Board of Governors of the Federal Reserve System

4. Funding Risk

The COVID-19 shock exposed vulnerabilities at nonbank financial firms that contributed to market turmoil and required the Federal Reserve to establish emergency facilities to restore the functioning of markets for short-term funding and corporate bonds

As of the second quarter of 2020, the total amount of liabilities most vulnerable to runs, including those of nonbanks, had increased 17.1 percent over the past year to $17.3 trillion (table 4). Banks rely only modestly on short-term wholesale funding and maintain large amounts of high-quality liquid assets, in part because of liquidity regulations and supervisory programs introduced after the 2007–09 financial crisis and the improved understanding and management by banks of their liquidity risks.¹⁵

Table 4. Size of Selected Instruments and Institutions

As noted in previous Financial Stability Reports, the financial system's vulnerability to funding risks had increased because of the renewed growth in prime MMFs during 2018 and 2019 as well as the increase in corporate debt held by long-term mutual funds since 2008. These developments, discussed in more detail later in this section, contributed to considerable funding strains in March. These strains, in turn, prevented a range of employers from obtaining access to credit markets during a period when borrowing needs were particularly acute; in response, the Federal Reserve undertook several actions, including establishing emergency lending facilities and providing regulatory relief, to ensure the smooth functioning of various markets and to support the flow of credit to households and businesses. For more information, see the boxes "Federal Reserve Actions to Stabilize Short-Term Funding Markets during the COVID-19 Crisis" and "Federal Reserve Actions and Facilities to Support Households, Businesses, and Municipalities during the COVID-19 Crisis." Going forward, regulatory agencies, including the Federal Reserve, are exploring reforms that will address structural vulnerabilities in the nonbank financial institutions sector that have required emergency interventions during both the 2007–09 financial crisis and the COVID-19 crisis.

Banks continue to have high levels of liquid assets and stable funding

At most large banks, liquid asset positions increased substantially in the second quarter, reflecting an increase in reserves (figure 4-1). In addition, their liquidity ratios are well above regulatory requirements. At the onset of the pandemic, bank reliance on the most unstable sources of funding stood at historically low levels (figure 4-2). Strong capital and liquidity buffers enabled banks to accommodate drawdowns when businesses relied heavily on their lines of credit as the COVID-19 shock hit. Banks also managed liquidity pressures by increased borrowing from the discount window and Federal Home Loan Banks. In addition, banks experienced heavy deposit inflows, consistent with investors becoming more risk averse and credit-line borrowers depositing the proceeds from line draws taken as precautionary measures. Core deposits continued to increase across the banking system through September 2020.

Funding strains on mortgage servicers eased after policy actions, but uncertainties remain

As discussed in the May Financial Stability Report, mortgage servicers are responsible for advancing payments on behalf of a borrower that requests forbearance under the CARES Act. This responsibility can cause strains for nonbank mortgage servicers because they do not have the kinds of strong capital and liquidity buffers that banks have built to weather shocks or access to the same sources of liquidity as banks. Instead, nonbanks have relied on their internal cash or, in some cases, fairly expensive private-market financing to fund these payments. Liquidity pressures on nonbank mortgage servicers eased in April, as Ginnie Mae established a facility to lend against advances of principal and interest (but not taxes and insurance) and the Federal Housing Finance Agency limited servicing advances up to four months. Mortgage servicer liquidity positions also benefited from an increase in refinancing activity through the second quarter. However, strains may emerge again if mortgage forbearance take-up increases substantially or the fiscal support provided to households under the CARES Act that enables them to continue to make mortgage payments is not extended.

Money markets have stabilized but would be vulnerable without the emergency facilities in place

Money-like liabilities that are prone to runs—an aggregate measure of private short-term debt that can be rapidly withdrawn in times of stress—increased substantially and stood at about 92 percent of GDP in the second quarter of 2020 (figure 4-3). The growth in runnable liabilities over the first half of 2020 was largely attributable to a surge in domestic MMFs and uninsured deposits.

Prime MMFs, particularly institutional funds, experienced runs in March, with outflows reaching the same proportion of assets redeemed during the run on MMFs in 2008. Heavy redemptions from these funds were prompted in part by investor concerns about the possibility of liquidity fees and redemption gates. Retail prime funds and tax-exempt funds also suffered heavy redemptions. As investors fled to safety, short-term funding markets became severely dislocated. Actions by the Federal Reserve were required to slow redemptions and restore the functioning of short-term funding markets (see the box "Federal Reserve Actions to Stabilize Short-Term Funding Markets during the COVID-19 Crisis"). Assets under management at prime MMFs regained most of the decrease in late March and remained stable from May through August 2020 (figure 4-4).

Emergency measures undertaken by the Federal Reserve with the support of the Treasury have temporarily lowered the risk of adverse events associated with vulnerabilities in the nonbank sector in the near term, but remaining vulnerabilities call for structural fixes in the longer term. In addition, other cash-management vehicles similar to institutional prime funds, such as dollar-denominated offshore funds and short-term investment funds, do not directly benefit from the backstop provided by the MMLF. Between $400 billion and $1 trillion of these vehicles' assets under management closely mirror institutional U.S. prime funds, and heavy redemptions may destabilize short-term funding markets even in the presence of the MMLF. Depressed asset prices due to fire sales could lead to mark-to-market losses for other investors, including U.S. prime funds.

