Board of Governors of the Federal Reserve System

4. Funding risk

Vulnerabilities from liquidity and maturity mismatches are currently low

A measure of the total amount of liabilities that are most vulnerable to runs, including those issued by nonbanks, is relatively low (top panel of table 4). Banks are holding higher levels of liquid assets and relying less on funding sources that proved susceptible to runs than in the period leading up to the crisis, in part because of liquidity regulations introduced after the financial crisis and banks' greater understanding of their liquidity risks. Money market fund reforms implemented in 2016 have reduced "run risk" in that industry.

Table 4: Size of Selected Instruments and Institutions

Banks have high levels of liquid assets and stable funding

Banks have strong liquidity positions. In total, liquid assets in the banking system have increased more than $3 trillion since the financial crisis. Large banks in particular hold substantial amounts of liquid assets, far exceeding pre-crisis levels and well above regulatory requirements (figure 4-1). Bank funding is less susceptible to runs now than in the period leading up to the financial crisis--further reducing vulnerabilities from liquidity transformation. Core deposits, which include checking accounts, small-denomination time deposits, and other retail deposits that are typically insured, are near historical highs as a share of banks' total liabilities. Core deposits have traditionally been a relatively stable source of funds for banks, in the sense that they have been less prone to runs. In contrast, short-term wholesale funding, a source of funds that proved unreliable during the crisis, is near historical lows as a share of banks' total liabilities (figure 4-2).

Run risk in short-term funding markets has declined substantially since the crisis...

During the financial crisis, runs occurred in the markets for asset-backed commercial paper, repos, and money market fund shares, as well as on individual institutions, greatly aggravating the economic harm from the crisis. An aggregate measure of private short-term, wholesale, and uninsured instruments that could be prone to runs--a measure that includes repos, commercial paper, money funds, uninsured bank deposits, and other forms of short-term debt--currently stands at $13 trillion, significantly lower than its peak at the start of the financial crisis (figure 4-3).

. . . and money market funds are less susceptible to runs

Money market fund (MMF) reforms implemented in 2016 have reduced run risk in the financial system. MMFs proved vulnerable to runs in the past, largely because they almost always maintained stable share prices by rounding net asset values to $1, which created an incentive for investors to redeem their shares quickly in the face of any perceived risk of losses to the assets held by the funds. The reforms required institutional prime MMFs, the most vulnerable segment, to discontinue the use of rounding and instead use "floating" net asset values that adjust with the market prices of the assets they hold. As the deadline for implementing the reforms approached, assets under management at prime MMFs fell sharply (figure 4-4). Many investors in those funds shifted their holdings to government MMFs, which continue to use rounded $1 share prices but have assets that are safer and less prone to losing value in times of financial stress. A shift in investments toward short-term investment vehicles that provide alternatives to MMFs and could also be vulnerable to runs or run-like dynamics would increase risk, but assets in these alternatives have increased only modestly compared to the drop in prime MMF assets.

Mutual funds holding corporate debt have grown in size...

Total assets under management in investment-grade and high-yield bond mutual funds and loan mutual funds have more than doubled in the past decade to over $2 trillion (figure 4-5). Bond mutual funds are estimated to hold about one-tenth of outstanding corporate bonds, and loan funds purchase about one-fifth of newly originated leveraged loans. The mismatch between the ability of investors in open-end bond or loan mutual funds to redeem shares daily and the longer time often required to sell corporate bonds or loans creates, in principle, conditions that can lead to runs, although widespread runs on mutual funds other than money market funds have not materialized during past episodes of stress. If corporate debt prices were to move sharply lower, a rush to redeem shares by investors in open-end mutual funds could lead to large sales of relatively illiquid corporate bond or loan holdings, further exacerbating price declines and run incentives. Moreover, as noted in earlier sections, business borrowing is at historically high levels, and valuations of high-yield bonds and leveraged loans appear high. Such valuation pressures may make large price adjustments more likely, potentially motivating investors to quickly redeem their shares.

. . . and life insurers have increased their holdings of less-liquid assets recently, though they now make less use of funding sources that suffered runs in the crisis

Funding risks in the insurance industry have declined significantly since the financial crisis. Life insurance companies' nontraditional liabilities--repos, funding-agreement-backed securities, securities lending cash collateral, all of which suffered runs during the financial crisis, and Federal Home Loan Bank, or FHLB, advances--have edged up over the past few years. However, the amounts of these nontraditional liabilities remain small relative to total assets of life insurance firms and continue to be below pre-crisis peaks (figure 4-6).⁹ That said, life insurers have been shifting their portfolios toward less liquid assets, somewhat weakening their liquidity positions.

Central clearing of financial transactions has grown, providing financial stability benefits but warranting continued attention

Central clearing of derivatives and securities transactions has grown over the past several decades--both in absolute terms and relative to the size of financial markets. Since the financial crisis, global regulatory efforts have contributed to this growth by encouraging and, in some cases, mandating central clearing of over-the-counter derivatives. By some estimates, the percentage of such activity that is centrally cleared now exceeds 60 percent. Some of the growth in central clearing of both securities and derivatives transactions has also been driven by market participants' recognition of its benefits. Central clearing can improve financial stability by insulating firms from each other's default, by reducing financial firms' gross exposures through the netting of positions by central counterparties (CCPs), and by improving risk management. That said, some CCPs are large, concentrated, highly interconnected, and systemically important and warrant continued monitoring. CCPs reduce credit risk partly through the daily exchange of margin. Such practices, however, expose CCPs and their counterparties to liquidity risk that must be managed, especially when volatility rises or financial conditions deteriorate unexpectedly.

 

References

 

 9. The data on securities lending and repos of life insurers are not available for the pre-crisis period. However, the firm American International Group, Inc., or AIG, alone had $88.4 billion in securities lending outstanding at the peak in 2007:Q3. See American International Group, Form 10-Q Quarterly Report for the Quarterly Period Ended September 30, 2007. Return to text