Potential Emerging Threats 123

Given the inherent difficulty in predicting shocks, 

perhaps the most important line of defense is to 

reduce vulnerabilities by ensuring that institutions 

have sufficient capital and liquidity resources, sound 

risk-management practices, and strong internal 

and regulatory controls. Policy efforts can also 

strengthen financial markets’ ability to withstand 

shocks by promoting greater informational 

transparency, for example, by addressing gaps 

in the availability of data and by producing 

consolidated audit trails. Additional policy measures 

that serve to enhance robustness of markets and 

institutions include comprehensive resolution 

planning, procedures for orderly liquidation of 

insolvent institutions, constraints on concentration 

in financial services, disciplined underwriting 

standards for credit origination, and exercising 

due diligence on emerging financial products. 

Finally, markets can be made more resilient if public 

authorities can respond to financial stresses in a 

flexible and timely manner. An example would 

be the central bank’s role as lender of last resort, 

accompanied by appropriate safeguards against the 

risk of moral hazard.

The public policy goal is not to reduce financial 

market vulnerabilities to zero. Many of the key 

tasks performed by financial markets inherently 

involve a degree of vulnerability to certain kinds of 

risk. Credit provision to risky borrowers, maturity 

transformation, and the clearing of financial 

transactions are all activities that can generate 

vulnerabilities. Accordingly, the goal of public policy 

is to design regulatory and institutional frameworks 

that reduce vulnerabilities of markets, institutions, 

and infrastructures to acceptable levels, while 

allowing the financial system to continue to serve 

the needs of the real economy.

Destabilizing shocks are more likely to occur 

when markets have undergone structural changes, 

including those from technological development 

and financial innovation. These changes may be 

slow moving, occurring over a period of years. For 

7.1 Framework: Threats as a Combination 

of Shocks and Vulnerabilities

Episodes of financial disruption typically arise when 

adverse developments unforeseen by most market 

participants, commonly referred to as shocks, 

interact with financial system vulnerabilities. A 

shock that potentially threatens stability is typically 

one that induces substantial losses on a class of 

assets over a short period of time. Recent history 

provides examples of shocks that created challenges 

for financial stability, such as the bursting asset 

price bubbles in stock markets (2000) and housing 

markets (2007), rapid increases in interest rates 

(1994), defaults on sovereign debt (for example, 

Mexico in 1982 or Russia in 1998), or severe 

operational stress in financial markets (for example, 

the so-called “flash crash” of May 2010). Shocks 

can also emerge from, or be exacerbated by, the 

failure of a specific firm, infrastructure events, or 

breakdowns in market functioning that create or 

aggravate losses on a class of assets. 

Not all such disturbances necessarily affect the 

stability of the financial system or the real economy. 

However, if the financial system is particularly 

vulnerable to shocks, for example, due to excessive 

leverage or excessive use of short-term wholesale 

funding of illiquid assets, a shock could have 

extreme balance sheet consequences and threaten 

institutions with insolvency. Market participants 

in general may not know which specific firms have 

balance sheets that are most at risk, so they may 

respond by avoiding exposure to any potential 

counterparty that might be at risk of insolvency. 

The resulting attenuation of credit provision could 

lead to disorderly liquidation of assets by all affected 

firms, inducing losses in other asset classes, thereby 

spreading and magnifying the effects of the initial 

disturbance. Credit flows to the non-financial 

sector could be disrupted, reducing the pace of 

real economic activity. In extreme cases, total 

economic losses could far exceed the original drop 

in asset value. 

7 Potential Emerging Threats
124 2012 FSOC / / Annual Report

Chart 7.2.1 Sovereign Yields example, the proliferation of mortgage-backed 

securities backed by subprime mortgage debt 

occurred over approximately eight years. 

Structural changes that occur during periods 

of low volatility can be particularly problematic, 

since such low-volatility episodes can lead to 

complacency on the part of risk managers and 

may lead to riskier behaviors in search of higher 

returns. The full implications of such structural 

changes are rarely recognized in real time. 

In particular, so-called “model risk” becomes 

more of a problem as market participants fail 

to adjust their risk-management models in 

response to the structural shifts. As a result, 

market participants are likely to underestimate 

the probability of shocks and to be unprepared 

when a shock actually occurs.

7.2 Areas of Heightened Uncertainty

There are several noteworthy aspects of the 

current economic environment in which 

structural change has elevated the level of 

uncertainty. A clear instance is the trajectory of 

growth, asset prices, and institutional change 

resulting from euro area sovereign stresses. 

The introduction of the euro represented a 

significant structural change that ushered in a 

related set of new developing institutions and 

policies. Initially, the unified monetary policy 

was associated with a convergence of sovereign 

yields across euro area countries (Chart 7.2.1), 

although this was not accompanied by a full 

convergence of macroeconomic fundamentals, 

such as productivity growth. 

The financial crisis and recession of 2007-2009 

drew attention to cross-sectional differences 

in growth prospects, competitiveness, and 

default risk among euro area countries, with 

yield spreads widening for some sovereigns. 

