2011 FSOC Annual Report

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Financial Stability

Oversight Council

2011 Annual Report


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Financial Stability Oversight Council

The Financial Stability Oversight Council (Council) was established by the Dodd-Frank WallStreet Reorm and Consumer Protection Act (Dodd-Frank Act) and is charged with three primarypurposes:

1. To identiy risks to the nancial stability o the United States that could arise rom thematerial nancial distress or ailure, or ongoing activities, o large, interconnected bankholding companies or nonbank nancial companies, or that could arise outside thenancial services marketplace.

2. To promote market discipline, by eliminating expectations on the part o shareholders,creditors, and counterparties o such companies that the U.S. government will shield them

rom losses in the event o ailure.3. To respond to emerging threats to the stability o the U.S. nancial system.

Pursuant to the Dodd-Frank Act, the Council consists o 10 voting members and 5 nonvotingmembers and brings together the expertise o ederal nancial regulators, state regulators, andan insurance expert appointed by the President.

The voting members are:

the Secretary o the Treasury, who serves as the Chairperson o the Council;

the Chairman o the Board o Governors o the Federal Reserve System;

the Comptroller o the Currency;

the Director o the Bureau o Consumer Financial Protection; the Chairman o the Securities and Exchange Commission;

the Chairperson o the Federal Deposit Insurance Corporation;

the Chairperson o the Commodity Futures Trading Commission;

the Director o the Federal Housing Finance Agency;

the Chairman o the National Credit Union Administration Board; and

an independent member with insurance expertise who is appointed by the President andconrmed by the Senate or a six-year term.

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

the Director o the Oce o Financial Research; the Director o the Federal Insurance Oce;

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 ocer perorming like unctions) designated by thestate securities commissioners.

The state insurance commissioner, state banking supervisor, and state securities commissionerserve two-year terms.


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Statutory Requirements for the Annual Report

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

(i) the activities o the Council;

(ii) signicant nancial market and regulatory developments, including insurance andaccounting regulations and standards, along with assessment o those developments onthe stability o the nancial system;

(iii) potential emerging threats to the nancial stability o the United States;

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

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

(vi) recommendations

(I) to enhance the integrity, eciency, competitiveness, and stability o United Statesnancial markets;

(II) to promote market discipline; and

(III) to maintain investor condence.

Approval of the Annual Report

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

22, 2011.

Abbreviations for Federal Member Agencies of the Council

Department o the Treasury (Treasury)

Board o Governors o the Federal Reserve System (Federal Reserve)

Comptroller o the Currency (OCC)

Bureau o 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)

Oce o Financial Research (OFR)

Federal Insurance Oce (FIO)


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Letter rom the Chair i

The institutions, markets, and inrastructure that make up the U.S. nancial system provide

essential services to the U.S. and global economieshelping to allocate unds rom savers to

borrowers, allowing households and businesses to plan or the uture and manage their risks

over time, and acilitating the enormous volume o nancial transactions necessary to support

real economic activity and employment on a daily basis.

Three years ater the worst nancial crisis in generations, our nancial 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 beore the crisis and und themselves

more conservatively. We have withdrawn most o the emergency actions we took to resolve thecrisis and recovered most o the investments we made to stabilize the nancial system.

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

important and undamental changes to the structure o the U.S. nancial system to strengthen

saeguards or consumers and investors and to provide better tools or limiting risk in the major

nancial institutions and the nancial markets. The core elements o the law were designed

to build a stronger, more resilient nancial systemless vulnerable to crisis, more ecient in

allocating nancial resources, and less vulnerable to raud and abuse.

Tougher constraints on excessive risk taking and leverage across the fnancial

system.To lower the risk o ailure o large nancial institutions and reduce the damage

to the broader economy o such ailures, the Dodd-Frank Act provided authority orregulators to impose more conservative limits on risk that could threaten the stability o the

nancial system.

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

Financial Protection to concentrate authority and accountability or consumer protection

in a single ederal agency, with the ability to enorce protections on banks as well as other

types o rms involved in the business o consumer nance.

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

ramework or 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 o measures

that increase disclosure and transparency o nancial markets, including new reportingrules or hedge unds, trade repositories to collect inormation 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 ailing nancial rm in a manner that protects

taxpayers and the economy.

Letter from the Chair


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ii 2011 FSOC Annual Report

Accountability or stability and oversight across the fnancial 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. nancial stability, and the Oce

o Financial Research to improve data quality and acilitate access to and analysis o data

or the Council and its member agencies.

The Council will play an important role in implementing and overseeing these reorms andmitigating current and potential uture threats to nancial stability.

In our regulatory ramework, a signicant number o independent agencies are responsible or

specic aspects o the challenge o promoting nancial stability, including overseeing the saety

and soundness o banking organizations, saeguarding the stability o nancial inrastructure,

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

abuse. Each o these individual responsibilities is critical to a stable and well-unctioning nancial

system, but as the crisis demonstrated, threats to nancial stability are oten maniested across

a range o markets and institutions and may not always be eectively mitigated by any one

agency alone.

The Dodd-Frank Act established the Council to create joint accountability or identiying and

mitigating potential threats to the stability o the nancial system. By creating the Council,

Congress recognized that nancial stability will require the collective engagement o the entire

nancial regulatory community.

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

predecessors, and the most signicant uture threats will oten be the ones that are hardest to

diagnose and preempt. Aspects o the nancial system that appear to make markets more liquid

and nancial 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 ace the nancial system. The best way to

prepare or this uncertainty is to continue to build the shock absorbers and saeguards thatimprove the resilience o the nancial system. We need to recognize that policy and regulation

will oten be behind the curve o innovation, and we must meet assumptions o ongoing stability

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

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

predict or ully understand.

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

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

ramework keeps pace with the evolving global nancial system. We cannot wait until we have

passed the point o no return to strengthen saeguards against the type o race to the bottom in

credit terms or underwriting standards that oten characterizes periods o nancial expansion.

We need to be willing to act prudently and preemptively in the ace o emerging vulnerabilities orimbalances.

This task will be made easier i we are able to better marshal the power o 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 nancial institutions rom

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

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

magnitude o the risks individual institutions are taking.


