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Financial Stability Report 2015

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Financial Stability Report 2015 OFFICE OF FINANCIAL RESEARCH Financial Stability Report 2015 Table of Contents 1 Executive Summary ..................................................................... 1 2 Assessing and Monitoring Threats to Financial Stability ............. 7 2.1 Assessment of Threats to U.S. Financial Stability ........................................................7 2.2 Focus on Selected Risks ..............................................................................................10 The Potential Role of ETFs in Generating and Propagating Liquidity Stress .............17 Data Deficiencies in Assessing Cyber Threats to Financial Stability ......................... 30 2.3 Financial Stability Monitoring: Progress and Challenges ...........................................32 Leverage, Borrowing, and Derivatives Activities of the 50 Largest Hedge Funds .....37 3 Evaluating Financial Stability Policies ........................................ 41 3.1 Micro- and Macroprudential Policy ............................................................................41 Possible Bank Responses to Binding Regulatory Ratios ............................................ 44 3.2 Addressing Risks in Systemically Important Financial Institutions..............................47 Categories of Systemic Importance for Banks ............................................................47 Rating Agencies Consider Expectation of Extraordinary Support in Rating Some Large Banks .......................................................................................................49 3.3 Addressing Risks in Nonbank Financial Institutions ....................................................53 Central Counterparty Links to Other Systemically Important Companies .................56 3.4 Potential Unintended Consequences of Macroprudential Policies ..........................59 4 Data Needs for Financial Stability Analysis ............................... 67 4.1 Addressing Gaps in Scope, Quality, and Accessibility ...............................................67 Scope, Quality, and Access ........................................................................................ 68 What are Financial Data Standards? ............................................................................69 Legal Entity Identifier Adoption Needs Regulatory Mandates .................................70 4.2 Analyzing Data Needs .................................................................................................73 Overview of U.S. Derivatives Trade Reporting ...........................................................78 Data Quality Analysis of Public Swap Data Repository Data ..................................... 84 5 Research on Financial Stability .................................................. 95 5.1 Research Agenda .........................................................................................................95 5.2 Central Counterparties ................................................................................................96 Central Counterparty Stress Tests: Research Questions ............................................96 i 5.3 Stress Testing: A Framework for Evaluation ................................................................97 Bank Stress Tests: Research Questions .......................................................................98 Asset Management Stress Tests: Research Questions .............................................. 99 Insurance Company Stress Tests: Research Questions .............................................100 5.4 Financial Networks ....................................................................................................102 5.5 Asset Management and Systemwide Risk.................................................................106 Liquidity and Leverage: Research Questions ............................................................106 Institutional Execution and Dark Markets: Research Questions ...............................108 6 Agenda Ahead .........................................................................113 Glossary .........................................................................................117 Bibliography .................................................................................. 127 ii 2015 OFR Financial Stability Report Executive Summary 1 n our first Financial Stability Report, the Office of Financial Research (OFR) Ihighlights key potential threats to U.S. financial stability, evaluates policy steps taken or aimed at reducing those threats, describes actions to be taken to improve U.S. financial data, and reports on key findings from our research. The OFR has a mandate under the Dodd-Frank Wall The primary responsibility of the Office of Street Reform and Consumer Protection Act of 2010 Financial Research (OFR), an independent to assess and monitor threats to financial stability office within the Department of the Treasury, by assessing vulnerabilities in the financial system is to assess and monitor threats to financial and weighing them against its resilience. Chapter 2 stability; improve the scope, quality, and places current threats to U.S. financial stability in accessibility of financial data; perform essential the medium range, focusing on elevated and rising financial research; and evaluate policies credit risks in the U.S. nonfinancial business sector, designed to improve resilience in the financial investors’ reach for yield in a climate of persistently system. This first Financial Stability Report low interest rates, and the uneven resilience of the provides the in-depth analysis contained in the financial system. OFR’s first three annual reports. The Office is charged with evaluating the effectiveness This report supplements and precedes the of tools designed to promote U.S. financial stability. OFR’s 2015 Annual Report to Congress, which Chapter 3 assesses progress in the development of the OFR will publish in January. The annual these tools and potential unintended consequences of report will summarize the financial stability financial regulation and financial stability policies. assessment in this report, report on the results The Office also is mandated to improve the scope, of our research, and provide an update on the quality, and accessibility of financial data for the efforts of the Office in meeting its mission, benefit of the Financial Stability Oversight Council which will fulfill the responsibility to report to (FSOC) and the public. Chapter 4 discusses ways Congress and the public in Section 154(d) of regulators can collectively better use financial data the Dodd-Frank Act. while minimizing burden on firms through up-front It is hoped that by creating these two reports, coordination on use of data standards, collaboration the Office can serve the needs of a wide array on data collections, and broader sharing of data with of stakeholders, while fulfilling its commitment appropriate safeguards. The chapter also assesses the to be transparent and accountable. progress in improving financial data since the crisis, paying particular attention to data about securities financing transactions, derivatives, mortgage markets, insurance, and asset management activities. In addition, the Office conducts research to improve our ability to monitor potential vulnerabilities in the Richard Berner financial system, assess causes and consequences of Director, Office of Financial Research financial crises, and evaluate financial stability policy and risk management practices. Chapter 5 highlights key findings and ongoing research questions from several important OFR research initiatives or studies. Executive Summary 1 In the coming years, the Office will organize our efforts in long-term interest rates may remain suppressed for some data, financial research, and policy evaluation around core time. The persistence of low rates contributes to excesses areas of concentration to promote coherence and coordina- that could pose financial stability risks, including investor tion in such initiatives. Chapter 6 describes that organiza- reach-for-yield behavior, tight risk premiums in U.S. bond tional framework and the initiatives we will pursue in 2016. markets, and, as noted, the high level and rapid growth of U.S. nonfinancial business debt. Assessing and Monitoring Threats to Financial Stability Third, although the resilience of the financial system has improved significantly in the past five years, it is uneven. Overall threats to U.S. financial stability remain moderate Since the financial crisis, regulatory reforms and changes in — that is, in a medium range — similar to our assessment risk management practices have strengthened key institu- of six months and a year ago. But some have edged higher tions and markets critical to financial stability. Yet, existing over the past year, as we discuss in Chapter 2. We discuss vulnerabilities persist and some new ones have emerged. three major themes. Financial activity and risks continue to migrate, challenging existing regulations and reporting requirements. Market First and most important, credit risks are elevated and liquidity appears to be episodically fragile in major U.S. rising for U.S. nonfinancial businesses and many emerging financial markets, diminishing sharply under stress. Run markets. OFR’s past annual reports highlighted the rising and fire-sale risks persist in securities financing markets. credit risks in both U.S. corporates and emerging markets. Interconnections among financial firms are evolving
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