These structural tensions were exacerbated by 

the cyclical downturn and by the fiscal burdens 

arising from bank support programs. 

Meanwhile, euro area integration on various 

fronts remained incomplete, complicating 

the crisis response. While euro area leaders 

have expressed a desire to deepen European 
Potential Emerging Threats 125

unification, there is continued uncertainty 

about how European official entities will resolve 

these fiscal strains and the extent to which euro 

area institutions may change as a result. Markets 

continue to believe that exits from the common 

currency cannot be ruled out, with attendant 

legal and other uncertainties. In particular, 

the threat of a breakup of the euro area carries 

with it redenomination risk—the risk that 

obligations due in euros will be repaid in an 

alternative, less valuable, currency.

Direct exposures of U.S. institutions to the 

most stressed euro area countries appear to be 

low (Charts 7.2.2, 7.2.3, and 7.2.4). However, 

U.S. banks, money market funds (MMFs), and 

the insurance industry have indirect exposures 

through other non-periphery countries 

and through asset markets. This generates 

heightened uncertainty about the extent to 

which evolving conditions could spill over to 

U.S. markets and institutions. 

Another key structural shift interacting with 

cyclical factors is the increased importance 

of emerging markets in global growth and 

the global financial system. The growth 

trajectories of emerging market economies 

(EMEs), notably the potential for a marked 

deceleration of growth in China as discussed 

in Section 4.4, could have a significant impact 

on growth and financial stability in the United 

States. In particular there continues to be 

uncertainty about the health and robustness of 

some of these economies, including concerns 

about banking and financial stability; the 

sustainability of regional real estate trends; the 

ability of policymakers to manage inflationary 

pressures; and the possibility of social unrest. 

The implications of these uncertainties for the 

U.S. financial system are primarily driven by the 

role of the EMEs as global providers of capital 

and as contributors to global growth. 

Uncertainty is also elevated in U.S. housing 

markets. The 30 percent decline in house prices 

since January 2006 continues to weigh on U.S. 

real estate markets, with 12 million mortgages 

having negative equity and continued high 

Chart 7.2.2 U.S. MMF Exposure to Europe

Chart 7.2.3 Large U.S. Banks’ Exposure* to Europe

Chart 7.2.4 Insurance Industry Exposure to Europe
126 2012 FSOC / / Annual Report

Chart 7.2.5 Real Private Residential Investment levels of foreclosure activity. Additional 

mortgage losses are possible over the next 

five years due to increased monthly payments 

on home-equity loans. The current sluggish 

growth in the housing sector contrasts with 

the historical post-recession patterns, where 

residential investment typically would display 

solid growth during recoveries (Chart 7.2.5). 

While there are signs of stabilization in housing 

prices, and the inventory of existing homes 

for sale has declined significantly, the overall 

weakness in the macroeconomy carries with it 

the risk of further declines in real estate prices, 

with additional stresses on household and 

institutional balance sheets.

In addition, the crisis exposed deep flaws in 

the structure of housing finance that need to 

be reformed, such as the incentives around 

securitization, the design of governmentsponsored enterprises (GSEs), and the overall 

quality of mortgage-servicing standards. 

Financial institutions continue to work 

through legacy mortgage assets and apply 

conservative credit standards to new mortgage 

activity. Given the scarcity of private capital 

in mortgage markets, federal government 

support continues to dominate the provision 

of residential mortgages. While some progress 

has been made in addressing mortgage loan 

servicing and foreclosure abuses, as well as 

gaps in protections for homeowners, lack of 

uniform servicing standards with appropriate 

safeguards for consumers, such as single points 

of contact, continue to create potential adverse 

consequences for distressed homeowners and 

their surrounding communities. The structural 

and cyclical problems of the housing finance 

market constitute a vulnerability of the financial 

system that makes the U.S. economy more 

susceptible to adverse shocks. For example, the 

effect of a slowdown in economic growth could 

be amplified by the mortgage market, leading 

to larger-than-expected declines in home prices 

and sales.

Another area of uncertainty is the fiscal policy 

outlook in the United States. A number of 

fiscal policy issues must be addressed around 
Potential Emerging Threats 127

the end of 2012, including expiration of the 

tax cuts originally enacted in 2001 and 2003, 

expiration of payroll tax cuts, expiration of 

extended unemployment benefits, the Budget 

Control Act-mandated sequester, and the need 

to raise the debt ceiling once again. As was 

the case with the debt ceiling debate in the 

summer of 2011, market volatility may increase 

as these fiscal deadlines approach, possibly 

weighing on growth. Furthermore, the longterm trajectory of U.S. fiscal policy is generally 

regarded as unsustainable, given the aging of 

the population and the likely path for health 

care expenditures. The way in which these longterm imbalances eventually will be resolved 

is unclear, representing yet another source 

of uncertainty for financial markets and the 

real economy.

