (Chart 7.1.9). The repo market has 

shrunk by approximately 30 percent and the 

asset-backed commercial paper market has 

shrunk by approximately two-thirds. However, 

large financial institutions differ in their ability to 

access stable retail deposits, which may expose 

vulnerabilities for certain firms (Chart 7.1.10). 

Large institutions’ funding structures and risk 

management operations are being monitored 

Chart 7.1.7 7.1.7 European Sovereign European Sovereign 5-year CDS Spreads 5-year CDS Spreads

Chart 7.1.8 7.1.8 Insurance Industry Exposure to Europe Insurance Industry Exposure to Europe

$

Chart 7.1.9 Short-Term Wholesale Funding

138 2011 FSOC Annual Report
Box L: Improvements in the 

Monitoring of Risks to Financial Stability

The crisis exposed crucial gaps in regulators’ knowledge about how the U.S. financial system allocates credit 

risk, finances long-term assets with short-term liabilities, and creates leverage. 

The gaps in regulators’ knowledge encompassed 

activities of regulated institutions as well as those of 

institutions that operated on the periphery of regulation, 

such as nonbank lenders, mortgage brokers, and 

private investment funds. For example, supervisors 

knew that much financial activity had moved from the 

banking sector to the capital markets, but they did 

not fully understand the risks that certain activities 

posed to the institutions they supervised and to the 

financial system as a whole. Regulators were also slow 

to appreciate the severity of the problems arising from 

the increase in consumer financial services offered by 

mortgage brokers, nonbank mortgage lenders, and 

other entities that were not federally supervised. 

The regulatory community is now working to fill these 

knowledge gaps. For example, the SEC and the 

CFTC, responding to a Dodd-Frank Act mandate, have 

proposed a new confidential reporting form, Form PF, 

that certain private fund advisers would file with their 

regulators. The form requests detailed information 

about the amount of assets under management, use of 

leverage, counterparty credit risk exposure, and trading 

and investment positions. This form would be required 

for investment advisers to private funds registered with 

the SEC and certain commodity pool operators and 

commodity trading advisors dually registered with the 

CFTC and the SEC.

Members of the Council have taken steps to improve 

the information available to investors about financial 

markets and institutions. The quarterly reporting 

forms filed by banks (Call Reports) and bank holding 

companies (Y-9C forms) now require greater detail on 

securities holdings, particularly of complex structured 

products; loan holdings, unused commitments, 

and the types of loans that are not performing; and 

derivatives and other trading activities. These forms 

have been revised since the crisis to include a new 

schedule on firms’ variable interest entities and 

significantly expanded schedules on firms’ residential 

and commercial mortgage activities. The forms 

also address troubled debt restructurings, and the 

measurement of both assets and liabilities under fair 

value accounting standards.

Since early 2008, the OCC and the Office of Thrift 

Supervision have released their quarterly Mortgage 

Metrics reports describing the state of the mortgage 

market, based on loan-level information collected 

by the agencies in their supervision of the federally 

regulated banks and thrifts with the largest mortgage 

servicing portfolios (Chart L.1). The OCC has followed 

up with similar projects to collect and aggregate loanlevel data on large banks’ exposures in home equity, 

credit card, and commercial real estate loans, often 

working in conjunction with the Federal Reserve and 

other regulators. The agencies, led by the Federal 

Reserve, have also expanded the long-standing Shared 

National Credit Program, under which regulators 

share information on banks’ credit exposures to large 

corporations. This provides more granular information 

about the credit risk of specific corporations; 

information is collected on a quarterly basis.

Chart L.1 Number of New Loan Modifications

Potential Emerging Threats to U.S. Financial Stability 139
Box L: Improvements in the Monitoring of Risks to Financial Stability

Owing to their presence in every state, state insurance, 

banking, and securities regulators can make important 

contributions to financial stability by providing 

information about developments or trends they are 

observing in institutions and markets and taking 

appropriate actions. For example, state securities 

regulators are often the first to identify new investment 

frauds and marketwide investment-related violations; 

to assist the Council in monitoring potential threats to 

the financial system, they have developed a protocol to 

facilitate the flow of information through their member 

representative to the Council. 

State mortgage regulators have developed and 

launched the Nationwide Mortgage Licensing System 

and Registry (NMLS), which enhances supervision of 

the residential mortgage market by granting a unique 

identifier to residential mortgage loan originators and 

companies. The unique identifier allows supervisors 

to track mortgage providers across state lines. 

Additionally, consumers, industry, and regulators 

have access to specific originators’ histories and 

qualifications through NMLS Consumer Access. The 

system was established as a voluntary licensing system 

for state-licensed and state-regulated mortgage loan 

originators but was codified by Congress for mandatory 

use through the Secure and Fair Enforcement for 

Mortgage Licensing Act of 2008; it enables state and 

federal regulators to better coordinate their mortgage 

supervision efforts. 

In June 2010, the Federal Reserve launched the 

quarterly Senior Credit Officer Opinion Survey on Dealer 

Financing Terms, which includes qualitative information 

on the leverage that dealers provide to financial market 

participants in the repo and over-the-counter derivatives 

markets (Chart L.2). This survey complements more 

frequent quantitative data that supervisors collect 

on a confidential basis from large complex financial 

institutions about their liquidity profiles.

In April 2010, the SEC proposed a requirement for 

enhanced disclosure by asset-backed issuers relying 

on the safe harbor provisions for privately issued 

securities. In addition, the SEC proposed amendments 

to Rule 144A that would provide more transparency 

with respect to the private market for these securities. 

Chart L.2 Changes in Demand for Securities Financing

These amendments require a structured finance product

issuer to file a public notice of the initial placement 

of structured finance products that are eligible for 

resale under Rule 144A. Regulators and other market 

participants may benefit from the availability of more 

information about private placements of structured 

finance products.

Because the securities-lending activities of some AIG 

insurance subsidiaries were a source of concern and 

cost during the crisis, state insurance regulators have 

adopted additional disclosure requirements designed 

to provide more complete disclosure of the securitieslending agreements used by insurers. Under the new 

rules, reinvested collateral from securities-lending 

programs that was previously reported in summary 

form will be subject to the same quarterly reporting 

required of an insurer’s regular investments. Programs 

will have to include details on carrying value, fair value, 

and maturity date, and a designation of credit quality 

for every single investment. Prior to the financial crisis, 

state insurance regulators did not generally monitor 

the securities-lending activities of insurance companies 

domiciled in other states; the crisis illustrated the need 

for greater transparency. Insurers are now required 

to complete an additional schedule on securitieslending activities in their quarterly and annual reports 

that highlights (1) any asset/liability mismatch that 

would result from reinvesting the collateral into longer 

duration assets, and (2) any market value/credit risk that 

could materialize if the insurer were required to return 

140 2011 FSOC Annual Report
Box L: Improvements in the Monitoring of Risks to Financial Stability

collateral to the counterparty. The enhanced securitieslending reports will help the new FIO monitor the 

insurance industry, including potential issues or gaps 

in the regulation of insurers that could contribute to a 

systemic crisis. 

To better understand and report insurers’ exposure to 

derivatives, state insurance regulators have enhanced the 

collection of information on the use of derivatives. These 

disclosures supplement state insurance regulators’ ability 

to monitor use of derivatives by insurers under state 

insurance laws, and support the FIO’s ability to monitor 

all aspects of the insurance industry. 

The OFR has helped launch an initiative to create a 

global system to identify parties to financial contracts. 

Unique legal entity identifiers (LEIs) will increase market 

transparency and benefit market participants by making 

it easier for them to report and evaluate aggregate 

exposures. LEIs will also improve the quality of 

supervisory and nonsupervisory data used by regulators 

to measure and assess risks, and will facilitate research 

outside the regulatory community that will promote 

market discipline.

For purposes of monitoring risks to financial stability, 

the Dodd-Frank Act authorizes the Council to request 

data from the OFR and its own member agencies. The 

Council may also require financial companies to submit 

reports that will allow it to evaluate whether a specific 

company, activity, or market could pose a threat to 

financial stability, after first relying to the extent possible 

on information provided by supervisors.

Potential Emerging Threats to U.S. Financial Stability 141
closely, especially their short-term funding 

strategies and new products. Financial 

institutions have begun to develop shortterm funding products, such as collateralized 

commercial paper, to comply with new 

regulatory guidelines and still meet their business 

objectives. Council members are closely 

monitoring the liquidity and credit risk these 

products entail for issuers and investors. 

Credit rating agencies continue to factor in 

ratings uplifts for firms that they consider might 

benefit from an implicit government backstop 

(see Section 5.4.5). However, as ratings are 

reviewed ahead of the implementation of the 

enhanced resolution authority under the DoddFrank Act, certain firms’ ratings have been 

placed on review for downgrade. If the rating 

uplift associated with the rating agencies’ 

current perceived likelihood of “systemic 

support” were to be removed without any 

offsetting action on the stand-alone rating, 

the short-term ratings of some firms could fall 

below A-1/P-1 (Chart 7.1.11). A downgrade of 

the short-term rating could affect the liquidity 

profile of these institutions because of their 

continued reliance on short-term wholesale 

funding, particularly at broker-dealers. The 

rating sensitivity of wholesale funding sources 

such as money market funds (MMFs), which 

are restricted in their ability to provide funding 

to lower rated counterparties, could also be 

a factor. Few historical precedents exist of 

firms with large broker-dealers operating with 

A-2/P-2 ratings. 

Since the crisis, assets managed by MMFs have 

declined. Council members have been tracking 

the exposures that domestic MMFs have to 

Europe (Chart 7.1.12). Their direct exposure 

to the countries that have been most affected 

by the sovereign debt crisis is minimal (Chart 

7.1.13), although some major European banks 

obtain substantial short-term wholesale U.S. 

dollar funding from U.S. money market funds. 