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Letter rom the Chair iii

The challenge o maintaining a stable nancial system is exacerbated by the diculty o

balancing the benets o regulation against the costs o excessively restraining prudent risk-

taking behavior. I we were to set the overall combination o margin, liquidity, and capital

requirements too high, we could handicap the ability o the nancial system to support

economic growth. Further, nancial activity would inevitably move more quickly to rms,

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

to strive or a careul balance between the imperatives o creating a more stable system andpromoting a level o innovation and dynamism.

Measures o risk in the nancial system beore the crisis provided little warning o the orce o

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

real warning sign was that neither credit ratings nor the pricing o a range o nancial products

showed any expectation o the ragility o the global nancial system to a all in U.S. house prices.

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

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

or improving the quality o inormation available to the public, supervisors, and regulators about

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

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

and markets, but throughout the whole system.

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

accurately the nature o risk in individual rms and across the system, but it must be

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

and activities and tests the resilience o the nancial system to a wide set o uture events.

This perspective requires careul assessments o the relative likelihood o a range o potential

outcomes, including assessing the potential impact on the unctioning o the nancial system

and understanding where reorms to markets, rms, and inrastructure may mitigate threats.

And it requires an ongoing ocus on incentives within the nancial system that might create or

exacerbate vulnerabilities.

Working through the Council, we will ocus our eorts in our distinct areas:

The ongoing interaction between the fnancial system and the economy. We need

to continue to strengthen our analysis o the interactions between the nancial system

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

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

by structural weaknesses and imbalances in the nancial 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 eects o shocks across

nancial institutions and markets. While it is impossible or stress tests to capture all

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

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

otherwise lead to harmul behaviors and outcomes. The buildup o systemwide leverage and unding mismatches. It is crucial to

complement the evaluation o the saety and soundness o individual institutions with

an assessment o leverage in the nancial system and imbalances between unding and

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

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

capital buers and liquidity saeguards available to the system are sucient.


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iv 2011 FSOC Annual Report

The ongoing evolution o fnancial market activity and practices. We will need to

be attentive to the implications o very rapid growth in types o nancial activity and

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

markets where large institutions and rms interact. Innovation is an essential element o 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 or regulatory arbitrage. Where the opportunity and

incentive exist to avoid regulation and supervision, nancial activity will migrate to areas o

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

substantial buildup in risk and leverage outside the regulated core o the nancial system

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

opportunities or arbitrage between countries, particularly in the key areas o capital and

liquidity, derivatives, and resolution authority.

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

positions o leadership in the nancial sector will need to establish and maintain much higher

standards or integrity and a more sophisticated understanding o the risk inherent in the

business o nance than prevailed beore and during this crisis.

This will require continued improvements in management structure and corporate governance

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

management. Risk management ocers in nancial rms need to have a strong voice in

decision making. Boards o 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, rms that take this long-

term perspective should prosper in the long run, while those that do not will ace higher unding

costs and less indulgent investors.

In this rst annual report, we describe the current state o the U.S. nancial system and some

o the major orces that will shape its development going orward. The Council and its members

will continue to implement the Dodd-Frank Act on a coordinated basis to enhance the integrity,eciency, transparency, competitiveness, and stability o U.S. nancial markets. The report

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

eorts and urther strengthen the nancial system.

Timothy F. Geithner

Secretary o the Treasury

Chairperson, Financial Stability Oversight Council


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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 o Assets ..........72

Box G: Analytical Basis or 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 o 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 o Risks to Financial Stability .........................139

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

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

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

List o Charts .................................................................................................................173


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Member Statement 1

1 Member Statement

In accordance with Section 112(b)(2) o the Dodd-Frank Wall Street Reorm and Consumer Protection Act,or the reasons outlined in the annual report, I believe that additional actions, as described below, shouldbe taken to ensure that the Council, the Government, and the private sector are taking all reasonable stepsto help ensure nancial stability and to mitigate systemic risk that would negatively aect the economy: theissues and recommendations set orth in the Councils annual report should be ully addressed; the Councilshould continue to build its systems and processes or monitoring and responding to emerging threats tothe stability o the United States nancial system, including those described in the Councils annual report;the Council and its member agencies should continue to implement the laws they administer, includingthose established by, and as amended by, the Dodd-Frank Act through ecient and eective measures; andthe Council and its member agencies should exercise their respective authorities or oversight o nancialrms and markets so that the private sector employs sound nancial risk management practices to mitigatepotential risks to the nancial stability o the United States.

The honorable John a. boehner

Speakerofthe houSe

United StateS HoUSeof RepReSentativeS

The honorable nancy Pelosi

Democratic LeaDer

United StateS HoUSeof RepReSentativeS

The honorable MiTch Mcconnell

repubLican LeaDer

United StateS Senate

The honorable JosePh r. biden, Jr.

preSiDentofthe Senate


The honorable harry reid

majority LeaDer


ben s. bernankechairman

BoaRdof GoveRnoRSoftHe fedeRal ReSeRve SyStem

Mary l. schaPiro

chairman

SecURitieS & excHanGe commiSSion

Gary Gensler

chairman

commodity fUtUReS tRadinG commiSSion

debbie MaTz

chairman

national cRedit Union adminiStRation

edward J. deMarco

acting Director

fedeRal HoUSinG finance aGency

TiMoThy F. GeiThnerSecretaryofthe treaSury

cHaiRpeRSon, financial StaBility oveRSiGHt coUncil

John walsh

acting comptroLLerofthe currency

officeoftHe comptRolleRoftHe cURRency

MarTin J. GruenberG

acting chairman

fedeRal depoSit inSURance coRpoRation


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2 Executive Summary

The ecient provision o nancial services is critical to the nations economic growth and

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

a range o shocks. A stable nancial system should not be the source o, nor ampliy the impact

o, shocks.

The Financial Stability Oversight Council is charged with identiying risks to the nancial

stability o 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

inrastructure oversight.

The U.S. economy continues to heal rom the 200709 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 nancial crisis produced great upheaval in the U.S. nancial

sector, but the impact on the economy was even more devastating.At the height o the crisis, credit conditions tightened or households

and businesses, as well as or nancial rms o all sizes, refecting

severe disruptions to a range o nancial markets that proved ar more

damaging than the disruptions rom the initial credit losses themselves.