7.3 Robustness of Financial 

Institutions and Markets 

While some indicators point to an increased 

level of robustness of financial institutions and 

markets over the past year, there continue to 

be areas of serious concern. The aggregate 

tier one capital ratio of domestically owned 

bank holding companies (BHCs) was 13.3 

percent of risk-weighted assets as of the first 

quarter of 2012, the highest level in more than 

10 years (Chart 7.3.1). Increased robustness 

can also be seen in the broker-dealer (BD) 

industry, which shows a sharp decline in 

leverage since 2007. Stress test results from 

the 2012 Comprehensive Capital Analysis and 

Review (CCAR) demonstrated the increase in 

capital, particularly common equity, held by 

the largest U.S. banking institutions since the 

onset of the financial crisis. Even so, 4 of the 

19 BHCs had post-stress capital ratios that fell 

below one or more regulatory minimums after 

including all planned capital distributions. 

The aggregate BHC funding profile has been 

strengthened by increased reliance on core 

deposits (Chart 7.3.2), continued reduction in 

short-term wholesale funding (Chart 7.3.3), 

and a substantial increase in the fraction of 

assets that are highly liquid. There is concern, 

however, that these funding and liquidity 

Chart 7.3.1 Aggregate BHC Capital Ratios

Chart 7.3.2 Core Deposits as a Percent of Total Liabilities

Chart 7.3.3 Short-Term Wholesale Funding
128 2012 FSOC / / Annual Report

Chart 5.2.12 CDS Spreads of 6 Large Complex BHCs developments may be short-lived implications 

of the low interest rate environment and the 

temporary unlimited coverage for non-interestbearing transaction accounts under Section 

343 of the Dodd-Frank Act, which is scheduled 

to expire on December 31, 2012.

Other indicators suggest a less sanguine view 

of U.S. financial institutions. The average 

cost of buying credit protection on the six 

largest U.S. BHCs started to rise in August 

2011, with increasing concerns about the euro 

area stability. (See Chart 5.2.12, displayed 

here for convenience.) While credit default 

swap (CDS) spreads on these BHCs have 

come down somewhat since their peak in 

November 2011, they remain above the levels 

that prevailed from mid-2009 through mid2011. Similarly, market valuations of the large 

BHCs are well below book value. Revenues 

at these institutions remain challenged by 

general market uncertainty and the low 

interest rate environment, and BHC earnings 

growth is largely dependent on non-recurring 

accounting items. In addition, approximately 

12 percent of all institutions within the 

commercial banking sector still remain on 

the FDIC’s problem bank list, accounting for 

approximately 2 percent of sectoral assets. 

Changes in financial market infrastructures 

are likely to make the derivatives market less 

vulnerable to shocks. In recent years, there have 

been substantial increases in the volume of 

swaps contracts being centrally cleared, which 

represents a significant step toward improved 

management of credit risks in these markets. 

In addition, informational transparency 

to regulators has been enhanced by the 

expansion of trade repositories (TRs). The 

availability of data from the Trade Information 

Warehouse, the TR for CDS, proved extremely 

useful to regulators in determining patterns 

of exposures to Greek sovereign default risk 

during the period leading up to the Greek 

debt restructuring in March 2012. Finally, it is 

anticipated that, pursuant to Title VII of the 

Dodd-Frank Act, many types of swaps will be 

traded on swap execution facilities (SEFs) and 
Potential Emerging Threats 129

security-based SEFs in the near future. This 

development should significantly enhance both 

pre- and post-trade transparency of price and 

volume information on executed transactions to 

swaps market participants. While the SEC and 

CFTC have not yet finalized rules relating to 

the regulation of SEFs and security-based SEFs, 

both agencies have issued detailed proposals. 

Another form of vulnerability has been 

highlighted by the failure of segregation 

procedures to fully protect customers of MF 

Global. (See Box D: MF Global Bankruptcy.)

For decades, segregation of customer funds 

has been the lynchpin of customer protection 

in futures markets. While MF Global customers 

recovered 72 percent of the value of their 

accounts for trading on U.S. futures exchanges 

within a few months of the bankruptcy, they 

lost use of those funds for critical weeks and 

are still owed hundreds of millions of dollars 

in the aggregate. MF Global customers 

trading on foreign exchanges have received 

a much lower percentage of recovery. The 

CFTC has taken steps to enhance customer 

protection and has solicited input on further 

possible actions. 

Financial reform efforts are essential in 

restoring the strength and stability of financial 

institutions and markets. Nevertheless, lessregulated institutions and markets could be 

perceived to hold competitive advantages. 

Accordingly, vulnerabilities could continue 

or increase if some participants choose to 

move business lines or activities to take 

advantage of perceived gaps or inconsistencies 

in regulation. This is particularly a concern 

when comparable financial activities are not 

subject to a comparable degree of regulatory 

stringency. This could occur, for example, if 

a lightly regulated swaps participant were to 

expand its business to approximate a full swaps 

dealership without the requisite regulatory 

oversight. The Dodd-Frank Act provides 

mechanisms to address such regulatory gaps, 

for example, by requiring oversight of all swap 

dealers and major swaps participants and 

improving regulatory oversight on nonbank 
130 2012 FSOC / / Annual Report

financial companies that could pose a threat to 

U.S. financial stability. 

7.4 Continuing Vulnerabilities in the 

Financial System

A number of characteristics of the current 

financial system continue to render it 

vulnerable to a variety of shocks and create 

the potential to amplify the destructive 

effects of such shocks. 