A sudden unexpected increase in volatility in 

financial markets could expose vulnerabilities 

(Chart 7.1.14). During periods of violent price 

movements, market liquidity can evaporate as 

hedging strategies to protect against market 

Chart 7.1.10 Less-Stable Funding Sources at 6 Largest BHCs

Chart 7.1.11 Potential BHC Ratings Without Support Uplift 7.1.11 Potential BHC Ratings Without Support Uplift

Chart 7.1.12 U.S. Prime MMF Exposure by Country and Type

142 2011 FSOC Annual Report
risk become strained or directly amplify the 

price movements. For example, in the October 

1987 equity market crash, portfolio insurance 

programs were designed to sell when prices 

declined; in fact, they were set to sell at an 

increasing rate, thereby accelerating the 

market decline. Similarly, in the flash crash of 

May 6, 2010, liquidity evaporated and market 

functioning deteriorated rapidly. Regulators 

have added circuit breakers in equity markets 

to mitigate such dynamics (see Section 

5.3.4), but this event illustrated the potential 

fragility of market liquidity, particularly in areas 

characterized by rapid innovation and change in 

market behaviors. 

The role of exchange traded funds (ETFs) 

during the flash crash has focused attention 

on these products. The rapid rise of ETFs has 

been driven by the attraction of gaining liquid 

exposure to less liquid asset classes—such as 

commodities and certain emerging markets—

without having to execute trades directly in 

less liquid markets (Chart E.1). However, the 

liquidity of ETFs depends heavily on the support 

of market makers and on market functioning in 

the underlying asset. The relationship between 

ETF turnover and market volatility bears further 

analysis, and regulators must continue to 

monitor the development of more complex 

products in both U.S. and foreign-domiciled 

funds that might heighten liquidity concerns. 

Financial contagion—the rapid transmission of 

distress to markets away from the epicenter of 

weakness—can occur with startling speed, as 

happened in September 2008 and again in May 

2010, after increased concerns about sovereign 

risk in peripheral Europe spread across global 

financial markets. The latter episode also 

showed how a combination of shocks and 

vulnerabilities—in this case, the flash crash and 

uncertainty over peripheral Europe—can amplify 

strains (Chart 7.1.15). 

Periods of heightened correlation across asset 

classes can also occur. During the financial 

crisis, investors pulled away from any assets 

with potential credit risk, regardless of the 

assets’ underlying fundamentals, in favor 

of U.S. Treasuries and other “safe havens.” 

Chart 7.1.13 U.S. Prime MMF European Exposures

Chart 7.1.14 VIX: A Measure of Financial Market Volatility

Chart 7.1.15 7.1.15 Sharp Jumps in Market Volatility Sharp Jumps in Market Volatility 

Potential Emerging Threats to U.S. Financial Stability 143
Conversely, a sharp transition away from this 

trading pattern could have implications for 

hedging strategies and could amplify market 

volatility. 

With heightened uncertainty, financial markets 

can experience fast price movements. For 

example, if the yield curve were to steepen 

abruptly, perhaps owing to uncertainty about 

raising the U.S. government’s debt limit, various 

markets could be strained. The impact of 

yield curve steepening on individual market 

participants could be mitigated to some extent 

by hedging activity, as interest rate risk is 

commonly transferred in derivatives markets, 

but recent financial crises have shown that 

larger-than-expected price movements can 

expose previously unknown vulnerabilities. 

The increasing asset allocations to commodities 

and emerging markets also may present 

challenges. Strong economic growth and 

capital inflows are drawing attention to the 

risks of overheating in certain emerging market 

economies and asset markets. Emerging 

market external bond issuance reached record 

levels in 2010 and is on pace to exceed those 

levels in 2011 (Chart 7.1.16). Commodity 

markets have recently shown high volatility. 

While expected volatility is high in these 

markets, uncertainty exists about how ETFs and 

other products related to commodities would 

perform under stressed market conditions. 

7.1.3 Financial Infrastructure

Council members have identified three 

components of the market infrastructure that 

require strengthening: (1) mortgage servicing, 

(2) derivatives, and (3) tri-party repo. Of the 

three, the weaknesses in the tri-party repo 

market are most likely to amplify current risks. 

Industry initiatives are underway to address 

shortcomings in the tri-party repo market 

infrastructure by reducing the market’s reliance 

on intraday credit provision by the clearing 

banks, but these efforts are unlikely to address 

all the structural weaknesses in the market, 

including dealer liquidity risk management, 

lender collateral management, and the market’s 

resilience to investor runs and a potential dealer 

Chart 7.1.16 Emerging Market Bond Issuance

144 2011 FSOC Annual Report
failure. During the crisis, the lack of transparency 

and the pervasive belief that the clearing bank 

would always unwind a dealer’s repos caused 

market participants to inaccurately assess 

the credit and liquidity risks inherent in their 

exposures, which contributed to the industry’s 

fragility. 

The fragility of market and funding liquidity and 

the constraints on the type of collateral certain 

investors (particularly MMFs) are prepared to 

take heighten the risk of contagion from the triparty repo market. Many tri-party repo lenders, 

given their regulatory structure and investor 

base, still have a strong incentive to withdraw 

funding from a borrower at the first sign of 

distress, which can accelerate dealers’ funding 

difficulties. For example, while MMF reform can 

help insulate these funds from runs by their 

investors, MMFs still have the incentive to pull 

away from a troubled dealer in the tri-party repo 

market because, in many cases, MMFs cannot 

take possession of the collateral in the event of a 

dealer default.

Other important classes of lenders, such as 

asset custodians administering securities 

lending programs, can also face significant 

liquidity demands from their clients under 

certain circumstances, which may make them 

unwilling or unable to hold pledged collateral. 

Regulators should ensure that the various 

participants in the tri-party repo market are 

implementing and sustaining the necessary 

improvements in their management of collateral 

to alleviate the risk of cash investor runs in this 

market. 

Another risk to the tri-party repo market is the 

possibility of a dealer default. A dealer default 

would likely result in the sudden liquidation of a 

large amount of collateral by its counterparties, 

creating fire sale conditions in the underlying 

asset markets that could set damaging spirals 

in motion (Chart 7.1.17). The Tri-Party Repo 

Infrastructure Reform Task Force has called 

for tri-party repo lenders to develop plans 

and arrangements for liquidating collateral in 

the event of a default, but supervisory action 

is needed to ensure that such plans are 

developed and maintained. The Dodd-Frank 

Chart 7.1.17 7.1.17 Market and Funding Liquidity Spirals Market and Funding Liquidity Spirals

Potential Emerging Threats to U.S. Financial Stability 145
Act includes reforms intended to help ensure that 

the risks posed by institutions such as the large 

dealers in the tri-party repo market are managed 

prudently and subject to adequate oversight. Among 

other actions, when the Federal Reserve and FDIC 

finalize the new rules, most of the largest dealers 

in this market will be required to submit detailed 

resolution plans that will provide regulators with the 

tools and authority necessary to resolve a failed 

institution in a way that limits broader systemic 

impact and taxpayer cost. Additional actions by the 

regulatory community may be necessary to promote 

confidence that liquidation of collateral from a major 

dealer will proceed in an orderly manner. 

7.2 Ongoing Challenges to 

Financial Stability

The financial system constantly evolves in response 

to changes in the environment in which financial 

institutions and market participants compete. 

Council members analyze the forces driving these 

changes in three categories: cyclical, secular, and 

regulatory. The Council closely monitors these forces 

and their effects on business models and product 

innovations, with a focus on understanding how 

financial activities could migrate to less-regulated 

corners of the financial system and give rise to 

imbalances and new vulnerabilities. 

7.2.1 Cyclical Forces

Two years into a relatively weak economic 

recovery, the U.S. financial system is at an 

uncertain stage in the business cycle. Real estate 

markets have not recovered, and lending remains 

weak by historical standards. At some point, 

monetary policy will normalize and fiscal policy will 

consolidate, which has implications for financial 

institutions and markets.

While business investment and consumer spending 

have begun to improve, household net worth 

remains depressed and unemployment is elevated. 

Loan demand from households and nonfinancial 

corporations remains weak by historical standards. 

As discussed in Section 4.1, the weakness in the 

economy is due at least in part to a reduction in the 

supply of credit, as financial institutions attempted 

to reduce their leverage by selling assets, extending 

fewer new loans, and conserving capital. 

Monetary policy will eventually normalize and fiscal 

consolidation will occur as the financial system 

and the real economy continue to heal from the 

financial crisis and the recession. The pace of these 

adjustments will have an impact on the economic 

prospects and business models of financial 

institutions. While banks’ earnings will likely benefit 

in the short run as short-term interest rates and 

credit flows increase, in the long run, strategies that 

are profitable in a low-interest-rate environment may 

not work as well when rates rise. 

As monetary policy normalizes, movements in 

the yield curve will affect financial institutions’ net 

interest margins. Statistical analysis of historical 

patterns suggests that net interest margins for 

the industry as a whole will remain at or above 

current levels, under the assumption that financial 

institutions will not adjust the composition of their 

portfolios. Financial institutions—ranging from small 

credit unions and community banks to the largest, 

most complex institutions—increased their holdings 

of government securities and agency mortgagebacked securities as loan growth slowed. High 

levels of reserves have helped banks strengthen 

their balance sheets, but reserves will decline as 

monetary policy normalizes. 

Banks experienced significant funding inflows 

from depositors attracted by the safety of insured 

deposits during the financial crisis. Typically, as 

short-term rates increase and risk appetites return 

to normal, some depositors will seek out the higher 

returns offered by MMFs and other short-term 

investments. Banks that are experiencing deposit 

outflows might have to raise their deposit rates or 

find alternative forms of funding, lowering their net 

interest margins. To mitigate that impact somewhat, 

banks can offer relatively low interest rates for some 

deposits because they offer important transaction 

services. But these outflows could be much larger 

than those that occurred after previous recessions, 

because depositor inflows have been more 

significant this time than during the spikes in the late 

1980s and mid-1990s.