Credit conditions have improved signicantly rom the depths o

the crisis. Recently, credit fows have shown signs o recovery, with

large corporate borrowers acing avorable nancing conditions and

households experiencing an increase in credit. Corporate balance

sheets deteriorated signicantly during the crisis, primarily as a result o

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

fows and prots have increased. Corporate bond markets have also

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

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

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

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

number o small businesses reporting diculties obtaining credit has

declined since the crisis.

Macroeconomic Environment

Executive Summary 3


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4 2011 FSOC Annual Report

Nonmortgage lending to consumers has grown recently ater declining

or several years. Household balance sheets are recovering, partly

because o 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 o the all in home values, a signicant number

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

and record numbers o homes have entered the oreclosure process.However, low interest rates have helped mitigate some o the costs o

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

payments has improved since 2007.

Government budgets, both ederal and nonederal, have been strained

by the cyclical response o revenues and expenditures to a weak

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

and aid the recovery. The ederal government decit grew rom 1.2

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

ederal debt outstanding rose rom $5 trillion to $9 trillion. This public

borrowing largely replaced private borrowing in the credit markets,

and global nancial markets readily accommodated the increase inederal debt. Even ater economic conditions return to normal, the

ederal government aces a long-run imbalance between revenues and

expenditures. This need or long-run scal sustainability has been a

ocus o recent attention rom credit rating agencies. Achieving long-

run sustainability o the national budget is crucial to maintaining global

market condence in U.S. Treasury securities and the nancial stability

o the United States.

State and local government revenues were severely aected by the

economic downturn. While state nances started to improve in the

second hal o 2010, several quarters into the economic recovery, local

governments remain challenged. The municipal debt market exhibitedevidence o considerable stress last year.

Sovereign and banking sector strains are evident among a number o

advanced economies. Three countries in the European Monetary Union

have required nancial assistance as markets have priced elevated

sovereign credit risk into their debt. The relatively new phenomenon

o dierentiated compensation or 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 o tools available to European policymakers to respond to

economic and nancial stress.

In contrast, most emerging economies have recovered relatively quicklyrom the crisis, partly because o their lack o nancial imbalances

beore the nancial crisis. However, emerging economies ace

challenges rom robust capital infows and the potential or overheating.

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

disaster in Japan have added to uncertainty in the international

environment.


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Executive Summary 5

At the peak o the nancial crisis, the U.S. government introduced

unprecedented support or nancial markets, injecting hundreds o

billions o dollars o capital and liquidity into the nancial sector. As

market condence has returned, private unding has gradually replaced

those support programs: many nancial institutions have returned

the governments capital; the Federal Reserve is no longer oering

extraordinary liquidity support to nancial markets; and the FDIC

guarantees or bank senior debt will expire in 2012.

Funding has not returned to the private securitized mortgage market,

which nanced a signicant portion o household borrowing in the rst

decade o the 2000s. In the past, the governments role encouraged

housing purchases and real estate investment over other sectors

and ultimately let taxpayers responsible or much o 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 ederal conservatorship. These entities and the FederalHousing Administration now dominate mortgage lending, guaranteeing

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

viable long-term solution, but, given the current ragility o the real estate

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

and care.

Protability has returned in the banking sector and or many other

nancial institutions. Investors purchased large amounts o new

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

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

banking institutions now have substantially stronger capital and liquidity

buers than beore the crisis. However, smaller banks, particularly thosewith large commercial real estate exposures, have not recovered as

quickly as larger banks and have continued to ail 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 nancial crisis.

Assets have grown at insured depository institutions relative to other

nancial institutions since the crisis, ollowing a long period in which

nancial activities moved rom banks to markets. In particular, money

market und assets declined as investors transerred signicant unds

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

crisis reinorced the trend toward concentration and globalization in thebanking industry, and oreign banking organizations have expanded

their activities in the United States in recent years.

The nancial system is less leveraged than it was beore the crisis. Four

o the ve largest independent investment banks, all highly leveraged

institutions, were acquired by or converted their charters to become

bank holding companies in 2008, and the th ailed. The specialty

nance sector, which also relied heavily on market nancing, is now

Financial Developments


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smaller and more stable. Several o the largest companies in the

specialty nance sector also became bank holding companies

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

companies have reduced their leverage signicantly below the levels

beore the crisis.

Short-term wholesale unding markets provide liquidity or nancialinstitutions to support their activities, but the nancial crisis showed

that these markets can be ragile 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 unctioning. The crisis also revealed, in

particular ater the reezing o Lehman Brothers prime brokerage

assets in London, that dierences in international bankruptcy

regimes can accelerate runs on short-term wholesale unding

markets. Activity in several o these markets remains signicantly

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

sensitivity to potential liquidity risks and other risks.

The credit risk transer markets that contributed to the nancial

crisisspecically, those or credit deault swaps and collateralized

debt obligationsare now signicantly 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 o the potential

or extreme market fuctuations in the uture and the need to

maintain a stronger set o shock absorbers in individual institutions

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

are particularly relevant when market participants are highly

leveraged or when derivatives or other complex instruments areinvolved.

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

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

ratios or corporate equities are well within historical ranges, and

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

lower part o its long-run historical range. Prices or commodities

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

associated with high debt levels.

Compensation practices that incented nancial institution

employees to take excessive risks are widely acknowledged to have

been a contributing actor in the nancial crisis. Under pressure romregulators and investors, nancial institutions are reorming their

compensation practices to better align the interests o managers,

traders, and other employees with the long-term health o the rm,

although more needs to be done.

Following the rebound in equity markets, aggregate assets in mutual

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

in dened contribution plans have also recovered, although many


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Executive Summary 7

pension plans or state and local government employees appear to ace

unding shortalls over the long run. Investors have increasingly turned

to exchange traded unds, which oer low ees and intraday liquidity.

Regulatory reorms and advances in technology have altered the

landscape or nancial inrastructure, providing nancial markets with

advances in eciency and transparency. While this inrastructure andthe markets that it supports have generally perormed their primary

unctions in an orderly ashion during and since the crisis, there were

exceptions. One was the so-called fash crash o May 2010, when

equities and equity utures markets plunged more than 5 percent and

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

the risks associated with increasingly complex and connected nancial

markets interacting with ever-aster automated trading systems. Poor

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

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

address them.