Different types of vulnerabilities can arise in 

financial systems. First, some vulnerabilities 

are inherent to the role that financial systems 

play in the economy. For example, maturity 

transformation (turning short-term savings 

into long-term capital investment) is an 

essential service of financial markets. But 

such transformation carries certain potential 

instabilities, such as the risk that short-term 

debt may not be rolled over or even the 

possibility of a run on a financial institution. 

Similarly, providing credit to risky borrowers is 

an important function of financial institutions. 

However, some degree of credit losses 

associated with such lending is inevitable. These 

sorts of vulnerabilities can be mitigated by 

appropriate public policy structures, including 

prudential regulation and supervision, robust 

capital and liquidity requirements, deposit and 

share insurance, orderly liquidation authority, 

and the role of the central bank as lender of last 

resort, but they cannot be fully eliminated.

A second type of vulnerability arises from 

control weaknesses in operations, risk 

management, and governance. Examples 

would include the possibility of erroneous 

trade completion in a high-speed trading 

environment, the danger of cybersecurity 

breaches, and risk-management deficiencies 

in financial institutions. Such vulnerabilities 

highlight the importance of regulatory 

measures, such as prudential capital and 

liquidity requirements and risk-management 

standards, as well as private-sector risk controls. 
Potential Emerging Threats 131

Finally, a third class of vulnerabilities is 

generated by the behavioral responses of market 

participants to financial developments, which 

could lead to undesirable vulnerabilities in the 

aggregate. An example would be the tendency 

for some investors to take on additional risk 

in a low interest rate environment in an effort 

to reach for yield. Another example would 

be the spillovers from the actions of firms in 

highly concentrated market segments or asset 

classes. Regulatory measures can be useful in 

addressing these sorts of vulnerabilities. For 

example, appropriate compensation regulation 

can deter firms from providing incentives to 

take on excessive risk. Equally important is to 

help ensure that stakeholders bear losses in 

downside scenarios and are subject to market 

discipline on an ongoing basis. 

These three types of vulnerabilities are not 

mutually exclusive: a given source of market 

vulnerability might be associated with all three 

types to varying degrees, so any classification 

of specific vulnerabilities is to some extent 

arbitrary. In the following text, we discuss 

specific vulnerabilities of each of these 

types in the current environment, with the 

vulnerabilities classified according to which 

characteristics are most predominant.

7.4.1 Inherent Vulnerabilities

Run Risk in Wholesale Short-Term Funding 

Markets

Broker-dealers (BDs) and other market 

participants typically fund some of their 

portfolio holdings and securities inventories 

using short-term funding, obtained through 

repos, commercial paper, and unsecured shortterm lending. While use of short-term wholesale 

funding has decreased overall (Chart 5.2.7, 

displayed here for convenience), the very large 

BHCs, especially those with large BD operations, 

continue to display a substantial dependence 

on short-term, less stable funding sources 

(Chart 7.4.1). Moreover, as discussed in Section 

5.2, the U.S. branches and agencies of foreign 

banks also rely heavily on short-term funding 

through MMFs and uninsured wholesale 

Chart 5.2.7 Short-Term Wholesale Funding at Largest BHCs

Chart 7.4.1 Less-Stable Funding Sources at 6 Largest BHCs
132 2012 FSOC / / Annual Report

depositors. In practice, institutions that rely 

on short-term funding must maintain strong 

short-term credit ratings. In June 2012, Moody’s 

reduced its short-term ratings by one notch for 

three large dealer banks: Barclays, Goldman 

Sachs, and Morgan Stanley. Markets will be 

monitoring the impacts of the downgrades on 

these banks’ funding models.

This continued reliance on short-term funding 

for illiquid assets can be a source of instability 

if borrowers have difficulty rolling over their 

maturing short-term debt on economically viable 

terms. This dynamic could force borrowers 

to sell long-duration assets under fire-sale 

conditions, generating a self-reinforcing negative 

feedback loop by putting downward pressure on 

prices that, in turn, stresses the balance sheets of 

a wider range of institutions. 

The vulnerabilities associated with the use of 

short-term funding for illiquid assets may be 

exacerbated by ongoing structural weaknesses 

in the tri-party repo market and in MMFs. The 

tri-party repo market relies heavily on intraday 

credit extensions from the clearing banks, 

is exposed to weaknesses in the credit and 

liquidity risk-management practices of market 

participants, and lacks a mechanism to help 

ensure orderly liquidation of tri-party repo 

collateral by creditors of a defaulting dealer. 

(See Box G: Ongoing Vulnerabilities in the 

Tri-Party Repo Market.) MMFs can be subject to 

runs if the $1.00 net asset value (NAV) is believed 

to exceed the liquidation value of the fund. 

(See Box H: Money Market Fund Responses 

to Euro Area Uncertainty.) 

7.4.2 Potential Control Weaknesses

High-Speed Trading

High-speed automated trading has become 

common in equity and derivatives markets, and is 

also spreading to markets for Treasury securities 

and foreign exchange. (See Section 5.4, Box 

F: Algorithmic and High-Frequency Trading.) 