Alternatively, in an environment of weak economic 

growth, a prolonged period of low interest rates 

would have its own effects. It might encourage 

excessive risk taking, a decline in credit standards, 

and speculation. The longer short-term interest rates 

146 2011 FSOC Annual Report
remain at their lower bound, the more strain will be 

placed on the business models of MMFs and other 

cash pools, which might cause some investors to 

reach for yield in untested areas. The new rules on 

MMF maturity structure and quality of assets are 

intended to limit this reaction. 

Another source of uncertainty is the real estate 

sector, on which many financial institutions’ business 

models depended before the crisis. Most projections 

assume a long, slow recovery in residential and 

commercial real estate activity. Small and mediumsized financial institutions, which have less scope 

to diversify their business models from real estate, 

may find it difficult to identify new profit streams and 

may enter competitive markets with which they are 

relatively unfamiliar. Another key uncertainty is the 

path of transition back to a housing finance system 

with less government involvement.

As firms adapt their business models, Council 

members will assess changes in earnings strategies, 

including signs of reaching for yield that may come 

from softening underwriting standards or shifts into 

riskier markets. Monitoring underwriting standards 

and appropriate pricing for risk in these and other 

products will be a key focus for Council members. 

7.2.2 Secular Forces 

The financial system evolves in response to 

long-term trends. Two important trends are 

technological change and the increasing 

globalization of financial activity. 

Technological progress in the financial industry 

is reflected in advances in firms’ and markets’ 

infrastructure and the introduction and development 

of new financial products, along with the analytical 

tools needed to value those products. Technological 

innovation can trigger dramatic changes in firms’ 

business models, increase the interconnectedness 

of the system as a whole, and facilitate a much 

more globalized financial system. Financial product 

innovation is often motivated by the need to identify 

new profit streams in a competitive environment. 

Innovations can also be enabled by new analytical 

tools; for example, the introduction of option pricing 

theory led to growth in the options market in the 

1970s, and new correlation models accelerated 

growth in the market for collateralized debt 

obligations of mortgage-backed securities in the 

pre-crisis period. 

Such innovations can provide firms with new ways to 

transfer risks, undertake different forms of maturity 

transformation, and create leverage. They may also 

increase the complexity and opacity of the financial 

system. Financial institution risk managers and 

their supervisors need to carefully monitor the risks 

of new products. A constant threat comes from 

“model risk,” which refers to the fact that modelbased predictions of behavior often miss important 

changes. Almost by definition, the newest financial 

products are most exposed to model risk, because 

their lack of historical data presents challenges for 

model development or back-testing.

Another result of technological innovation is the 

advent of faster computers and the ability to 

accommodate more complex networks, which 

has enabled a surge in electronic trading in many 

markets (see Section 5.3.3). Under normal market 

conditions, the presence of electronic traders 

supports immediate and competitive execution of 

orders. However, the combination of speed and 

automatic execution creates risks. First, electronic 

trading occurs too quickly for human judgment to 

intercede. For example, the rapid pace of order 

execution is vulnerable to runaway processes. If 

the trading algorithms are not properly designed 

for these situations, the results may be far different 

than they would be if humans could intercede. 

Second, liquidity provided by electronic traders 

may deteriorate in stressed environments. Third, 

electronic trading enables strategies that can 

inhibit price discovery. For example, some trading 

algorithms seek out liquidity demand, presenting 

bids and offers into the market and then retracting 

them in a space of nanoseconds. 

Technological innovation has allowed many 

transactions and payments to be completed 

electronically. While this lowers transactions costs, 

it has exposed the financial system to a new set of 

risks. Recently, federal regulators released updated 

guidance on how banks should guard against 

cybersecurity threats. The guidance is intended 

to help ensure that the financial system increases 

its protection against the evolving methods used 

to penetrate computer networks. The regulators 

Potential Emerging Threats to U.S. Financial Stability 147
noted that successful cyberattacks have stolen 

hundreds of millions of dollars from online accounts 

by exploiting vulnerabilities in identifying the true 

account owner. The new guidance addresses these 

vulnerabilities.

Another secular trend is the rise of international 

banking. Foreign banks play an increasingly 

important role in U.S. financial markets. Moreover, 

certain globally operating institutions pose outsized 

risks to domestic and global markets, regardless 

of where they have their headquarters, owing 

to their size, complexity, and interconnections. 

The financial crisis illustrated the difficulty of 

resolving, in an orderly fashion, a failing financial 

institution that operates in many jurisdictions (see 

Box I: Addressing Issues Related to Large 

Complex Financial Institutions). Regulators are 

collaborating globally to address the systemic and 

moral hazards associated with these institutions 

through common regulatory standards, capital 

surcharges on the most systemically important 

global institutions, coordination among supervisors, 

and improvements to resolution regimes. For 

regulation of the global financial system to be 

effective, a cohesive regulatory framework across 

countries is crucial. 

Globalization of finance is particularly relevant in the 

United States because of the role of the dollar as 

the international reserve currency and the fact that 

foreign financial institutions have large holdings of 

U.S. dollar-denominated assets. During the crisis, 

banks in other countries faced significant difficulties 

in continuing to fund their holdings of distressed 

U.S. assets, particularly housing-related securities. 

Similarly, distress in other countries can affect the 

U.S. financial system if banks in those countries 

experience widespread deposit runs or short-term 

funding withdrawals and are forced to sell U.S. dollar 

assets in large quantities.

7.2.3 Regulatory Forces

Innovations and changes in the financial system 

are significantly motivated by changes in the 

regulatory environment and, in turn, often require 

additional responses by regulators.

In the wake of the crisis, sweeping regulatory 

changes have been enacted in the United States 

and abroad to improve the resilience of the financial 

system; for example, through increased capital and 

liquidity standards. The designation of nonbank 

financial companies for supervisory oversight will 

enable regulators to impose capital, liquidity, and 

risk management standards on a wider set of firms. 

Accounting changes for asset-backed markets 

have helped reduce regulatory arbitrage in these 

products. The establishment of the Consumer 

Financial Protection Bureau will have a direct impact 

on the functioning of mortgage markets through the 

imposition of a suitability standard and changes in 

disclosure. Derivatives reform will require the use of 

central counterparties for standardized derivatives 

and increased transparency. 

The largest financial institutions will be most 

influenced by regulatory forces, given their extensive 

role in the financial system. For example, derivatives 

reform will likely pressure the margins of dealers, 

which include several of the largest BHCs, as 

transparency and standardization are brought to this 

market. Implementation of the Volcker rule will also 

require changes in business models. Although these 

institutions should have enough flexibility to refine 

their core business activities, changes in their risk 

profiles must be carefully monitored.

The regulatory reforms that are most likely to 

affect the business models of the largest globally 

active financial firms and the structure of the 

global financial system are the new Basel III capital 

and liquidity rules. The significantly higher capital 

requirements for all internationally active banks, the 

capital surcharge framework for globally systemic 

banks, the higher risk weights on capital market 

activity and exposures to other large financial firms, 

the stricter definition of capital, the new international 

leverage ratio, and the new quantitative liquidity 

standards will cause global banks to reduce their 

interconnectedness, operate with larger capital 

and liquidity buffers, and otherwise lower their 

systemic footprint. This stricter regulatory regime 

will also create powerful incentives for global banks 

to restructure their internal operations, their capital 

bases, their funding profiles, and their transactions 

with other market participants to arbitrage the rules.

Council members expect that the combined impact 

of financial reform will be to improve financial 

stability. However, regulatory forces are bound to 

influence market dynamics in unpredictable ways; 

148 2011 FSOC Annual Report
care must be taken to ensure that these effects do 

not undermine the intent of the reforms. Product 

innovation may be driven by gaps or inconsistencies 

in the new regulatory framework, further highlighting 

the need for cooperation among regulators. 

Changes in regulations can give rise to unintended 

consequences. Under the new regulatory regime, 

less regulated institutions are likely to find 

competitive advantages. As a general principle, 

similar activities should be subject to similar 

regulations, but applying this principle in a globally 

integrated financial system is challenging. For this 

reason, the United States is continuously engaged 

with its international partners. This engagement 

occurs through participation in the Financial Stability 

Board and G-20 working groups, as well as bilateral 

dialogues such as the U.S.-E.U. Financial Market 

Regulatory Dialogue. This ongoing engagement 

promotes consistency and is intended to create a 

“race to the top,” so U.S.-based firms are not at a 

competitive disadvantage in the global marketplace. 

Council members will be attuned to the benefits and 

costs of existing and new regulations, and to the 

risk that financial market participants will respond by 

moving activities outside the U.S.-regulated core. 

Potential Emerging Threats to U.S. Financial Stability 149

Glossary

Adjustable-Rate 

Mortgage (ARM)

A mortgage that allows for the periodic adjustment of the interest rate 

on the basis of changes in a specified index or rate.

Agency 

MortgageBacked Security

A mortgage-backed security issued or guaranteed by federal 

agencies or government-sponsored enterprises. 

Asset-Backed 

Commercial 

Paper (ABCP)

Short-term debt that has a fixed maturity of up to 270 days and is 

backed by some financial asset, such as trade receivables, consumer 

debt receivables, or auto and equipment loans or leases. 

Asset-Backed 

Security (ABS)

A debt instrument that is collateralized by specific financial assets 

that generate the cash flow used to service the debt instrument.

Auction Rate 

Security (ARS)

A debt security, often issued by municipalities, in which the yield is 

reset regularly via a Dutch auction.