Progress of Regulatory Reform

In the period ater the nancial crisis, the legal, regulatory, and

accounting ramework o our nancial system has changed signicantly.

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

nancial regulatory ramework and strengthened supervisory, risk

management, and disclosure standards in important ways. The new

Basel III international standards or banks, negotiated with major input

rom 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 or the rst time, and new accounting rules will serve

to limit nancial institutions o-balance-sheet activities.

For the rst time, inormation on trading in swaps will be available

through trade repositories. In addition, standardized derivatives will

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

improving price transparency and reducing counterparty credit risk or

market participants. Once regulators complete the implementation o

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

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

nancial crisis is unlikely to reappear in its previous orm.

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

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

agreed to with their international counterparts. For example, the Councilhas dened the characteristics under which it will designate systemically

important nancial market utilities or enhanced supervision. The Council

is also in the process o dening the characteristics under which it will

designate nonbank nancial institutions or Federal Reserve supervision,

and the Federal Reserve, in consultation with other Council member

agencies, is establishing tougher supervisory guidelines or large

nancial institutions. Regulators are also developing new reporting and

disclosure requirements or designated nonbank nancial companies.


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The Dodd-Frank Act also established a new ramework or resolving

large complex nancial institutions, limiting the expectation that the

government will bail out such institutions in a crisis. As part o 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 ully implemented, the

public will not receive the ull set o protections provided by theimproved regulatory system. In addition, to maximize all the benets o

the new regulatory ramework, it is imperative that relevant regulatory

agencies be unded at levels consistent with their expanded missions.

Regulators are also working with their international counterparts to

promote consistency in global regulatory reorm, particularly with

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

strengthening the supervision o, designing capital surcharges or,

and developing a ramework or the resolution o large, globally active

nancial institutions; promoting harmonization or the oversight o

derivatives markets; and regulating global nancial inrastructures.

Potential Emerging Threats to U.S. Financial Stability

Assessing uture threats to nancial stability will require attention to

the broad orces driving the evolution o the nancial system, which

determine the prot opportunities available to market participants

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

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

o possible shocks and vulnerabilities could produce more immediate

threats to U.S. nancial stability.

Globalization and technological innovation are among the most

important orces that could aect uture nancial stability. While the riseo international banking and the important role o oreign banks in U.S.

nancial markets allow risks to be transerred more broadly across the

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

to the complexity o the nancial system. Global interconnectedness

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

currency and the unding needs o large oreign rms 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 o linkages among rms. Three such products examined in thereport are exchange traded unds, structured notes, and collateralized

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

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

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

countries to ocus special attention on them.

The unctioning o the U.S. nancial system has proven resilient to the

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

Japan and the fuctuating concerns over European sovereign debt.


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Executive Summary 9

Further, increases in trading volumes and enhanced market liquidity

have been ostered, in part, by the increasing use o electronic trading.

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

demonstrated. New technology has helped strengthen the resilience o

payment systems, data repositories, and other nancial inrastructure.

This has given rms the tools to handle increasingly intricate

transactions, including transactions in short-term wholesale undingmarkets that can provide hundreds o billions o dollars overnight to

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

high-prole cyberattacks, are important reminders that both regulators

and rms need to continuously upgrade the resilience o their electronic

systems and networks.

There is signicant market uncertainty in Europe, notably associated

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

nancial institutions have very limited net direct exposure to these

three countries. They have larger exposure and important ties to

major nancial 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 unding rom U.S. money market unds. Further, money

market unds remain an important supplier o cash to the tri-party repo

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

repo amplied a number o shocks in the nancial crisis. Reorms

undertaken since the crisis have improved resilience, and money market

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

however, amplication o a shock through these channels is still

possible.

The impact on the U.S. nancial system o events in Europe dependson how the peripheral European sovereign debt crisis evolves and on

the resilience o U.S. nancial institutions and markets. I the crisis, now

aecting Greece, Ireland, and Portugal, were to intensiy signicantly

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

U.S. nancial system would be greater. Supervisors have or some time

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

withstand a variety o possible nancial contagion stress scenarios

emanating rom Europe. The Council and its member agencies will

continue to careully monitor the potential risks that could emerge rom

the peripheral European sovereign debt crisis.

Real estate-related exposures remain a signicant risk or many U.S.

nancial institutions. However, the improvement in capital across the

nancial system provides an important buer against urther declines

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

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

in lending in response to a more prolonged period o 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 or private capital in the

housing nance system remains uncertain.


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The weakness o the current recovery has delayed monetary policy

normalization and exacerbated the unsustainable scal trajectory in

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

there is limited evidence o major U.S. market participants reaching or

yield. One possible exception has been in some o the activity in the

markets or non investment-grade bonds and loans.

Both monetary policy normalization and scal consolidation will have

important consequences or the business models o many nancial rms

that are currently unding large holdings o government securities and

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

over the pace o monetary policy normalization and scal consolidation

has the potential to generate shocks; however, with appropriate

planning and risk diversication, the nancial market impact o such

shocks should be absorbed without aecting the unctions o the

system.

The capital and liquidity o the largest U.S. nancial institutions have

improved substantially. However, many large U.S. nancial institutionscurrently receive the highest credit rating or short-term unding partly

because o a presumption o possible government support in stressed

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

Analysis and Review, ound a number o weaknesses in the capital

planning processes at many large banking institutions. These actors

highlight some o the challenges still ahead in building a stronger

nancial system.

The recent nancial crisis provides a stark illustration o how quickly

condence can erode and nancial 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 inthe ederal governments debt limit. It is vital to the stability o the U.S.

nancial system and the global nancial system or the debt limit to be

raised in a timely manner to avoid creating any risk o deault on U.S.

obligations.


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Annual Report Recommendations 11

3 Annual Report Recommendations

In the ollowing areas, market participants should employ heightened

risk management, and Council member agencies should enhance

ongoing supervisory attention to determine whether any o these market

dynamics rises to a level that merits a regulatory response.