It is likely that high-speed trading increases 

market liquidity in normal market conditions. 

However, any market in which liquidity is 
Potential Emerging Threats 133

BOX G: ONGOING VULNERABILITIES IN THE TRI-PARTY REPO MARKET

While regulators have gained much better visibility into 

the activity of the tri-party repo market in recent years, 

it remains a significant source of potential contagion. 

Despite the recent steps taken by participants to 

advance changes in the market’s infrastructure to 

mitigate key vulnerabilities, progress is taking longer 

than initially anticipated. Three specific sources of 

vulnerability remain of great concern to the Council:

•	 Heavy reliance by market participants on 

intraday credit extensions from the 

clearing banks,

•	 Weakness in the credit and liquidity risk 

management practices of many market 

participants, and

•	 Lack of a mechanism to ensure orderly 

liquidation of tri-party repo collateral by 

creditors of a defaulting dealer.

Over-reliance on intraday credit. Currently, 

tri-party repo trades “unwind” every day, meaning that 

the clearing bank returns cash to the lender’s account 

and returns collateral to the borrower’s account. Trades 

are not settled until several hours later. For several hours 

each afternoon, dealers require funding of their entire 

tri-party repo book that lenders do not provide. This 

$1.7 trillion funding need is provided by the two 

clearing banks. 

This is a potentially unstable situation. In times of market 

stress, the clearing bank faces a conflict of interest 

between its own risk-management needs and the role 

it performs as a lender to dealers experiencing funding 

problems. Given its intraday exposure to dealers, the 

clearing bank could have a strong incentive, in the face 

of a dealer’s deteriorating credit quality, to refrain from 

unwinding in order to avoid extending credit and taking 

on exposure to the dealer’s collateral. 

Poor risk management practices. Some dealers 

remain very dependent on short-term repo funding 

and are heavily exposed to rollover risk. Of particular 

concern is the use of short-term borrowing to finance 

less liquid collateral, such as asset-backed securities 

or corporate bonds. In addition, some lenders do 

not exercise sufficient rigor in setting haircuts and 

in evaluating appropriate asset types as collateral, 

particularly for less liquid assets. This can create a 

destabilizing cycle: if lenders do not feel protected by 

the haircuts they have in place, they may respond to a 

dealer stress event or rising price volatility by increasing 

haircuts sharply, further reducing the dealer’s ability to 

obtain needed funding. Instability is also intensified by 

the fact that some lenders (notably MMFs subject to 

Rule 2a-7 under the Investment Company Act) accept 

collateral that they are unable to hold and liquidate 

gradually following a default. These lenders are likely to 

pull back their funding altogether if they are subject to 

redemptions to avoid being forced to take possession 

of the collateral—further destabilizing market conditions. 

Presently, there is no process in place to prevent 

lenders from taking on collateral that they could not 

properly manage or permissibly hold outright.

Absence of a mechanism to facilitate orderly 

liquidation of a defaulted dealer’s collateral. 

A large dealer’s default could leave lenders with billions 

of dollars of collateral that they would likely seek to 

liquidate quickly. The resulting large volume of asset 

sales could depress prices, significantly impair market 

liquidity, and erode the capital of many financial firms 

through mark-to-market losses. This erosion of capital 

could, in turn, create intense pressure for holders to 

shrink their balance sheets by selling additional assets, 

creating a downward spiral. There is currently no 

mechanism in place to ensure that lenders will be able 

to liquidate the collateral of a defaulted dealer gradually 

over time in a manner that avoids this sort of fire 

sale dynamic.
134 2012 FSOC / / Annual Report

BOX H: MONEY MARKET FUND RESPONSES TO EURO AREA UNCERTAINTY 

Vulnerabilities from reliance on short-term funding can be 

compounded by structural problems with money market 

funds (MMFs). MMFs are promoted to institutional and 

retail investors as stable investments that provide cash 

on demand at a constant net asset value (NAV) of $1 

per share, very much like bank deposits. However, these 

funds are prone to runs, as investors have an incentive 

to exit a fund at $1 per share if they suspect that its 

NAV is likely to decline below $1 (that is, they expect the 

fund to “break the buck”). A clear example is the wave 

of redemptions from MMFs after the Reserve Primary 

Fund broke the buck in September 2008 because of its 

Lehman exposures. 

A more recent episode of large-scale MMF redemptions 

is the response of MMFs to increased uncertainty about 

euro area stability in June 2011. This episode provides 

an opportunity to examine potential vulnerabilities in the 

MMF industry. In June 2011, the potential for European 

bank downgrades and rising concern about the euro 

area periphery debt crisis prompted concerns about 

MMF exposures to European banks. Prime MMFs began 

experiencing substantial redemptions, with assets falling 

by $165 billion (or 5.1 percent) in June 2011 and with 

some MMFs losing as much as 20 percent of their assets 

during this period. 

