Board of Governors of the Federal Reserve System

4. Funding Risks

The banking industry maintained a high level of liquidity overall, but some banks continued to face funding pressures; meanwhile, structural vulnerabilities persisted in other sectors engaged in liquidity transformation

The banking industry overall maintained a high level of liquidity since the May report. Funding risks for most banks remained low, and large banks that are subject to the liquidity coverage ratio (LCR) continued to maintain ample levels of HQLA given the risk of their funding structures. That said, banks that came under stress and experienced large deposit outflows in March continued to face funding pressure. Since March, volatility has abated and deposit outflows have largely stabilized—owing, in part, to actions by the Department of the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation—but these banks nonetheless continued to face challenges navigating changes in depositor behavior, higher funding costs, and reduced market values for investment securities.

Prime MMFs and other cash-investment vehicles remained vulnerable to runs and, hence, contributed to the fragility of short-term funding markets. In addition, some cash-management vehicles, including retail prime MMFs, government MMFs, and short-term investment funds, maintained stable net asset values (NAVs) that make them susceptible to sharp increases in interest rates. The market capitalization of the stablecoin sector continued to decline, but the sector remained vulnerable to liquidity risks like those present in other vehicles that attempt to substitute for cash. Some open-end bond mutual funds continued to be susceptible to large redemptions because they must allow shareholders to redeem every day even though the funds hold assets that can face losses and become illiquid amid stress. Life insurers continued to face liquidity risk owing to heavy reliance on nontraditional liabilities in combination with an increasing share of illiquid and risky assets on their balance sheets.

Overall, estimated runnable money-like financial liabilities increased 3.4 percent to $20.3 trillion (75 percent of nominal GDP) over the past year. As a share of GDP, runnable liabilities continued their post-pandemic decline but remained above their historical median (table 4.1 and figure 4.1).

Table 4.1. Size of selected instruments and institutions

Most banks maintained high levels of liquid assets and stable funding

Aggregate liquidity in the banking system appeared ample even as HQLA measured relative to total assets decreased among most banks over the past year (figure 4.2). These declines in HQLA were driven by reductions in holdings of central bank reserve balances and by declines in the market values of securities as interest rates increased. Aggregate central bank reserve balances held by banks remained above $3 trillion, significantly higher than pre-pandemic levels. And despite the recent declines, U.S. G-SIBs continued to hold more HQLA than required by their LCR—the requirement that ensures banks hold sufficient HQLA to fund estimated cash outflows for 30 days during a hypothetical stress event. Moreover, banks' reliance on short-term wholesale funding remained low (figure 4.3).

As interest rates increased throughout 2022, higher-paying alternatives to bank deposits became more attractive to businesses and households and, as a result, core deposits began flowing out of the banking sector. The pace of outflows accelerated temporarily in the wake of the March 2023 stresses in the banking system and, within the banking sector, deposits at some midsize banks were moved to the largest banks. Deposit flows have since stabilized across all bank groups and market sentiment has improved, but many of the vulnerabilities that came to light because of the bank stresses persist for a subset of large banks (outside of the G-SIBs) and regional banks. At the same time, some banks also increased their reliance on wholesale funding sources, which are typically more expensive and less stable than retail deposits. As competition for deposits intensified, financial markets continued to signal concerns over banks with high levels of uninsured deposits, high reliance on wholesale funding, and significant declines in the fair value of securities.

The BTFP was created during the acute phase of the banking stresses and offers loans of up to one year to eligible depository institutions against high-quality securities at par value, thereby eliminating an institution's need to quickly sell those securities should depositors suddenly withdraw their funding. The facility helped reassure depositors that banks can meet their customers' needs and contributed to the stabilization of deposit flows. Since its inception, the amount of credit extended by the BTFP increased steadily and has stabilized at around $110 billion (figure 4.4).

Structural vulnerabilities remained at some money market funds and other cash-management vehicles

In the immediate aftermath of the failures of Silicon Valley Bank and Signature Bank, prime MMFs experienced a jump in redemptions. Although outflows from prime MMFs eased after a few days, the episode illustrated again that these funds remain a prominent vulnerability due to their susceptibility to large redemptions during episodes of financial stress and the significant role they play in short-term funding markets. Since the May report, assets under management (AUM) in prime MMFs offered to the public increased $100 billion, driven mostly by inflows into retail prime funds (figure 4.5).

On July 12, 2023, the SEC voted to adopt amendments to rules that govern MMFs.¹¹ The key elements of the reforms make dynamic liquidity fees mandatory for institutional prime and tax-​exempt funds, eliminate temporary gates and redemption fees linked to liquid asset levels with the intent of removing incentives for investors to run preemptively, and increase a fund's daily liquid asset and weekly liquid asset requirements. On net, the reforms represent significant progress in making prime and tax-exempt MMFs more resilient, although these funds remain vulnerable to runs in periods of significant stress.