Outflows from long-term mutual funds that hold less liquid assets have mostly reversed, but the redemption waves had run-like characteristics that highlighted significant structural vulnerabilities in the sector

U.S. corporate bonds held by mutual funds increased substantially in the second quarter of 2020 and reached $1.7 trillion after contracting in the first quarter (figure 4-5). Mutual funds are estimated to hold about one-sixth of outstanding corporate bonds. These open-end mutual funds engage in liquidity transformation by offering daily redemptions to investors, notwithstanding the liquidity profile of a fund's underlying assets. Funds investing substantially in corporate bonds and bank loans may be particularly exposed to liquidity transformation risks given the relative illiquidity of such assets.

The record outflows from fixed-income mutual funds in March caused considerable strains for the affected funds, and their forced sales contributed to a deterioration in liquidity in fixed-income markets. The magnitude of investor redemptions was unprecedented, and heavy redemptions occurred among a wide range of funds, including investment-grade corporate bond funds and municipal bond funds. There were no reports of mutual funds failing to meet investor redemptions, but funds were forced to sell assets under worsening market conditions, further draining liquidity from corporate bond markets.

The announcement of a number of emergency lending facilities, including those designed to support corporate borrowing, improved bond market liquidity significantly and eased strains faced by mutual funds. Investment-grade and high-yield bond funds received inflows since May, and assets under management now exceed their pre-pandemic levels (figure 4-6). Bank loan mutual funds, which faced record redemptions in March, subsequently had more modest outflows through August (figure 4-7). Their total assets under management have decreased about 25 percent since February and stood at $64 billion in August.

The fire-sale dynamics in March associated with open-end mutual funds concentrated in fixed-income assets demonstrated the severity of structural vulnerabilities highlighted in previous Financial Stability Reports. By providing a backstop in the corporate bond market, the emergency lending facilities significantly alleviated the stress of large outflows faced by investment-grade corporate bond funds, and the backstop's effect has also flowed through to high-yield bond funds and bank loan funds. Even so, the March turbulence demonstrated that fixed-income mutual funds continue to be vulnerable to large, sudden redemptions, and sizable outflows can still lead to a deterioration in market liquidity of underlying assets. This structural vulnerability may call for structural reforms.

Central counterparties continue to manage risks amid elevated volatility

Meanwhile, driven largely by increased clearing of over-the-counter derivatives, central counterparties (CCPs) intermediate a larger share of transactions across more markets than at the time of the 2007–09 financial crisis. CCPs have supported market functioning throughout the pandemic, effectively managing the increased risks posed by elevated volatility and mitigating counterparty risks. However, the volatile environment continues to imply heightened tail risks for clearinghouses and their members. Further market stresses, as well as resulting increases in cash and collateral requirements by CCPs, could increase liquidity pressures on market participants, potentially even beyond the heightened pressures met during the acute phase of the COVID-19 shock.

Collateralized loan obligation fundamentals have improved in recent months but are still weak compared with pre-pandemic levels

CLO issuance declined about 33 percent through September 2020 compared with the same period in 2019. These securities fund more than 50 percent of outstanding institutional leveraged loans—loans that have been under significant price pressures, as previously discussed. Unlike open-end mutual funds, CLOs do not generally permit early redemptions or rely on funding that must be rolled over before the underlying assets mature. As a result, CLOs avoid the run risk associated with a rapid reversal in investor sentiment. Overall, CLO fundamentals have improved in recent months but are still weak compared with pre-pandemic levels, and some risks remain. For example, the surge in underlying loan downgrades and defaults led to a spike in the number of CLOs that failed collateral tests in recent months. Managers of CLOs that failed overcollateralization tests typically attempted to cure those failures by selling risky collateral. To the extent that CLO managers fail to remedy impairments in junior CLO tranches, the resulting downgrades of those tranches may force some CLO investors, including leveraged funds, to sell their CLO holdings. Such sales have the potential to put pressure on the prices of junior CLO tranches.

Liquidity risks at life insurers are at post-2008 highs and have been increasing

Over the past decade, life insurers have widened the gap between the liquidity of their assets and the liquidity of their liabilities, potentially making it harder for them to meet sudden claims. Life insurers have been increasing the share of illiquid, risky assets on their balance sheets. These assets—including CRE loans, less liquid corporate debt, and alternative investments—edged up to 35 percent of general account assets, the same level as just before the 2007–09 financial crisis (figure 4-8). Meanwhile, the share of liquid liabilities remains above its level during the financial crisis, in part because of increasing nontraditional liabilities (figure 4-9).

 

References

 

 15. The large increase in uninsured deposits shown in table 4 is mostly excluded from this definition of short-term wholesale funding. Return to text