Construct robust capital, liquidity, and resolution plans.To

support stability in the nancial system, nancial institutions

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

and resolution planning processes. The Federal Reserves

Comprehensive Capital Analysis and Review exercise ound that

all o the largest banking companies need to bolster their capital

planning processes. The largest nancial institutions must also

incorporate within their planning processes contingencies or

resolution that would acilitate resolvability under bankruptcy

without government assistance. In addition, the largest banks

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

the integrity, eciency, competitiveness, and stability o U.S. nancial markets; (2) promote

market discipline; and (3) maintain investor condence. The Council ullls this requirement by

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

urther reorms to address structural vulnerabilities in key markets; (3) steps to address reorm o

the housing nance market; and (4) coordination on nancial regulatory reorm.

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

eciency, competition, market discipline, and investor condence, while maintaining

nancial stability. For instance, recommendations to improve capital and liquidity planning,address vulnerabilities in the money market und and tri-party repo markets, and coordinate

implementation o the Dodd-Frank Act will improve the stability o the nancial system. To

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

housing nance reorms, including mortgage servicing standards and servicer compensation;

and eective implementation o orderly liquidation authority or the largest nancial rms. To

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

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

emerging nancial products. Collectively, the Council recommendations address the identied

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

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

system. The discussion below outlines the Council recommendations and their ulllment o theCouncils statutory mandate.

I. Heightened Risk Management and Supervisory Attention


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should plan urther improvement in their capital levels and liquidity

risk proles to support unding models without any assumption o

government assistance and their continued smooth transition to

new global standards.

Bolster resilience to unexpected interest rate shits. In

light o a sustained, historically low interest rate environment,

market participants should work to ensure that they have robust

processes or measuring and, where necessary, mitigating their

exposure to a range o interest rate scenarios. Preparedness to

ace unexpected rate changes or yield curve shits 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 dicult to make denitive determinations regarding the

appropriateness o risk pricing, there have been some indicators

that credit underwriting standards might have overly eased

in certain products, such as leveraged loans, refecting the

dynamics o competition among arranging bankers. Greatermarket discipline can be supported through robust due diligence

practices and processes or monitoring and responding to

developments in credit underwriting standards, including deal

eatures that may allow borrowers to take on excessive risk.

Sound underwriting standards, which were abandoned in the run-

up to the crisis, will encourage greater investor condence and

stability in the market.

Employ appropriate due diligence or emerging fnancial

products. Council agencies are highly attentive to the emergence

and growth o nancial products, particularly those that may be

designed to arbitrage new capital and accounting standards bymoving nancial activities outside the regulated core. A robust

nancial system should acilitate innovation. Market participants,

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

an adequate understanding o the risks that products such as

exchange traded unds 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 o the number o

trading venues and the rise o electronic trading. The fash crash o

May 6, 2010 demonstrated that regulators and market participantsshould continue to monitor these changes and take action as

necessary to help ensure that the market structure regulatory

ramework and operational policies keep pace with changes

to trading and other market practices. Regulators and market

participants should also continue to oster investor condence by

promoting market integrity, eciency, and competition.


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II. Additional Reforms to Address Structural Vulnerabilities

Financial systems are vulnerable to shocks that can be exacerbated

by weaknesses in the structure o nancial institutions, markets, and

inrastructure.

The Council recommends reorms to address structural vulnerabilitiesin the tri-party repo market, or money market mutual unds, and in

mortgage servicing:

Elimination o most intraday credit exposure and reorm o

collateral practices in the tri-party repo market to strengthen

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

repo nancing and the broad array o nancial institutions

active in this market, the regulatory community should exert its

supervisory authority over the industrys reorm eorts to ensure

that the Tri-Party Repo Inrastructure Reorm Task Force meets

its commitments as promptly as possible. The Task Forces

eorts should ultimately improve market unctioning, but severalimportant structural reorm issues require coordinated supervisory

and regulatory attention. Chie among these priorities are

enhancing dealer liquidity risk management practices, alleviating

the propensity o cash investors to withdraw unding and exit the

market when risk suraces, and implementing mechanisms to

manage a potential dealer deault. The ragility o broader market

liquidity acilities and the constraints on the types o collateral that

certain investors are prepared to take (particularly money market

unds) heightens the risk o contagion in the market. Reorm

eorts should practically eliminate intraday credit exposures

o clearing banks to borrowers and strengthen collateral

management practices to improve the stability o this critical short-term unding market.

Implement structural reorms to mitigate run risk in money

market unds. When the SEC adopted new rules or money

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

o eatures still make MMFs susceptible to runs and should be

addressed to mitigate vulnerabilities in this market. To increase

stability, market discipline, and investor condence in the MMF

market by improving the markets unctioning and resilience, the

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

urther reorm alternatives to reduce MMFs susceptibility to runs,

with a particular emphasis on (1) a mandatory foating net assetvalue (NAV), (2) capital buers to absorb und losses to sustain a

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

buers, to mitigate investor runs.

Improve the overall quality o mortgage servicing by

establishing national mortgage servicing standards and

servicer compensation reorm.The mortgage servicing

industry was unprepared and poorly structured to address the

rapid increase in deaults and oreclosures. To address this



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structural vulnerability, regulators should establish national

mortgage servicing standards and promote alternative servicer

compensation models.

National mortgage servicing standards should provide clarityto borrowers and investors, and servicers should be held tothe same quality and responsiveness standards regardless o

whether the loans being serviced are held on the originatorsbooks, have been sold, or have been securitized. Nationalstandards would align incentives and provide clarity andconsistency to borrowers and investors, especially in the caseo delinquency. These standards will enhance the integrity andeciency o mortgage servicing and help reestablish investorcondence in the housing nance market.

Today, the structure o servicing compensation generallydoes not adjust to refect the amount o servicing eortand expense required. This fat-ee structure does notappropriately incent servicers to invest the time and eort towork with borrowers to avoid deault or oreclosure. The FHFA

and the Department o Housing and Urban Developmentshould continue to coordinate a review o the structural fawsin the current mortgage servicing compensation model and

should consider alternatives.

III. Housing Finance

The U.S. housing nance system required extraordinary ederal

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

continues to unction on the basis o this government support

and without sucient return o private capital. This dynamic is not

sustainable over the long term. The Council member agencies and

the Department o Housing and Urban Development should continuetheir work to strengthen the housing nance system, which includes

developing a ramework or the return o private capital to the system.