Other cash-management vehicles, including dollar-denominated offshore MMFs and short-term investment funds, also invest in money market instruments, engage in liquidity transformation, and are vulnerable to runs. Since the May report, estimated aggregate AUM of these cash-management vehicles remained around $1.8 trillion. Currently, between $0.6 trillion and $1.5 trillion of these vehicles' AUM are in portfolios like those of U.S. prime MMFs, and large redemptions from these vehicles also have the potential to destabilize short-term funding markets.¹²

Many cash-management vehicles—including retail and government MMFs, offshore MMFs, and short-term investment funds—seek to maintain stable NAVs that are typically rounded to $1.00. When short-term interest rates rise sharply or portfolio assets lose value for other reasons, the market values of these funds may fall below their rounded share prices, which can put the funds under strain, particularly if they also have large redemptions.

The market value of many stablecoins declined, and they remain vulnerable to runs

The total market capitalization of stablecoins, which are digital assets designed to maintain a stable value relative to a national currency or another reference asset, fell 21 percent since the beginning of 2022 to $130 billion. While not widely used as a cash-management vehicle by institutional and retail investors or for transactions for real economic activity, stablecoins are important for digital asset investors. They remain structurally vulnerable to runs and lack a comprehensive prudential regulatory framework. Moreover, stablecoins could scale quickly, particularly if the stablecoin is supported by access to an existing customer base.

Bond mutual fund asset holdings stabilized, but they remained exposed to liquidity risks

Mutual funds that invest substantially in corporate bonds, municipal bonds, and bank loans may be particularly exposed to liquidity transformation risks, given the relative illiquidity of their assets and the requirement that these funds offer redemptions daily. The total outstanding value of U.S. corporate bonds held by mutual funds remained flat during the first half of 2023 following consecutive years of sharp declines, primarily reflecting a fall in bond values associated with higher interest rates (figure 4.6). Mutual fund holdings through the second quarter of 2023 were approximately 13 percent of all U.S. corporate bonds outstanding. Total AUM at high-yield bond and bank loan mutual funds, which primarily hold riskier and less liquid assets, continued declining in recent quarters following sharp decreases in real terms during 2022 (figure 4.7). Bond and loan mutual funds experienced negative returns and notable outflows during most of 2022, but outflows have stabilized in the first half of 2023 (figure 4.8).

Central counterparties' initial margin levels and prefunded resources remained high, but liquidity risks remain amid elevated volatility

Interest rate volatility rose to elevated levels late last year and stressed some central counterparties (CCPs) that focus on clearing interest rate products. As volatility in rates and other markets retreated from recent highs, CCPs' margin and prefunded resources fell more slowly.¹³ Taken together, higher initial margins and elevated levels of prefunded resources relative to anticipated volatility likely lowered credit risk at CCPs because the amount of resources readily available in case of default by one or more clearing members is likely to be generally higher relative to the market risk of cleared portfolios. However, CCPs continue to face potentially substantial liquidity needs in the event of a default during highly volatile stressed markets. Further, additional liquidity risk remains around the concentration of clients at the largest clearing members, which could make transferring client positions to other clearing members challenging if it were ever necessary.

Life insurers' reliance on nontraditional liabilities remained high

Over the past decade, the liquidity of life insurers' assets steadily declined, and the liquidity of their liabilities slowly increased, potentially making it more difficult for life insurers to meet a sudden rise in withdrawals and other claims. As of 2022, the share of illiquid assets held on life insurers' balance sheets—including CRE loans, less liquid corporate debt, and alternative investments—stood at a historic high (figure 4.9). In addition, they have continued to rely on nontraditional liabilities—including funding-agreement-backed securities, Federal Home Loan Bank advances, and cash received through repurchase agreements and securities lending transactions—which offer some investors the opportunity to withdraw funds on short notice (figure 4.10).

 

References

 

11. See Securities and Exchange Commission (2023), "SEC Adopts Money Market Fund Reforms and Amendments to Form PF Reporting Requirements for Large Liquidity Fund Advisers," press release, July 12, https://www.sec.gov/news/press-release/2023-129. Return to text

12. Cash-management vehicles included in this total are dollar-denominated offshore MMFs, short-term investment funds, private liquidity funds, ultrashort bond mutual funds, and local government investment pools. Return to text

13. Prefunded resources represent financial assets, including cash and securities, transferred by the clearing members to the CCP to cover that CCP's potential credit exposure in case of default by one or more clearing members. These prefunded resources are held as initial margin and prefunded mutualized resources, which builds the resilience of CCPs to the possible default of a clearing member or market participant. Return to text