Automated 

Clearing House

(ACH)

An electronic clearing and settlement system for exchanging batches 

of electronic transactions among participating depository institutions; 

such electronic transactions are often substitutes for paper checks 

and may be used to make recurring payments, such as payroll 

or loan payments, or single payments, such as transferring funds 

between accounts or paying bills online. In the United States, the 

system or network has two operators: the Federal Reserve Banks 

and a private sector organization.

Available-forSale (AFS)An accounting term for debt and equity securities that have readily 

determinable fair values and are not classified as trading securities 

or as held-to-maturity securities. Available-for-sale securities are 

accounted for at fair value on a company’s balance sheet.

Bank for 

International 

Settlements (BIS)

An international financial organization that serves central banks in 

their pursuit of monetary and financial stability, helping to foster 

international cooperation in those areas and acting as a bank for 

central banks.

Bank Holding 

Company (BHC)

Any company that has direct or indirect control of one or more 

banks and is regulated and supervised by the Federal Reserve in 

accordance with the Bank Holding Company Act of 1956.

Glossary 151
 

Basel Accords, 

Basel Standards

The Basel Committee on Banking Supervision (BCBS) develops and

issues international standards on bank capital adequacy. In 1988 the 

BCBS introduced a capital measurement system commonly known 

as the Basel Capital Accord or Basel I. In 2004 the BCBS issued a 

revised capital adequacy framework titled “International Convergence 

of Capital Measurement and Capital Standards: A Revised 

Framework,” which is commonly referred to as the New Accord, 

or Basel II. Following the financial crisis, the BCBS developed new 

global standards for the banking system that are collectively referred 

to as Basel III. 

Broker-Dealer An entity that is engaged in the business of buying and selling

securities for itself and others.

Capitalization 

Rate

In commercial real estate, the ratio of net operating income from a 

property to its value.

Central Bank 

Reserves

In the United States, balances held at Federal Reserve Banks to

satisfy reserve requirements, plus any balances held in excess of 

required reserve balances and contractual clearing balances.

Central 

Counterparty 

An entity that is interposed between the initial participants to a

bilateral transaction, and becomes the buyer to every seller and 

the seller to every buyer of a specified set of contracts or financial 

instruments.

Clearing Bank A commercial bank that facilitates payment and settlement of 

financial transactions, such as check clearing or facilitating trades 

between the sellers and buyers of securities or other financial 

instruments or contracts.

Clearing House 

(Derivatives 

Clearing 

Organization or 

Clearing Agency)

An entity through which financial institutions agree to exchange 

payment instructions or other financial obligations (e.g., securities). 

The institutions settle for items exchanged at a designated time 

based on the rules and procedures of the clearing house. In some 

cases, the clearing house may assume significant counterparty, 

financial, or risk management responsibilities for the clearing system.

Clearing House 

Interbank 

Payments 

System (CHIPS)

An automated clearing system used primarily for international 

payments. This system is owned and operated by The Clearing 

House and engages Fedwire Funds Service for settlement.

Closed-End 

Fund

A type of investment company that issues a fixed number of

nonredeemable shares that trade intraday in secondary markets at 

market-determined prices.

152 2011 FSOC Annual Report
CLS Bank 

International 

(CLS)

A private-sector, special-purpose bank used for settling foreign 

exchange transactions to eliminate settlement risk on a gross, 

payment-versus-payment basis.

Collateralized 

Debt Obligation 

(CDO)

A type of structured asset-backed security that has tranches with 

distinct interest rates, payment flows, and risk levels. 

Commercial 

Bank

A chartered and regulated financial institution authorized to take 

deposits from the public, obtain deposit insurance from the FDIC, 

and engage in certain lending activities.

Commercial 

MortgageBacked Security 

(CMBS)

A security that is collateralized by a pool of commercial mortgage 

loans and makes payments that are based primarily on the 

performance of those loans.

Commercial 

Paper (CP)

Short-term (maturity of up to 270 days), unsecured corporate debt.

Commercial 

Paper Funding 

Facility (CPFF)

A Federal Reserve funding facility that enhanced liquidity in the 

commercial paper markets by providing a liquidity backstop to U.S. 

issuers of commercial paper. The facility purchased three-month 

unsecured and asset-backed commercial paper directly from eligible 

issuers. The program was announced in October 2008 and was 

closed on February 1, 2010.

Committee on 

Payment and 

Settlement 

Systems (CPSS)

A committee of central banks hosted by the Bank for International 

Settlements that sets standards for payment and securities 

settlement systems.

Comprehensive 

Capital Analysis 

and Review 

(CCAR)

A cross-institution study, completed in March 2011, conducted 

by the Federal Reserve of the capital plans and capital planning 

processes of the 19 largest U.S. bank holding companies.

Confidential 

Supervisory 

Information

Generally refers to information consisting of reports of examination 

and inspection, confidential operating and condition reports, and 

any information derived from, relating to, or contained in them, and 

information gathered by agencies responsible for supervising financial 

institutions in connection with any investigation or enforcement 

action. Confidential supervisory information also may consist 

of documents prepared by, on behalf of, or for the use of such 

agencies.

Glossary 153
Core Deposits Deposits that are stable, lower cost, and reprice more slowly than 

other deposits when interest rates change. Core deposits are 

typically funds of local customers who also have a borrowing or other 

relationship with the bank.

Credit Default 

Swap (CDS)

A bilateral over-the-counter contract in which one party agrees to 

make a payment to the other party in the event of a specified credit 

event, in exchange for one or more fixed payments.

Credit 

Intermediation

The process of receiving funds in order to provide debt financing to 

third parties. 

Credit Rating 

Agency

A private company that evaluates the credit quality of debt issuers 

as well as their issued securities and provides ratings on the issuers 

and those securities. Many credit rating agencies are nationally 

recognized statistical rating organizations, the largest of which are 

Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s.

Credit Union A member-owned, not-for-profit cooperative financial institution 

formed to permit members to save, borrow, and obtain related 

financial services. All federally chartered credit unions and most 

state-chartered credit unions provide federally insured deposits and 

are regulated by the NCUA.

Current Account 

Balance

The difference between a country’s total exports and imports of 

goods, services, and transfers. Current account balance calculations 

exclude transactions in financial assets and liabilities.

Dark Pool A trading network that matches the orders of multiple buyers and 

sellers for a financial instrument without displaying quotations to the 

public.

Debt Guarantee 

Program (DGP)

One of two components of the FDIC’s Temporary Liquidity Guarantee 

Program. The DGP provided liquidity through an FDIC guarantee 

of certain types of senior unsecured debt issued by participating 

entities. Participating entities could issue FDIC-guaranteed debt 

through October 31, 2009, with maturities lasting through December 

31, 2012. 

Defined Benefit 

Plan

A retirement plan that uses a predetermined formula to calculate the 

amount of a participant’s future benefit.

Defined 

Contribution 

Plan

A retirement plan in which the amount of the employer’s annual 

contribution is specified. 

Deposit 

Insurance Fund 

(DIF)

The fund managed by the FDIC to pay deposit insurance claims on

failed banks, financed through assessments paid by FDIC-insured 

depository institutions.

154 2011 FSOC Annual Report
Deposit 

Insurance Limit

The standard maximum deposit insurance amount granted to each 

depositor, per insured bank, for each account ownership category.

Depository 

Institution

A financial institution that is legally permitted to accept deposits. 

Depository institutions include savings banks, commercial banks, 

savings and loan associations, and credit unions. 

Discount 

Window

The Federal Reserve facility for extending credit directly to eligible 

institutions.

Dividend 

Recapitalization

A transaction in which debt is used to finance a company’s dividend 

payment, often in the form of a special one-time payment.

European 

Stability 

Mechanism 

(ESM)

A European intergovernmental crisis financing facility that will be 

activated in 2013, following ratification of an amendment to the EU 

treaties. The ESM will be backed by €80 billion in paid-in capital and 

€620 billion of callable capital by euro area member states, and will 

have a €500 billion lending capacity. The ESM will be permitted to 

lend only to Eurozone sovereigns in the context of an adjustment 

program, and all lending decisions must be made by unanimous 

agreement by creditor states.

Exchange Traded

Note (ETN)

Senior unsecured debt securities issued by a firm. These structured 

notes are listed and traded on securities exchanges and offer returns 

based on exposure to different underlying assets.

Farm Credit 

System

A government-sponsored enterprise created by Congress and 

composed of a network of borrower-owned financial institutions that 

provide credit to farmers, ranchers, residents of rural communities, 

agricultural and rural utility cooperatives, and other eligible borrowers. 

The Farm Credit System is the largest agricultural lender in the United 

States and is regulated by the Farm Credit Administration.

Fedwire Funds 

Service

A real-time gross settlement system owned and operated by the 

Federal Reserve Banks that offers participants the ability to send and 

receive time-critical payments for their own account or on behalf of 

their clients.

Fedwire 

Securities 

Service

A book-entry securities transfer system operated by the Federal 

Reserve Banks that provides participants safekeeping, transfer, and 

delivery-versus-payment settlement services.

FICO Score A measure of a borrower’s creditworthiness based on the borrower’s 

credit data; developed by the Fair Isaac Corporation.

Glossary 155
Financial Market 

Infrastructure

A multilateral system among participating financial institutions, 

including the operator of the system, used for the purposes of 

recording, clearing, or settling payments, securities, derivatives, or 

other financial transactions. Financial market infrastructures exist 

in many financial markets to support and facilitate the transferring, 

clearing, or settlement of financial transactions.

Financial Market 

Utility (FMU)

Subject to certain exclusions, the Dodd-Frank Act defines an FMU as 

“any person that manages or operates a multilateral system for the 

purpose of transferring, clearing, or settling payments, securities, or 

other financial transactions among financial institutions or between 

financial institutions and the person.”