The ramework should include regulatory activities that set orth

standards and guidelines or participants in the housing nance system,

and other actions that strengthen mortgage underwriting. To give urther

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

nancial system, the Council believes Congress must pass responsible

legislation to reorm the housing nance system. The reorm eorts

should not urther destabilize the ragile housing market.

IV. Financial Regulatory Reform

Council member agencies are committed to implementation o nancial

regulatory reorm. While important steps have been taken, both

domestically and in the international policy arena, much work remains

to be done. The agencies are approaching reorm careully, mindul

o the need or sucient public comment and the risks o unintended

consequences.


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Coordinated implementation o regulatory reorm will enhance the

integrity, eciency, competitiveness, and stability o U.S. nancial

markets; promote market discipline; and maintain investor condence by

closing regulatory gaps that contributed to the crisis and previous market

dislocations.

Dodd-Frank Act

The Dodd-Frank Act provides comprehensive reorms and protections

across the nancial regulatory system. These reorms include the creation

o a regulatory ramework or the over-the-counter derivatives market;

investor protection measures that increase disclosure, transparency,

and condence; reporting or managers o hedge unds and other

private unds; and the establishment o a single agency dedicated to

ensuring consumer nancial protection and the integrity o the market

or consumer nancial products and services. The Dodd-Frank Act also

requires regulators to impose heightened prudential standards on certain

large nancial rms to help oster market discipline and stability, and

to make clear that no rm will be considered too big to ail, by creatinga new authority to break up and wind down a ailing nancial rm in a

manner that protects taxpayers and the economy. In addition, the Dodd-

Frank Act created the Council to monitor risks that could build across

the system in a way that threatens the stability o the nancial markets in

the United States, and the OFR to collect data on the Councils behal,

working closely with supervisors.

The Council member agencies have made signicant progress in

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

The Council and its member agencies recognize that successul

implementation o reorm across complex areas o the nancial system

requires independent agencies to coordinate their eorts, even i

such consultation is not statutorily required. Coordination is critical to

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

way, but also appropriately balance market eciencies, competitiveness,

and stability while providing or innovation. To meet the challenges

o designing and enorcing these new rules, the quality and scale o

resources dedicated to nancial oversight must increase. Agencies must

have sucient resources to attract and retain talented individuals and

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

International Coordination

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

agreed that reorms were needed to build high-quality capital andmitigate pro-cyclicality in the nancial system; improve compensation

practices to support nancial stability; reorm the over-the-counter

derivatives markets or greater transparency and risk management; and

address cross-border resolutions and systemically important nancial

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

many o these goals within the United States, but international

coordination is required to ensure that similar reorms are applied

consistently across the global nancial system to mitigate regulatory gaps



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

working with their international counterparts to implement these reorms

in a timely manner. Key reorms include the ollowing:

Capital and liquidity standards. In 2010, central banks and

supervisors reached agreement on the core elements o new

global capital and liquidity standards, Basel III. As a result othis agreement, internationally active banks will have to hold

substantially more capital in the orm o common equity against

the risks they take. This agreement was the oundation o a

comprehensive new capital ramework to urther stabilize global

markets, but it let open several areas or urther analysis, including

the size and composition o 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 o assets across countries.

Globally active systemically important banks. The Financial

Stability Board, a global body o nance ministers, central bankers,

and supervisors, has been working to develop guidelines orcooperation in the supervision o large, globally active nancial

institutions, and to develop a consistent international ramework

or the orderly resolution o such companies. These initiatives

complement Dodd-Frank Act requirements, and Council members

are actively supporting eorts to promote international consistency

on resolution rameworks.

Derivatives markets. A core element o the international

ramework or reorm o the over-the-counter derivatives market is

a requirement or 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 or central counterparties and margin

requirements or swaps and security-based swaps that are not

centrally cleared. Other key elements o reorm are the reporting

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

trading o standardized over-the-counter derivatives on exchanges

or electronic trading platorms. In each o these areas, Council

member agencies are committed to working with international

counterparts to harmonize requirements.

Inrastructure. International authorities have released revisedstandards or nancial market inrastructures that provide a single

set o principles (CPSS-IOSCO Principles or nancial market

inrastructures) or greater consistency in the oversight and

regulation o nancial inrastructures worldwide, including enhanced

requirements or 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 o nancial inrastructures worldwide and thus

enhance the integrity o markets and global investor condence.


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Macroeconomic Environment 17

4 Macroeconomic Environment

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

healing slowly rom the lingering eects o the extraordinary fnancial market dislocations

in 200809 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 insufcient to raise the

employment-population ratio.

Most oreign economies also continue torecover rom the most severe global downturn

since the Great Depression, albeit at diering

paces. Emerging economies, which suered

ewer nancial disruptions rom the crisis, have

been able to recover more quickly, and many o

those economies have returned to or exceeded

their previous trend growth rate. Recovery in

the advanced economies has been slowed

by the weakness o the nancial sector, and

many have not yet reached their pre-crisis

level o economic activity. With interest rates in

advanced economies at historically low levels tosupport economic growth, unds have fowed to

emerging markets, where returns are relatively

higher. Political tensions in North Arica and the

Middle East, and the natural disaster in Japan

added to uncertainty in the rst hal o 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, nancial markets have been able tosmoothly accommodate elevated government

borrowing, as private savers have increased

their demand or government debt. However,

certain governments and nancial institutions

in peripheral Europe have encountered

severe diculties in maintaining access to

private nancial market unding. As the global

economy continues to recover, governments

Chart 4.0.1 Real GDP Growth and the Unemployment Rate

-8

-4

0

4

8

12

1995 1999 2003 2007 2011

2

4

6

8

10

12

Percent Change Annual Rate Percent

Source: BLS and BEA

GDP Growth(left axis)

Unemployment Rate

(right axis)

Chart 4.0.2 Real GDP Growth and Its Components

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

2007:Q1 2008:Q1 2009:Q1 2010:Q1 2011:Q1

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

Percent Contribution Percent Change Annual Rate

Source: BEA

Personal Consumption ExpendituresResidential Investment + StructuresGovernment Consumption and Investment

Net Exports

GDP Growth(right axis)

left axis

Equipment and Software

left axisChange in Inventories


28/192


ace the challenge o rebalancing revenue and

expenditures.