MMFs were able to satisfy these redemptions with 

internally generated liquidity. (See Chart 5.3.7, 

displayed here for convenience.) In addition, while 

MMFs’ euro area exposures had generated negative press 

attention, these positions had not actually experienced 

any losses affecting the mark-to-market value of MMFs’ 

portfolios. MMFs were also better able to absorb these 

redemptions because they occurred on a steady basis 

over a period of weeks, as opposed to the sort of run on 

MMFs that occurred in 2008, where investors withdrew 

over $300 billion in a matter of days from prime MMFs, 

several of which were simultaneously experiencing markto-market losses in their portfolios. These mitigating 

circumstances allowed MMFs to absorb redemptions in 

the summer of 2011 while maintaining a stable NAV. 

Chart 5.3.7 Prime Funds Liquidity

Following this period of redemptions, MMFs rapidly 

reduced their exposure to euro area counterparties. 

For example, prime MMF exposures to French issuers 

declined from a peak of $274 billion at May 31, 2011, to 

$176 billion (or 36 percent) by July 31, 2011, and to as low 

as $48 billion by December 31, 2011. Overall euro area 

exposures of prime MMFs decreased considerably from 

nearly 30 percent of prime MMF assets to 18 percent 

of assets between May 31, 2011, and May 31, 2012 

(Chart H.1). 

While this rapid reduction in short-term dollar funding 

for euro area banks reduced MMF exposure to the debt 

crisis, it added to strains in the global financial system. For 

those institutions in which MMFs continue to invest, credit 

has been provided at shorter maturities and increasingly 

in secured form through repurchase agreements. From 

March 2011 to May 2012, the weighted average life for 

prime MMFs declined from 81 to 71 days. As of June 

2012, MMFs have a relatively small direct exposure of 

approximately $1 billion to Spanish banks, with no direct 

exposure to Italian or Greek banks. Prime MMFs also, on 

average, reduced their overall credit exposure, shifting 

portfolio assets from bank certificates of deposit into 

government debt and repos (Chart H.2). 
Potential Emerging Threats 135

Chart H.1 Prime Fund Bank Holdings

Chart H.2 Prime Fund Portfolio Composition
136 2012 FSOC / / Annual Report

provided by automated trading strategies could 

find significant amounts of liquidity suddenly 

withdrawn if those automated strategies pause 

due to changes in market conditions. Evidence 

suggests that the so-called “flash crash” of May 

2010 involved a temporary liquidity withdrawal 

of this type. Attenuated market liquidity, in 

turn, can adversely affect market functioning 

more generally. Risk controls must keep pace 

with these developments. Unfortunately, the 

risk arising from high-speed trading is difficult 

to assess because it is opaque and difficult to 

monitor (particularly in real time). 

Complex Trading Strategies and Risk 

Management

The effects of advances in technology and 

financial innovation have also resulted in 

financial firms employing trading and hedging 

strategies that rely increasingly on complex 

assumptions regarding the performance and 

interrelationships of financial instruments 

and contracts. Recent events, including the 

publicly announced trading losses at JPMorgan 

Chase (JPM), highlight the risks that can 

develop in the use of such complex strategies. 

This incident reinforces how essential it is 

that assumptions underlying trading and risk 

management models be properly validated 

and monitored on an ongoing basis to help 

ensure that risks of complex trading strategies 

are appropriately measured and understood. 

Institutions also should establish a process to 

review the effect of approved model changes to 

help ensure that such changes are appropriate.

Cybersecurity 

Cyberattacks represent an increasing threat to 

financial institutions and the infrastructure 

components on which financial systems depend 

for communicating, sharing information, 

and conducting business. The number and 

sophistication of malicious incidents continue 

to grow as business and financial institutions 

continue to adopt Internet-based commerce 

systems. Account takeovers can occur, including 

fraudulent money transfers and counterfeiting 

of stored value cards. Third-party payment 

processor breaches represent a continuing risk, 
Potential Emerging Threats 137

whereby the computer networks of large payment 

processors are targeted, potentially leading to 

financial losses and compromised personally 

identifiable information.

Cyber criminals are becoming more 

sophisticated, and attack vectors are evolving. 

Social-engineering techniques used in attempts 

to gain unauthorized access into networks 

and systems are shifting from generalized and 

random to highly targeted. Another cyber threat 

can emerge from individuals with direct access 

to core processing centers. Such individuals may 

be in a position to steal intellectual property, 

insider information, or data that can damage the 

reputation of the company. Market participants 

report that attacks targeting data and assets are 

increasingly focused on institutional aspects of 

infrastructure as opposed to retail operations. 

These types of attacks are associated with 

increased severity of potential losses and could 

be increasingly disruptive. Cyber threats also 

pose a potentially significant risk to the stability 

of financial markets through the disruption of 

critical payment, clearing, and settlement systems 

for key financial institutions. 