Fiscal 

Consolidation

Government policy aimed at reducing government deficits and the 

pace of debt accumulation.

Fiscal Year (FY) Any 12-month accounting period. The fiscal year for the federal 

government begins on October 1 and ends on September 30 of the 

following year; it is named after the calendar year in which it ends.

Fixed-Rate 

Mortgage

A mortgage loan in which the interest rate does not change during 

the term of the loan.

Floating Rate

Note

A debt instrument with a variable interest rate.

General 

Obligation (G.O.) 

Bond

A type of municipal bond backed by the full faith and credit of the 

governmental unit that issues the bond.

GovernmentSponsored 

Enterprise (GSE)

A corporate entity that has a federal charter authorized by law but 

that is a privately owned financial institution.

Gross Domestic 

Product (GDP)

The broadest measure of aggregate economic activity, measuring the 

total value of all final goods and services produced within a country’s 

borders during a specific period.

The Group of 

Twenty Finance 

Ministers and 

Central Bank 

Governors (G-20)

An international forum established in 1999 to bring together officials 

of systemically important industrialized and developing economies to 

discuss key issues in the global economy. 

Held-to-Maturity 

(HTM)

An accounting term for debt securities held in portfolio and 

accounted for at cost, under the proviso that the company has the 

positive intent and ability to hold those securities to maturity.

156 2011 FSOC Annual Report
Household Debt 

Service Ratio

An estimate of the ratio of debt payments to disposable personal 

income. Debt payments consist of the estimated required payments 

on outstanding mortgage and consumer debt.

Interest Rate 

Risk

The exposure of an individual’s or an institution’s financial condition to 

movements in interest rates.

International 

Organization 

of Securities 

Commissions 

(IOSCO)

An international organization of securities market regulatory agencies 

that sets standards for securities markets. 

InvestmentGrade SecurityA security whose rating is among the highest in credit-worthiness as 

measured by credit rating agencies.

Large Bank 

Holding 

Company

Any bank holding company (BHC) that files the FR Y-9C. All BHCs 

with total consolidated assets of $500 million or more are required 

to file. Before March 2006, the threshold was $150 million. BHCs 

meeting certain additional criteria determined by the Federal Reserve 

may also be required to file regardless of size.

Leveraged 

Buyout (LBO)

An acquisition of a company in which the buyer uses borrowed funds 

for a significant portion of the purchase price.

Leveraged Loan A loan or revolving credit facility provided to a borrower that is 

carrying a high debt burden.

LIBOR-OIS 

Spread

The difference between LIBOR and an OIS rate of a similar term, 

which serves as a measure of market pricing of the credit and 

liquidity risk in term, unsecured interbank lending. The LIBOR-OIS 

spread is widely viewed as a barometer of stress in money markets.

Loan-to-Value 

Ratio (LTV)

The ratio of the amount of a loan to the value of an asset, typically 

expressed as a percentage. This is a key metric when considering 

the financing of a mortgage.

London 

Interbank 

Offered Rate 

(LIBOR)

The interest rate at which banks can borrow unsecured funds from 

other banks in London wholesale money markets, as measured by 

daily surveys of the British Bankers’ Association. The published rate 

is a trimmed average of the rates obtained in the survey. 

Loss-Sharing 

Arrangement

A method in a purchase and assumption transaction in which the 

seller agrees to share with the acquirer losses on certain types of 

assets. The seller usually agrees to absorb a significant portion of 

future disposition losses on covered assets. The economic rationale 

for such transactions is that retaining loss share assets in the 

banking sector would produce a better net recovery than the seller’s 

liquidation of the assets.

Glossary 157
Maastricht Treaty The treaty establishing the European Union, enacted in 1993. The 

Maastricht Treaty laid the basis for a common currency (the euro) 

and the European Central Bank. Subsequently amended (most 

recently by the Lisbon Treaty), the Maastricht Treaty lays out the 

basic policymaking responsibilities of member states, the European 

Commission, and the European Parliament.

Macroprudential 

Regulation

Regulation aimed at promoting the stability of the financial system as 

a whole rather than individual institutions. 

Marketable Debt Obligations that can be bought and sold on public secondary 

markets.

Mark-to-Market The process by which the reported value of an asset is adjusted to 

reflect its market value.

Maturity 

Transformation

A condition in which a financial intermediary issues shorter-term 

liabilities to fund longer-term assets. 

Model Risk Risk related to using an incorrect model specification. For example, 

misspecification can be due to programming errors, technical errors, 

data issues, or calibration errors.

Money Market 

Fund (MMF)

A type of mutual fund that is required by law to invest in low-risk 

securities and pays dividends that generally reflect short-term interest 

rates. MMFs typically invest in government securities, certificates 

of deposit, commercial paper, or other highly liquid and low-risk 

securities. 

Mortgage 

Servicer

A company that acts as an agent for mortgage holders by collecting 

and distributing mortgage cash flows. Servicers also handle defaults, 

modifications, settlements, and foreclosure proceedings.

MortgageBacked Security 

(MBS)

An asset-backed security backed by a pool of mortgages. Investors 

in the security receive payments derived from the interest and 

principal payments on the underlying mortgages.

Municipal Bond A bond issued by states, cities, counties, local governmental 

agencies, or certain nongovernment issuers.

Mutual Fund A type of investment company that issues redeemable securities, 

which the fund generally stands ready to buy back from investors 

at their current net asset value. Also called an open-end investment 

company or open-end fund.

158 2011 FSOC Annual Report
Nationally 

Recognized 

Statistical Rating 

Organization 

(NRSRO)

A credit rating agency that is registered with the SEC as an NRSRO.

Overnight 

Indexed Swap 

(OIS)

An interest rate swap that serves as a measure of investor 

expectations of an average effective overnight rate over the term of 

the swap. 

Over-theCounter (OTC)A method of trading that does not involve an organized exchange. In 

over-the-counter markets, participants trade directly with each other, 

typically through voice or computer communication.

Private-Label 

MortgageBacked Security

In housing finance, a mortgage-backed security or other bond 

created and sold by a company other than a government-sponsored 

enterprise (GSE). The security often is collateralized by loans that are 

ineligible for purchase by a GSE.

Prudential 

Regulation

Regulation aimed at ensuring the safe and sound operation of 

financial institutions, set by both state and federal authorities.

Public Debt Cumulative amounts borrowed by the Treasury Department or the 

Federal Financing Bank from the public or from another fund or 

account. The public debt does not include agency debt (amounts 

borrowed by other agencies of the federal government).

Ratings Uplift The difference between the stand-alone credit rating assigned by 

a credit rating agency to an issuer, based on that issuer’s intrinsic 

financial strength, and the higher credit rating that considers the 

possibility of implicit external (e.g., government) support.

Real Estate 

Mortgage 

Investment 

Conduit 

A type of multiclass mortgage-backed security in which interest and 

principal payments from the underlying mortgages are structured into 

separately traded securities.

Receiver A custodian appointed to maximize the value of the assets of a failed 

institution or company, and to settle the liabilities.

Recourse 

Obligation

An obligation for which the lender has a legal right to seek repayment 

from a borrower if the collateral is insufficient to pay the debt in full.

Repurchase 

Agreement 

(Repo)

A transaction in which one party sells a security to another party 

while agreeing to repurchase it from the counterparty at some date in 

the future, at an agreed price.

Glossary 159
Reserve 

Requirements

The amount of funds that a depository institution must hold in reserve 

against specified deposit liabilities. In the United States, within limits 

specified by law, the Federal Reserve has authority over changes in 

reserve requirements. Depository institutions must hold reserves in 

the form of vault cash or deposits with Federal Reserve Banks.

Residential 

MortgageBacked Security 

(RMBS)

A security that is collateralized by a pool of noncommercial, 

residential mortgage loans and makes payments that are based 

primarily on the performance of those loans.

Revenue Bond A type of municipal bond backed by revenue from the project the 

bond finances.

Revolving Credit A lending arrangement whereby a lender commits to provide a 

certain amount of funding to a borrower on demand. The borrower 

may generally borrow and repay the committed funding at any time 

over the term of the agreement.

Risk-Based 

Capital

An amount of capital, based on the risk-weighing of various asset 

categories, that a financial institution should hold to protect against 

adverse developments.

Secured Lending Lending in which the borrower pledges collateral to the lender to 

secure repayment of the loan. 

Securities 

Lending/

Borrowing

The temporary transfer of securities from one party to another for a 

specified fee and term, in exchange for collateral in the form of cash 

or securities.

Securitization A financial transaction in which assets such as mortgage loans are 

pooled, and securities representing interests in the pool are issued.

Self-Regulatory 

Organization 

(SRO)

An organization that has the authority to regulate its members 

by establishing and enforcing rules and standards regarding its 

members’ conduct.

Settlement Risk The risk that settlement of a transaction in a transfer system will not 

take place as expected. In foreign exchange, this is the risk that one 

party will pay out the currency it sold but not receive the currency it 

bought. This risk may comprise both credit and liquidity risk. In the 

settlement process, this term is typically associated with exchangefor-value transactions when there is a lag between the final settlement 

of the various legs of a transaction (i.e. the absence of delivery versus 

payment). 

160 2011 FSOC Annual Report
Short-Term 

Wholesale 

Funding

Large-value, short-term funding instruments, exceeding deposit 

insurance limits, that are typically issued to institutional investors. 

Examples include large checkable and time deposits, financial open 

market paper, and repurchase agreements.

Structured Note An unsecured debt instrument that has a derivative element. The 

return on structured notes is based in part on the performance of one 

or more underlying reference assets, such as equities, commodities, 

or interest rates. Structured notes remain recourse obligations of the 

issuer and are subject to default risk.