4.1 Provision o Financial

Services to the Real Economy

Functions o the Financial System

The nancial system has three primary

unctions: (1) credit fow acilitation, (2) risk

transer, and (3) transaction and payment

services.

Credit ows: A primary unction o the nancial

system is to acilitate the fow o unds rom

savers to borrowers at prices that appropriately

compensate all parties or the inherent riskiness

o lending; hence, nancial markets and their

participants play a key role in price discovery.

Risk transer: Another key unction o the

nancial system is to acilitate the ecient

allocation o risk across households and

businesses.

Transaction and payment services:The

nancial system is also responsible or providing

reliable and robust transaction and payment

services to the real economy.

4.1.1 Credit Flows

The reduction in credit ows to households

and businesses during the crisis reected both

a decline in demand or credit and a reduction

in the supply o available credit. Combined

credit ows to businesses and households

have started to increase. However, persistent

weakness in real estate markets continues to

restrain demand or and supply o mortgage

credit.

Beore the nancial crisis, many households

and nancial market participants increased

their debt loads. Some o this credit fowedto borrowers with limited ability, and at times

limited incentives, to repay their loans. Further,

some companies that originated mortgages and

sold them or securitization were compensated

on the basis o 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 Nonfnancial Net Debt Flows

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

Trillions of US$ Trillions of US$

Private Nonfinancial SectorGeneral Government

Source: Flow of Funds Note: At a quarterly rate.

Chart 4.0.4 Euro Area Nonfnancial Net Debt Flows

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

Trillions of Euros Trillions of Euros

Private Nonfinancial SectorGeneral Government

Source: Eurostat Note: At a quarterly rate.

Chart 4.1.1 Net Debt Outstanding as a Percent o GDP

40

50

60

70

80

90

100

110

120

130

2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1

40

50

60

70

80

90

100

110

120

130

Percent Percent

Source: Flow of Funds, BEA

NonfinancialCorporate

Financial Institutions

U.S. GeneralGovernment

Household


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originate-to-hold lenders to underwrite loans to

high standards.

The crisis triggered signicant reductions

in the fow o credit and an unprecedented

deleveraging by consumers, businesses, and,

most dramatically, the nancial sector itsel.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 fows o credit to the private

nonnancial sector have turned marginally

positive owing to increases in both demand or

and supply o credit.

Credit Flows to the Corporate Sector

The nonnancial corporate sector continues

to recover as increased demand and low laborcosts contribute to protability. In the aggregate,

corporate borrowers are experiencing more

avorable nancing conditions rom banks,

bond markets, and syndicated loan markets,

which allow large corporate rms to nance

their activities on better terms. For instance,

bank underwriting standards have eased rom

the extremely tight conditions at the peak o the

crisis (Chart 4.1.2).

Credit intermediation or large corporations

in the United States is characterized by ahigh degree o unding through debt capital

markets rather than through banks. Debt

capital markets, somewhat impaired during the

crisis, are again unctioning well. Corporate

bond markets have recovered, and issuance

o 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 hasbeen 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 Bank Business Lending Standards and Demand

-80

-60

-40

-20

0

20

40

60

80

100

2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1

-80

-60

-40

-20

0

20

40

60

80

100

Net Percent Net Percent

Source: SLOOS

ReportingIncreasedDemand

ReportingHigher Spreads

ReportingTightenedStandards

Note: For C&I loans to medium and large firms.

Chart 4.1.3 Corporate Bond Market Issuance

0

20

40

60

80

100

2005 2006 2007 2008 2009 2010 2011

0

20

40

60

80

100

Billions of US$ Billions of US$

Source: Dealogic

Investment-Grade

High-Yield

Note: U.S. marketed issuance only.

Chart 4.1.4 Corporate Bond Spreads

Source: Bloomberg

0

400

800

1200

1600

2000

2400

2005 2006 2007 2008 2009 2010 2011

0

400

800

1200

1600

2000

2400

Basis Points Basis Points

Investment-Grade

High-Yield

Note: Spreads to Treasuries.


30/192


(Chart 4.1.5). Private equity rms continue to

hold high levels o committed but uninvested

capital available or LBO activity.

Credit Flows to the Small Business Sector

Banks are a large source o credit or small

businesses: banks provide these businesseswith 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, beore declining by more than 10 percent

through 2010 (Chart 4.1.6). A number o

related actors explain the decline, including the

general dislocation o credit during the crisis,

the adverse eect o the crisis on borrowers

balance sheets and on the value o theiravailable collateral, and the reduced demand

or credit in light o lower inventory investment

and cuts in investment and payrolls as these

businesses have experienced weak demand

and stagnant prospective sales.

In the National Federation o Independent

Business (NFIB) June 2011 Small Business

Survey, the number o small businesses

reporting that credit is harder to obtain has

declined to mid-2008 levels. Small businesses

continue to cite weak demand or their productsor services as the main actor limiting growth.

Additionally, with more than hal o credit to

small businesses secured by some orm o 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

fows, which ell sharply during the crisis, have

only recently begun to recover. The modest

recovery o these fows refects restraints on

the availability o consumer credit as well as

subdued demand as households ace weaker

income prospects. Nonmortgage lending to

consumers, which declined or several years,

began growing in 2010, driven by nonrevolving

credit (Chart 4.1.7). The amount o revolving

credit available to consumers has been

Chart 4.1.5 North American Completed LBOs

0

50

100

150

200

250

2003:Q1 2005:Q1 2007:Q1 2009:Q1 2011:Q1

0

50

100

150

200

250

Billions of US$ Number of Deals

Source: Thomson Reuters

Deal Value Net Debtof Target(left axis)

Number of Deals(right axis)

Chart 4.1.6 Proxy or Small Business Lending

500

550

600

650

700

750

800

2000:Q2 2002:Q2 2004:Q2 2006:Q2 2008:Q2 2010:Q2

500

550

600

650

700

750

800

Billions of US$ Billions of US$

Source: FDICNote: Data from all FDIC-insured institutions; includes C&I and NFNR loans

less than 1MM, agriculture and farm loans less than 500k.