Robustness of Operational, Risk 

Management, and Governance Controls at 

Central Counterparties

In its 2009 meeting in Pittsburgh, the G-20 

established the goal of having standardized 

swap contracts centrally cleared by the end of 

2012. This objective was codified in Title VII 

of the Dodd-Frank Act. Central clearing of 

swaps will enhance the stability and soundness 

of over-the-counter (OTC) derivatives markets 

in a variety of ways, including improved 

counterparty risk management and multilateral 

netting of contracts. However, it could also lead 

to an increased number of financial contracts 

cleared by a relatively small number of central 

counterparty (CCP) clearinghouses, which 

mitigate counterparty credit risk between 

market participants by becoming the universal 

counterparty and providing time-specific 

settlement of transactions. As a result, these 

clearing institutions have become associated 
138 2012 FSOC / / Annual Report

with even more critical concentration of risk 

than before. 

The default of a major participant could impair 

the liquidity available to a CCP, requiring 

that liquidity for settlement be replaced from 

the CCP’s own resources if it is to meet its 

obligations in a timely fashion. The Principles 

for Financial Market Infrastructures, finalized 

this past April by the Committee on Payment 

and Settlement Systems (CPSS) and the 

International Organization of Securities 

Commissions (IOSCO), provides a set of 

international standards for CCPs and other 

financial market utilities that address these 

issues. In addition, Title VIII of the DoddFrank Act provides an enhanced regulatory 

framework for CCPs through the Council’s 

authority to designate financial market utilities 

as systemically important.

Data Standards and Analytics

The financial crisis revealed that lack of 

data standards and poor data management 

threatened financial stability in several ways. 

Those who created, collected, and relied upon 

financial data found that financial data quality 

and scope simply had not kept up with the 

increasing complexity of, and innovation in, 

modern financial markets. That was especially 

the case as financial activity migrated from 

traditional depository institutions into the 

capital and securitization markets and across 

national borders. Consequently, during the 

crisis, a lack of consistent and high-quality 

data made it difficult or impossible for some 

market participants and their regulators to 

monitor risks in trading books, gauge overall 

exposures to specific counterparties, price 

complex securities, or even assess the potential 

losses that individual firms might face due to 

falling house prices. Different data systems 

using different naming conventions made 

comparisons difficult or impossible, even within 

the same firm. Resolving a large, complex 

financial institution like Lehman Brothers was 

hobbled by the snarled nature of insufficient, 

conflicting, and inconsistent data. 
Potential Emerging Threats 139

Since then, policymakers have broadened the 

scope of data they collect and have made efforts 

to improve their quality. Examples include 

the new Form PF (for private funds) and data 

to be collected by swap data repositories and 

security-based swap repositories for swaps and 

other derivatives, as well as international efforts 

by the International Monetary Fund (IMF) 

and the Financial Stability Board (FSB) to 

close data gaps, particularly for derivatives and 

nontraditional funding activities. Yet significant 

gaps remain in both the scope and quality of 

data needed to monitor and enhance financial 

stability. More needs to be done, particularly 

in the activities that have traditionally 

resided outside the regulators’ sphere such as 

securitization markets and OTC derivatives. 

Data standards facilitate improvements in 

data quality. For instance, efforts to establish 

a global legal entity identifier (LEI) have 

made significant progress in the last year, 

including the establishment of the CFTC 

Interim Compliant Identifier (CICI) initiative, 

but work remains to be done to complete this 

important effort. The Office of Financial 

Research (OFR), established in Title I of the 

Dodd-Frank Act, is tasked with improving the 

quality of financial data and data analytics 

along multiple dimensions, including LEI 

implementation and enhancement.

7.4.3 Behavioral Vulnerabilities 

Managing Risk in a Low Interest 

Rate Environment

An unusually low rate environment, such as 

that currently in place, is prone to several 

behavioral vulnerabilities. Market participants 

may have an incentive to take on additional 

leverage, credit risk, and duration risk in an 

effort to boost yields. While increased risk 

taking is one possible transmission mechanism 

for expansionary policies, such reach for 

yield behavior without appropriate risk 

management could leave many participants with 

portfolios that are more vulnerable to adverse 

market moves. 
140 2012 FSOC / / Annual Report

The tendency to reach for yield may be 

especially pronounced for entities such as 

pension funds or insurance companies that face 

a stream of quasi-fixed nominal liabilities. For 

example, the investment yield for life insurers 

in aggregate is only around 1.1 percentage 

points above the minimum yield needed to 

maintain policyholder reserves, leaving these 

insurers with a relatively small margin of error. 

Hedge funds also may have an incentive to 

reach for excess yield if they manage to specific 

hurdle rates expected by their investors or if 

the value of their fund is considerably below 

the high-water mark that would trigger a large 

payout. In addition, money market funds may 

have an incentive to increase their risk profiles, 

especially if the low interest rates do not provide 

sufficient yield to cover their expenses.

We do not see much evidence of such behaviors 

currently. Risky assets do not exhibit signs of 

overvaluations associated with widespread 

reach-for-yield behavior. If anything, measures 

of risk premia for equities and corporate bonds 

are very wide by historical standards. However, 

indicators of such behaviors should be watched 

carefully, including leverage, contractual terms, 

borrower characteristics, the use of levered 

instruments for funding, issuance of “covenant 

lite” loans, and the rate of original issue, 

CCC-rated high-yield bonds (Chart 7.4.2).