Stub Quote An offer to buy or sell a stock at a price so far away from the 

prevailing market price that it is not intended to be executed, such as 

an order to buy at a penny or an offer to sell at $100,000.

Supervisory 

Capital 

Assessment 

Program (SCAP)

A stress test, conducted from February to May 2009, designed to 

estimate the capital needs of U.S. bank holding companies with 

assets exceeding $100 billion under an adverse macroeconomic 

scenario; it was administered by the Federal Reserve, OCC, and 

FDIC.

Synthetic 

Collateralized 

Debt Obligation

A collateralized debt obligation, issued by an entity that holds credit 

default swaps on reference assets (rather than holding the reference 

assets themselves), that allows investors to gain exposure to those 

reference assets.

System Open 

Market Account 

(SOMA)

The SOMA consists of the Federal Reserve’s domestic and foreign 

portfolios, which include both dollar-denominated and euro and yendenominated assets, in addition to reciprocal currency arrangements 

made with foreign institutions. The Federal Open Market Committee 

(FOMC) has selected the Federal Reserve Bank of New York to 

execute open market transactions, using the SOMA portfolio, to 

implement monetary policy and foreign exchange intervention at the 

direction of the FOMC. 

Systemic Risk 

Determination

Upon the written recommendation of two-thirds of the FDIC Board 

and two-thirds of the Federal Reserve Board, the Secretary of 

the Treasury (in consultation with the President) determines that 

conformance with least-cost resolution would have serious adverse 

effects on economic conditions or financial activity before the FDIC 

is allowed to take action other than least-cost resolution or provide 

assistance as necessary to avoid or mitigate such effects.

Temporary 

Liquidity 

Guarantee 

Program (TLGP)

A program implemented in October 2008 by the FDIC through 

a systemic risk determination to provide liquidity to the banking 

industry by restoring banks’ access to funding markets and by 

stabilizing bank deposits. The program had two components: the 

Debt Guarantee Program and the Transaction Account Guarantee 

Program.

Glossary 161
Tender Option 

Bond (TOB)

An obligation, also known as a “put bond” or “puttable security,” that 

grants the bondholder the right to require the issuer or a specified 

third party acting as agent for the issuer (such as a tender agent) to 

purchase the bond, usually at par, at a certain time or times prior to 

maturity or upon the occurrence of specified events or conditions.

Term AssetBacked 

Securities Loan 

Facility (TALF)

A Federal Reserve funding facility that issued loans with terms of 

up to five years to holders of eligible asset-backed securities (ABS). 

TALF was intended to assist the financial markets in accommodating 

the credit needs of consumers and businesses by facilitating the 

issuance of ABS collateralized by a variety of consumer and business 

loans. TALF was also intended to improve the market conditions 

for ABS more generally. The program was announced in November 

2008. The facility ceased making loans collateralized by newly issued 

commercial mortgage-backed securities on June 30, 2010, and loans 

collateralized by all other types of TALF-eligible newly issued and 

legacy ABS on March 31, 2010. 

Term Auction 

Facility (TAF)

The program in which the Federal Reserve made term funds, at either 

28- or 84-day maturity, available to all eligible depository institutions 

through a regular auction that determined the interest rate. The 

facility was announced in December 2007, and the final auction was 

held in March 2010. 

Term Loan A loan granted by a commercial bank, insurance company, or 

commercial finance company for a fixed term. 

Thrift A financial institution that ordinarily possesses the same depository, 

credit, financial intermediary, and account transactional functions as a 

bank, but that is chiefly organized and primarily operates to promote 

savings and home mortgage lending rather than commercial lending. 

Also known as a savings bank, a savings association, or a savings 

and loan association.

Time Deposits Deposits which the depositor, generally, does not have the right to 

withdraw funds before a designated maturity date without paying an 

early withdrawal penalty. A certificate of deposit is a time deposit. 

Trading 

Securities

An accounting term for debt and equity securities that are bought 

and held principally for the purpose of selling them in the near term. 

Trading securities are accounted for at fair value, with unrealized 

gains and losses included in earnings.

Tranche A claim on a portion of the cash flows from an underlying asset or 

pool of assets defined by its risk, maturity, or other characteristics.

Transaction 

Account 

Guarantee 

Program (TAGP)

One of two components of the FDIC’s Temporary Liquidity Guarantee 

Program. The TAGP provided liquidity by guaranteeing all funds held 

in certain noninterest-bearing transaction accounts at participating 

insured depository institutions through December 31, 2010.

162 2011 FSOC Annual Report
Tri-Party Repo A repurchase agreement in which a third party agent, such as a 

clearing bank, acts as an intermediary to facilitate the exchange of 

cash and collateral between the two counterparties. In addition to 

providing operational services to participants, the tri-party agents in 

the U.S. tri-party repo market extend large amounts of intraday credit 

to facilitate the daily settlement of tri-party repos. 

Troubled Asset 

Relief Program 

(TARP)

A government program to address the financial crisis, authorized 

by the Emergency Economic Stabilization Act of 2008, allowing the 

government to purchase or insure up to $700 billion in assets and 

equity from financial institutions.

Underwriting 

Standards

Terms, conditions, and criteria used to determine the extension of 

credit in the form of a loan or bond.

Yield Curve A curve mapping the relationship between bond yields and their 

respective maturities. 

Glossary 163

Abbreviations

ABCP Asset-Backed Commercial Paper

ABS Asset-Backed Security

ACH Automated Clearing House

AFS Available-for-Sale

AMLF ABCP Money Market Mutual Fund Liquidity Facility

ANPR Advance Notice of Proposed Rulemaking

ARM Adjustable-Rate Mortgage

ARS Auction Rate Security

ASC Accounting Standards Codification

BAB Build America Bonds

BAC Bank of America

BCBS Basel Committee on Banking Supervision

BEA Bureau of Economic Analysis

BHC Bank Holding Company

BIS Bank for International Settlements

BLS Bureau of Labor Statistics

C Citigroup

C&I (Loans) Commercial and Industrial (Loans)

CBO Congressional Budget Office

CCAR Comprehensive Capital Analysis and Review

CDO Collateralized Debt Obligation

Abbreviations 165
CDS Credit Default Swap

CFPB Bureau of Consumer Financial Protection

CFTC Commodity Futures Trading Commission

CHIPS Clearing House Interbank Payments System

CLS CLS Bank International

CMBS Commercial Mortgage-Backed Security

CP Commercial Paper

CPFF Commercial Paper Funding Facility

CPSS Committee on Payment and Settlement Systems

CRE Commercial Real Estate

DCE Designated Clearing Entity

DGP Debt Guarantee Program

DIF Deposit Insurance Fund

DTCC Depository Trust and Clearing Corporation

DVP Delivery Versus Payment

EFSF European Financial Stability Facility

EFSM European Financial Stability Mechanism

EME Emerging Market Economies

ESM European Stability Mechanism

ETF Exchange Traded Fund

ETN Exchange Traded Note

EU European Union

FBO Foreign Banking Organization

FDIC Federal Deposit Insurance Corporation

FHA Federal Housing Administration

FHFA Federal Housing Finance Agency

166 2011 FSOC Annual Report
FHLB Federal Home Loan Bank

FICO Fair Isaac Corporation 

FIO Federal Insurance Office

FMU Financial Market Utility

FOMC Federal Open Market Committee

FRB Federal Reserve Board

FRBNY Federal Reserve Bank of New York

FSB Financial Stability Board

FSOC Financial Stability Oversight Council

FY Fiscal Year

G.O. (Bond) General Obligation (Bond)

G-20 The Group of Twenty Finance Ministers and Central Bank Governors

GDP Gross Domestic Product

GS Goldman Sachs

GSE Government-Sponsored Enterprise

HTM Held-to-Maturity

IMF International Monetary Fund

IOSCO International Organization of Securities Commissions

JPM JPMorgan Chase

LBO Leveraged Buyout

LCFI Large Complex Financial Institution

LEI Legal Entity Identifier

LIBOR London Interbank Offered Rate

LTV Loan-to-Value Ratio

M&A Mergers and Acquisitions

MBS Mortgage-Backed Security

Abbreviations 167
MMF Money Market Fund

MMIFF Money Market Investor Funding Facility

MS Morgan Stanley

NAIC National Association of Insurance Commissioners

NAICS North American Industry Classification System

NAV Net Asset Value

NBER National Bureau of Economic Research

NCUA National Credit Union Administration

NFIB National Federation of Independent Business

NFNR Nonfarm Nonresidential

NMLS Nationwide Mortgage Licensing System and Registry

NPR Notice of Proposed Rulemaking

NRSRO Nationally Recognized Statistical Rating Organization

NSA Not Seasonally Adjusted

NSCC National Securities Clearing Corporation

OCC Office of the Comptroller of the Currency

OECD Organisation for Economic Co-operation and Development

OFR Office of Financial Research

OIS Overnight Indexed Swap

OLA Orderly Liquidation Authority

OTC Over-the-Counter

OTS Office of Thrift Supervision

PDCF Primary Dealer Credit Facility

REIT Real Estate Investment Trust

Repo Repurchase Agreement

RMBS Residential Mortgage-Backed Security

168 2011 FSOC Annual Report
RTGS Real-Time Gross Settlement

RWA Risk-Weighted Assets

S&P Standard & Poor’s

SA Seasonally Adjusted

SAAR Seasonally Adjusted Annual Rate

SCAP Supervisory Capital Assessment Program

SCOOS Senior Credit Officer Opinion Survey

SEC Securities and Exchange Commission

SLOOS Senior Loan Officer Opinion Survey

SOMA System Open Market Account

SPV Special Purpose Vehicle

SRC Systemic Risk Committee

SRO Self-Regulatory Organization

TAF Term Auction Facility

TAGP Transaction Account Guarantee Program

TALF Term Asset-Backed Securities Loan Facility

TARP Troubled Asset Relief Program

TIPS Treasury Inflation Protected Securities

TLGP Temporary Liquidity Guarantee Program

TOB Tender Option Bond

TOP Term Securities Lending Facility Options Program

TSLF Term Securities Lending Facility

VA Department of Veterans Affairs

WFC Wells Fargo

Abbreviations 169

Notes on the Data

Except as otherwise indicated, data cited in this report is as of July 18, 2011.