Chart 4.1.7 Nonmortgage Consumer Credit Flows

-4

-3

-2

-1

0

1

2

3

4

5

2000 2002 2004 2006 2008 2010

-4

-3

-2

-1

0

1

2

3

4

5

% Change 3-month % Change 3-month

Source: FR G-19

Nonrevolving

Revolving


31/192


substantially reduced, although aggregate

borrowing capacity remains considerable

(Chart 4.1.8). Demand or auto nancing

has risen along with the increase in vehicle

purchases rom the lows o the crisis. Student

loan volumes increased during the downturn

in part because o rising enrollments andincreased tuition costs; these volumes have

been increasingly supported by government-

guaranteed loan programs.

Real Estate and Mortgage Markets

The housing sector remains depressed. To

date, real residential investment has allen

nearly 60 percent since its peak in early 2006.

Housing starts and sales o new homes have

remained near record low levels, and distressed

sales have increased, recently comprising 46

percent o all sales (Charts 4.1.9 and 4.1.10).As a result o the pullback in mortgage lending

and an elevated level o charge-os, overall

mortgage debt outstanding contracted or two

years (Chart 4.1.11).

Home prices ace continued downward

pressure rom excess inventory, lackluster

demand, and distressed sales, in part coming

rom oreclosures. Ater stabilizing in late

2009 and early 2010, home prices have

allen urther since the summer o 2010. The

CoreLogic repeat sales home price index,which is representative o conorming and

non-conorming mortgages, is back down to

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

2006 peak (Chart 4.1.12). The Federal Reserve

Boards Senior Loan Ocer Opinion Survey or

April 2011 showed that demand or residential

mortgages at banks continued to decrease.

Some o the housing market undamentals

have shown signs o improvement. Indexes o

aordability based on current interest rates,

median incomes, and median home prices haverisen to historic highs (Chart 4.1.13). The very

low levels o new home construction in recent

years have helped trim the backlog o excess

new homes or sale. In addition, the unusually

low levels o household ormation over the past

several years could reverse once the labor

market improves suciently, suggesting the

possibility o pent-up demand or housing.

Chart 4.1.8 Credit Card Limit and Outstanding Balance

0

1

2

3

4

2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1

-20

-10

0

10

20

30

40

Trillions of US$ % Change Annual Rate

Credit Card Available Credit (left axis)

Credit Card Balance (left axis)

Source: FRBNY Consumer Credit Panel

Growth in Credit Card Balance(right axis)

Chart 4.1.9 Single-Family New Home Starts and Sales

0

400

800

1200

1600

2000

2000 2002 2004 2006 2008 2010

0

400

800

1200

1600

2000

Thousands of Units, Annual Rate Thousands of Units, Annual Rate

Source: Census Bureau

Starts

Sales

Chart 4.1.10 Distressed Sales Share o Total Home Sales

0

10

20

30

40

50

2000 2002 2004 2006 2008 2010

0

10

20

30

40

50

Percent Percent

Source: CoreLogic


32/192


More than osetting the developments in these

undamentals, ongoing operational deciencies

and legal challenges in the processing o

oreclosure lings have signicantly slowed

the oreclosure process, adding to a growing

inventory o distressed properties. Moreover,

the government-sponsored enterprises (GSEs)Fannie Mae and Freddie Mac, as well as the

Federal Housing Administration (FHA) and

the Department o Veterans Aairs (VA)

which together account or the guarantee

and insurance o more than 90 percent o

originationshave tightened their underwriting

standards. Standards have been tightened

across product, credit score, and loan-to-

value (LTV) spectrums, and ewer loans with

low down payments are being guaranteed.

FICO scores on mortgage originations have

risen sharply, refecting the tighter underwritingstandards as well as the characteristics o

borrowers who are applying or 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 o the market, rising rom 3 percent

o 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. Moodys/

REAL commercial property price index ell

by about 45 percent rom its 2007 peak

(Chart 4.1.15). Sales activity also decreased

sharply: commercial property transactions

ell 89 percent to $66 billion in 2009 rom a

peak o $579 billion in 2007. A combination o

weaker cash lows, lower collateral values, and

tightened underwriting standards since 2008

has made it more diicult or CRE owners to

reinance their debt, putting urther stress onthe market. Since mid-2008, bank lending to

inance commercial property has allen by 50

percent. One-quarter o recent CRE activity

has involved distressed properties.

Commercial mortgage-backed security (CMBS)

issuers account or nearly 25 percent o the

total CRE debt. Refecting the credit crisis

Chart 4.1.11 Net Consumer Sector Credit Flows

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

2000:Q1 2002:Q1 2004:Q1 2006:Q1 2008:Q1 2010:Q1

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Trillions of US$ Trillions of US$

Mortgage and Home EquityNonmortgage

Source: FRBNY Consumer Credit Panel

Chart 4.1.12 National Repeat Sales Home Price Indexes

100

120

140

160

180

200

220

2000 2002 2004 2006 2008 2010

100

120

140

160

180

200

220

Index, January 2000 = 100 Index, January 2000 = 100

Source: FHFA and CoreLogic

CoreLogic(including distressed sales)

FHFA

CoreLogic(excluding distressed sales)

Chart 4.1.13 Housing Aordability Index

80

100

120

140

160

180

200

1990 1994 1998 2002 2006 2010

80

100

120

140

160

180

200

Index Index

Source: NAR

Note: At 100 the income of a median family would qualify for an80% LTV mortgage on a median priced single-family home.


33/192


and economic stress, issuance o 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 hasshown tentative signs o recovery, with more

sales activity among higher quality, well-leased

properties in major metropolitan markets, as

well as signs o increased demand or and

supply o commercial property loan nancing.

The Senior Loan Ocer Opinion Survey or

April 2011 showed that about 35 percent o

domestic banks on net had seen increased

demand or CRE loans, and a ew large banks

and oreign banks had eased their lending

standards somewhat, although outstanding

bank commercial property loans have continuedto all.

Securitization Markets

Much o the large increase in credit leading

up to the nancial crisis was driven by an

expansion o securitized credit, particularly in

the mortgage market. During this time, nancial

market participants and regulators tended to

view securitization avorably: it allowed banks

to reduce their exposure to certain types o

loans, redistributing

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2011 FSOC Annual Report

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