Eventually, interest rates will move up to 

more normal levels. If market participants are 

adequately prepared for such an increase in 

rates, and if this increase occurs gradually, 

it is unlikely that financial stability would be 

adversely affected. However, a rapid increase 

in interest rates could be disruptive. For 

example, interest rates could increase rapidly 

following a loss in investor confidence in the 

sustainability of U.S. fiscal policy. It is unclear 

how well prepared fixed income markets are 

to the possibility of such rapid interest rate 

movements. Those especially vulnerable would 

be market participants with highly leveraged 

carry-trade positions. It is important to 

recognize that while any institution in isolation 

can insulate itself from movements in interest 

Chart 7.4.2 Credit Quality of High-Yield New Issues
Potential Emerging Threats 141

rates via swaps and derivatives, these contracts 

are in zero net supply in the aggregate. As 

a result, some market participants must be 

exposed to interest rate risk. 

Moral Hazard Issues for Large, Complex 

Financial Institutions

Behavioral vulnerabilities of large, complex 

financial institutions could increase with the 

complexity and size of these institutions. These 

vulnerabilities occur because an expectation 

of government support could generate more 

risk taking by institutions that are perceived 

as too big or too complex to fail. Indeed, 

many observers interpret actions taken by 

government authorities during the recent crisis 

as evidence that the public sector provides an 

implicit guarantee to large complex financial 

institutions. Such beliefs, if widespread, 

could lead to increased concentration in 

financial services and greater risk taking by 

those institutions deemed protected, as the 

implicit government guarantee reduces market 

discipline. The result could be higher overall 

risk in financial markets with attenuated 

risk management.

Large financial institutions continue to have 

a high degree of operational complexity and 

interconnectedness. These complexities may 

reflect the diverse lines of businesses and 

locations in which these firms operate, but 

lead to legal structures with activities spread 

over hundreds, and in some cases thousands, 

of subsidiaries (Chart 7.4.3). Market 

participants could believe that the complexity 

and interconnectedness of these companies 

could make them harder to resolve and induce 

further likelihood of government support 

in a stress environment. Such beliefs could 

therefore promote continued moral hazard 

problems for such complex financial entities.

In addition, there may continue to be 

perceptions that some institutions may 

receive special treatment by virtue of their 

size. Such beliefs could be exacerbated 

by greater concentration in the financial 

services industry. The financial industry 

Chart 7.4.3 Complex Financial Institutions in 2012
142 2012 FSOC / / Annual Report

has become increasingly concentrated for 

decades, a trend enhanced in part by such 

legislative developments as the Riegle-Neal 

Interstate Banking and Branching Efficiency 

Act of 1994 permitting interstate branching, 

and the Gramm-Leach-Bliley Act, enacted 

in 1999, that allowed affiliations among 

commercial banks, investment banks, and 

insurance companies. This trend continued 

through the crisis (Chart 7.4.4) in part due 

to acquisitions of failing firms. As of the 

first quarter of 2012, the 10 largest banks 

held 52 percent of industry assets, worth 

approximately 47 percent of GDP, compared 

with 45 percent of industry assets, worth 

approximately 40 percent of GDP at the end 

of 2006. Notwithstanding this trend towards 

greater concentration, the U.S. banking system 

remains significantly less concentrated than 

that of most developed countries.

These moral hazard problems are partially 

addressed by raising capital requirements. 

An additional important priority is to develop 

credible and robust failure resolution 

procedures for large complex institutions—

procedures that would allow the institution to 

be liquidated or restructured, as appropriate, 

with minimal damage to the markets as a 

whole. The FDIC is authorized to resolve 

certain failing financial companies under 

the Dodd-Frank Act and has developed a 

resolution strategy for such firms that will 

promote financial stability by minimizing 

contagion and requiring accountability by 

forcing the firms’ shareholders and creditors 

to bear losses. 

The credit rating agencies appear to have 

recognized that the Dodd-Frank Act limits 

the ability of the government to provide 

extraordinary support to shareholders 

and creditors of large complex financial 

institutions. This recognition can be seen in 

the reduced uplift the major rating agencies 

incorporate into the long-term ratings for 

a number of large financial institutions, 

many of which have been downgraded or 

Chart 7.4.4 Assets of the 10 Largest Depository Institutions
Potential Emerging Threats 143

Chart 7.4.5 Moody’s BHC Systemic Support Uplift assigned a negative rating outlook as a result 

(Chart 7.4.5). However, a degree of ratings 

uplift still remains for the largest banks, 

typically 1 to 2 notches for large bank holding 

companies and 2 to 3 notches for large bank 

subsidiaries. In addition, there is evidence that 

market-derived indicators of credit quality 

tend to be lower than the levels assigned by 

ratings agencies (Chart 7.4.6). While ratings 

agencies typically report uplifts only for 

long-term ratings, these uplifts also support 

the short-term ratings that help firms access 

short-term unsecured wholesale funding. 

Vulnerabilities can arise when a financial 

institution’s funding model depends in part 

on the belief that the government will provide 

support, rather than only on the intrinsic 

strength of the institution and its portfolio. Chart 7.4.6 S&P Current Actual Rating & Market 

Derived Signal*