Glossary of certain government data sources:

FFIEC 002: Federal Financial Institutions Examination Council report of balance sheet and off–

balance sheet information for U.S. branches and agencies of foreign banks.

Flow of Funds: Data release compiled and published by the Federal Reserve.

FR 2004: Report of market activity for primary dealers in U.S. government securities published 

by the Federal Reserve.

FR G-19: Statistical release published by the Federal Reserve.

FR Y-9C: Consolidated financial statement for domestic bank holding companies published by 

the Federal Reserve.

SCOOS: Survey of senior credit officers on availability and terms of credit conducted and 

published by the Federal Reserve Board.

SLOOS: Survey of senior loan officers on bank lending practices conducted and published by 

the Federal Reserve Board.

Papers cited in this report:

Brunnermeier, Markus and Lasse Pedersen. “Market Liquidity and Funding Liquidity,” Review 

of Financial Studies, 2009, 22(6): 2201-2238, by permission of Oxford University Press.

Copeland, Adam M., Antoine Martin, and Michael Walker. “The Tri-Party Repo Market before 

the 2010 Reforms,” Federal Reserve Bank of New York Staff Reports, 2010, No. 477.

Cordell, Larry, Yilin Huang, and Meredith Williams. “Collateral Damage: Sizing and Assessing 

the Subprime CDO Crisis,” Federal Reserve Bank of Philadelphia Working Paper, 2011.

“White Paper on Tri-Party Repo Infrastructure Reform,” Federal Reserve Bank of New York, 

published online on May 17, 2010.

“The 2010 Federal Reserve Payment Study: Noncash Payment Trends in the United States: 

2006-2009.” Federal Reserve System, April 5, 2011.

Other: 

Certain data was obtained through Haver Analytics. 

Moody’s data provided by Moody’s Investors Service.

Bloomberg data: © 2011 Bloomberg Finance L.P. All rights reserved. Used with permission. 

NAR data: Copyright National Association of REALTORS®. Used with permission.

Tri-Party Repo Infrastructure Reform Task Force: Industry working group sponsored by the 

Federal Reserve Bank of New York to address vulnerabilities in the tri-party repo market.

Notes on the Data 171

List of Charts

Chart 4.0.1 Real GDP Growth and the Unemployment Rate 17

Chart 4.0.2 Real GDP Growth and Its Components 17 

Chart 4.0.3 United States Nonfinancial Net Debt Flows 18

Chart 4.0.4 Euro Area Nonfinancial Net Debt Flows 18

Chart 4.1.1 Net Debt Outstanding as a Percent of GDP 18

Chart 4.1.2 Bank Business Lending Standards and Demand 19

Chart 4.1.3 Corporate Bond Market Issuance 19

Chart 4.1.4 Corporate Bond Spreads 19

Chart 4.1.5 North American Completed LBOs 20

Chart 4.1.6 Proxy for Small Business Lending 20

Chart 4.1.7 Nonmortgage Consumer Credit Flows 20

Chart 4.1.8 Credit Card Limit and Outstanding Balance 21

Chart 4.1.9 Single-Family New Home Starts and Sales 21

Chart 4.1.10 Distressed Sales Share of Total Home Sales 21

Chart 4.1.11 Net Consumer Sector Credit Flows 22

Chart 4.1.12 National Repeat Sales Home Price Indexes 22

Chart 4.1.13 Housing Affordability Index 22

Chart 4.1.14 Median Credit Score at Mortgage Origination 23

Chart 4.1.15 Commercial Property Price Indexes 23

Chart 4.1.16 CMBS New Issuance 23

Chart 4.1.17 Private-Label RMBS Gross Issuance 24

Chart 4.1.18 GSE and Private-Label RMBS Gross Issuance 24

Chart 4.1.19 OTC Derivatives 25

Chart 4.1.20 OTC Derivatives Growth 25

Chart 4.1.21 Distribution of OTC Derivatives 25

List of Charts 173
Chart 4.1.22 Private-Label Residential MBS Exposures 26

Chart 4.1.23 Ownership of Investment Grade Subordinates in RMBS and 

 ABS CDOs (June 2007) 26

Chart 4.1.24 ABS Structured Finance CDO Issuance 26

Chart 4.1.25 Impaired MBS and CDO Securities 27

Chart 4.1.26 Noncash Retail Payments: 2006 27

Chart 4.1.27 Noncash Retail Payments: 2009 27

Chart 4.1.28 Money Market Funds and Checking Deposits 28

Chart 4.2.1 Corporate Credit Market Debt to Net Worth 29

Chart 4.2.2 Financial Ratios for Nonfinancial Corporations 29

Chart 4.2.3 Nonfinancial Corporate Bond Default Rate 29

Chart 4.2.4 Noncorporate Assets 30

Chart 4.2.5 Noncorporate Credit Market Debt to Net Worth 30

Chart 4.2.6 Household and Nonprofit Balance Sheets 31

Chart 4.2.7 Share of Owners’ Equity in Household Real Estate 31

Chart 4.2.8 Household Debt Service Ratio 32

Chart 4.2.9 Household Financial Obligations Ratio 32

Chart 4.2.10 Outstanding Balances of Consumer Loans 32

Chart 4.3.1 Total Treasury Market Turnover 33

Chart 4.3.2 Federal Government Debt Held by the Public 33

Chart 4.3.3 Outlays and Revenues Using CBO Projections 33

Chart A.1 U.S. Dollar Share of Allocated Reserves 34

Chart A.2 Currencies in Allocated Global Reserves 34

Chart 4.3.4 Interest Rate Payer Skew 35

Chart 4.3.5 Interest Outlays and Average Maturity 35

Chart 4.3.6 Outright Holdings of Domestic Assets in the SOMA 35

Chart 4.3.7 Municipal Liabilities as a Percent of GDP 36

Chart 4.3.8 State Tax Revenue 37

Chart 4.3.9 City General Fund Revenues and Expenditures 37

Chart 4.3.10 City General Fund Tax Receipts 37

174 2011 FSOC Annual Report
Chart B.1 Issuance by Tax Status 38

Chart B.2 ARS and VRDO Funding of Long-Term Muni Bonds 38

Chart B.3 Municipal Bond Flows 39

Chart B.4 Municipal Tax-Exempt Bond Ratios 39

Chart 4.4.1 Indebtedness and Leverage in Selected Advanced Economies (April 2011) 40

Chart 4.4.2 Real GDP Growth 40

Chart 4.4.3 Emerging Markets: Public Debt to GDP 40

Chart 4.4.4 Emerging Markets: Current Account 41

Chart 4.4.5 Private Capital Flows to Emerging Markets 41

Chart 4.4.6 EM Foreign Exchange Reserves Coverage 41

Chart C.1 2009 Gross General Government Debt & Deficits 42

Chart C.2 European Sovereign 10-year Spreads 43

Chart 5.0.1 The Financial Crisis in the Interbank Market 45

Chart 5.1.1 Federal Reserve Balance Sheet: Assets 46

Chart 5.1.2 Federal Reserve Facilities 46

Chart 5.1.3 US$ FX Swap Facility Usage Since Inception 46

Chart 5.1.4 EUR-US$ FX Implied Basis Spreads 47

Chart 5.1.5 CPFF Support of Commercial Paper Market 47

Chart 5.1.6 30-Day CP Rates Less 1-Month OIS Rates 47

Chart 5.1.7 Nonmortgage ABS Issuance 48

Chart 5.1.8 ABS Issuance 48

Chart 5.1.9 Securitized Auto ABS Spreads 48

Chart 5.1.10 CMBS AAA Spread 49

Chart 5.1.11 Debt Spreads vs. 3-year U.S. Treasury Securities 49

Chart 5.1.12 Total Debt Outstanding for TLGP Firms 49

Chart D.1 Money Market Fund Assets 50

Chart D.2 Money Market Fund Sponsor Support 51

Chart 5.1.13 Prime Money Market Fund Assets 52

Chart 5.1.14 The Financial Panic in the Interbank Market 52

Chart 5.1.15 Price-to-Book Ratio of 6 Large Complex BHCs 52

List of Charts 175
Chart 5.1.16 CDS Spreads of 6 Large Complex BHCs 53

Chart 5.1.17 Aggregate Large BHC Total Equity Capital 53

Chart 5.1.18 Fannie Mae Option-Adjusted Spreads 54

Chart 5.1.19 GSE: Net Income and Losses 54

Chart 5.1.20 FHLB Bank Advances 54

Chart 5.2.1 Origin of Private Nonfinancial Debt Outstanding 55

Chart 5.2.2 Bank vs. Market Intermediated Credit Outstanding 55

Chart 5.2.3 Large Bank Holding Company Pre-Tax Income 56

Chart 5.2.4 Independent Broker-Dealer Assets 56

Chart 5.2.5 SCAP Bank Noninterest Income 56

Chart 5.2.6 Assets of Foreign Bank Branches and Agencies 57

Chart 5.2.7 Asset Distribution of FDIC-Insured Institutions 57

Chart 5.2.8 Assets of the Ten Largest Depository Institutions 57

Chart 5.2.9 Largest 4 Banking Institutions as Percent of GDP 58

Chart 5.2.10 Commercial Bank and Thrift Pre-Tax Income 58

Chart 5.2.11 FDIC-Insured Failed Institutions 58

Chart 5.2.12 Large Bank Pre-Tax Income 59

Chart 5.2.13 Community Bank Pre-Tax Income 59

Chart 5.2.14 Federally Insured Credit Union Income 59

Chart 5.2.15 Assets of the Ten Largest Credit Unions 60

Chart 5.2.16 Finance Company Mortgage Assets 60

Chart 5.2.17 Real Estate Investment Trust (REIT) Assets 60

Chart 5.2.18 Consumer Loans Outstanding 61

Chart 5.2.19 Business Loans Outstanding 61

Chart 5.2.20 Finance Company Liabilities 61

Chart 5.2.21 Property and Casualty Insurance: Assets 62

Chart 5.2.22 Life Insurance: Assets 62

Chart 5.2.23 Property and Casualty Insurance: Capital and Income 62

Chart 5.2.24 Life and Other Insurance: Capital and Income 63

Chart 5.2.25 Household Financial Assets 63

176 2011 FSOC Annual Report
Chart 5.2.26 Household Equity Holdings 63

Chart 5.2.27 Investment Management Industry 64

Chart 5.2.28 U.S. Mutual Fund and ETF Assets 64

Chart 5.2.29 Retirement Funds by Type 64

Chart 5.2.30 Pension Fund Assets Allocated to Equities 65

Chart 5.2.31 State and Local Government Pension Plans 65

Chart 5.2.32 Private Defined Benefit Pension Plans 65

Chart E.1 U.S. Exchange Traded Funds (ETFs) 66

Chart E.2 Major ETF Divergence From Net Asset Value (NAV) 66

Chart 5.2.33 Private Defined Contribution Pension Plans 68

Chart 5.2.34 Public and Private Pension Funding Level 68

Chart 5.2.35 Private Equity 68

Chart 5.2.36 Change in Hedge Fund AUM 69

Chart 5.2.37 Hedge Fund Performance By Strategy 69

Chart 5.2.38 Distribution of Net Asset Flows by Size of Fund 69

Chart 5.2.39 Retail Deposits vs. Short-Term Wholesale Funding 70

Chart 5.2.40 Composition of Short-Term Wholesale Funding 70

Chart 5.2.41 FBO Share of US$ Short-Term Wholesale Debt 70

Chart 5.2.42 Short-Term Collateralized Debt 71

Chart 5.2.43 Estimated Size of Repo Market 71

Chart 5.2.44 Bilateral vs. Tri-party Repo Market 74

Chart 5.2.45 Estimated Value of the Tri-party Repo Market 74

Chart 5.2.46 Tri-party Repo Collateral 74

Chart 5.2.47 Tri-party Repo Collateral Distribution 75

Chart 5.2.48 Wholesale Cash Investors 75

Chart 5.2.49 Securities Lending Cash Reinvestment 75

Chart 5.2.50 U.S. Futures and Options Trading 76

Chart 5.2.51 Trading Venues for U.S. Equities by Market Share 76

Chart 5.2.52 OTC and Exchange Traded Derivatives Growth 76

Chart 5.2.53 OTC and Exchange Traded Derivatives 77

List of Charts 177
Chart 5.2.54 Exchange Traded Derivatives 77

Chart 5.2.55 U.S. Regulated Derivatives Central Counterparties 77

Chart 5.2.56 Bilateral Execution 78

Chart 5.2.57 Execution Through Central Clearing 78

Chart 5.2.58 Average Daily US$ Payment Flows in 2010 78

Chart 5.2.59 U.S. Financial Infrastructure 79

Chart 5.2.60 Annual Payment Clearing Volumes 79

Chart 5.2.61 Annual Payment Clearing Values 79

Chart 5.2.62 Collateralized Commercial Paper Market 80

Chart 5.2.63 Global Structured Note Issuance 80

Chart 5.2.64 US$ Structured Notes by Asset Class 80

Chart 5.2.65 Non-US$ Structured Notes by Asset Class 81

Chart 5.3.1 Financial to Private Sector Gross Liabilities 81

Chart 5.3.2 Financial Sector Gross Liabilities to GDP 81

Chart 5.3.3 Change in Tier 1 Common Ratios for Large BHCs 82

Chart 5.3.4 Large BHC Dividends and Repurchases 82

Chart 5.3.5 Change in Tier 1 Common Ratios for Large BHCs 83

Chart 5.3.6 Aggregate Large BHC Capital Ratios 83

Chart 5.3.7 Tier 1 Common at the 100 Largest BHCs 83

Chart G.1 Return on Risk-Weighted Assets: 99th Percentile 84

Chart G.2 Percentile of the Distribution of After-Tax Net Income to RWA for U.S. BHCs 85

Chart 5.3.8 Core Deposits as a Percent of Total Liabilities 86

Chart 5.3.9 Short-Term Wholesale Funding at Large BHCs 87

Chart 5.3.10 Domestic vs. Foreign US$ Bank Debt Issuance 87

Chart 5.3.11 Foreign Bank Issuance of US$ Short-Term Debt 87

Chart 5.3.12 Reserves Held by Foreign Bank Branches 90

Chart 5.3.13 Average Daily Value of CLS Transfers 91

Chart 5.3.14 Average Daily Volume of CLS Transfers 91

Chart 5.3.15 Globex CME September 13, 2010 Incident 93

Chart 5.3.16 Current Tri-party Repo High Level Process Flow 94

178 2011 FSOC Annual Report
Chart 5.3.17 Tri-party Concentration by Asset Class 94

Chart 5.3.18 Tri-party Repo Aggregate Median Haircut 95

Chart 5.3.19 Lehman Tri-party Repo Assets in 2008 95

Chart 5.3.20 Lehman Tri-party Repo Cash Investors in 2008 95

Chart 5.3.21 Residential Mortgage Foreclosure Starts Rate 97

Chart 5.3.22 Residential Mortgage Delinquency Rate 98

Chart 5.3.23 S&P 500 and VIX on May 6, 2010 99

Chart 5.3.24 Citi FX/Equity Realized Correlation Index 100

Chart 5.3.25 S&P 500 Implied Correlation Index 100

Chart 5.4.1 Dow Jones U.S. Total Stock Market Index 101

Chart 5.4.2 Price-to-Earnings Ratio for Corporate Equities 101

Chart 5.4.3 High-Yield Credit Risk Premium 102

Chart 5.4.4 Correlation of Stock Prices and Treasury Returns 103

Chart 5.4.5 Price-to-Rent Ratio for Residential Property 103

Chart 5.4.6 Capitalization Rate and Spread 104

Chart 5.4.7 Farm Land Prices 104

Chart 5.4.8 Agricultural Real Estate Debt Outstanding 104

Chart 5.4.9 Syndicated Leveraged Loan Market 105

Chart 5.4.10 Composition of Leveraged Loan Investors 105

Chart 5.4.11 All in Cost of Leveraged Loans 105

Chart 5.4.12 Leveraged Loan New Issuance Metrics 106

Chart 5.4.13 Leveraged Loan New Issuance Characteristics 106

Chart 5.4.14 Commodity Prices 106

Chart 5.4.15 Middle East Producers: Production and Capacity 107

Chart 5.4.16 Oil Market Price and Net Long Positions 107

Chart 5.4.17 BHC Systemic Uplift 108

Chart 5.4.18 S&P Current Actual & Market Implied Rating 108

Chart 5.4.19 Current Long-Term Ratings and Uplift 108

Chart 5.4.20 Current Short-Term Ratings 109

Chart 5.4.21 Interest Expense as a Percent of Total Liabilities 109

List of Charts 179
Chart 5.4.22 Noninterest-Bearing Liabilities to Total Liabilities 109

Chart 5.4.23 Value Added Share of Financial Sector 110

Chart 5.4.24 Financial Sector Share of Nonfarm Payroll 110

Chart 5.4.25 Financial Sector Share of Corporate Profits 110

Chart 5.4.26 Financial Sector Wages to All Wages 111

Chart 5.4.27 Investment Banking Wages to All Wages 111

Chart 5.4.28 Compensation Share of Industry Value Added 111

Chart I.1 Complex Financial Institutions in 2007 112

Chart J.1 Average Risk Measures Across the 5 Largest BHCs 132

Chart 7.1.1 Real GDP Growth in Recoveries 136

Chart 7.1.2 Percent of Mortgages with Negative Equity 136

Chart 7.1.3 Real Estate Exposure as a Percent of Assets 136

Chart 7.1.4 House Prices Under Supervisory Scenarios 137

Chart 7.1.5 Securities and Reserves as a Percent of Assets 137

Chart 7.1.6 Large BHC Treasury and Agency Debt Holdings 137

Chart 7.1.7 European Sovereign 5-year CDS Spreads 138

Chart 7.1.8 Insurance Industry Exposure to Europe 138

Chart 7.1.9 Short-Term Wholesale Funding 138

Chart L.1 Number of New Loan Modifications 139

Chart L.2 Changes in Demand for Securities Financing 140

Chart 7.1.10 Less-Stable Funding Sources at 6 Largest BHCs 142

Chart 7.1.11 Potential BHC Ratings Without Support Uplift 142

Chart 7.1.12 U.S. Prime MMF Exposure by Country and Type 142

Chart 7.1.13 U.S. Prime MMF European Exposures 143

Chart 7.1.14 VIX: A Measure of Financial Market Volatility 143

Chart 7.1.15 Sharp Jumps in Market Volatility 143

Chart 7.1.16 Emerging Market Bond Issuance 144

Chart 7.1.17 Market and Funding Liquidity Spirals 145

180 2011 FSOC Annual Report

Financial Stability Oversight Council

1500 Pennsylvania Avenue, NW 

Washington, D.C. 20220 

www.fsoc.gov