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
(billions of dollars)
|Average annual growth,
|Total runnable money-like liabilities*||17,349||17.1||4.8|
|Domestic money market funds**||4,635||44.8||6.3|
|Bond mutual funds||4,445||7.0||9.0|
Note: The data extend through 2020:Q2. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period. Total runnable money-like liabilities exceeds the sum of listed components. Items not included in the table are variable-rate demand obligations (VRDOs), federal funds, funding-agreement-backed securities, private liquidity funds, offshore money market funds, and local government investment pools.
* Average annual growth is from 2003:Q2 to 2020:Q2.
** Average annual growth is from 2001:Q2 to 2020:Q2.
*** Average annual growth is from 2000:Q2 to 2020:Q2.
Source: Securities and Exchange Commission, Private Funds Statistics; iMoneyNet, Inc., Offshore Money Fund Analyzer; Bloomberg Finance L.P.; Securities Industry and Financial Markets Association: U.S. Municipal Variable-Rate Demand Obligation Update; Risk Management Association, Securities Lending Report; DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation: commercial paper data; Federal Reserve Board staff calculations based on Investment Company Institute data; Federal Reserve Board, Statistical Release H.6, "Money Stock and Debt Measures" (M3 monetary aggregate); Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States"; Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income (Call Report); Morningstar, Inc., Morningstar Direct; Moody's Analytics, Inc., CreditView, Asset-Backed Commercial Paper Program Index.
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).
LIBOR Transition Update
Recognizing the potential instability in LIBOR (London interbank offered rate) and other similar interbank offered rates (IBORs), the Group of Twenty asked the Financial Stability Board's (FSB) Official Sector Steering Group in 2012 to identify more robust potential alternative rates, while seeking to strengthen the existing IBORs to the extent possible. Although LIBOR has undergone substantial reforms since that time, most panel banks are forced to base their submissions on expert judgment because their reliance on the type of wholesale unsecured funding that LIBOR is meant to represent has declined significantly. In 2017, after some banks had started leaving IBOR panels, the LIBOR regulator, the U.K. Financial Conduct Authority (FCA), brokered a voluntary agreement with the remaining panel banks to continue their participation through the end of 2021. The FCA has warned that market participants should prepare for the possibility that LIBOR will end at that time or thereafter. The FSB has stated that the LIBOR transition remains a priority even during the COVID-19 crisis.
The pace of preparation for the cessation of LIBOR publication has picked up in recent months. Changes to infrastructure are now in place or expected to be ready soon. Although disruptions from COVID-19 caused many firms to slow some transition activities temporarily, a recent survey of financial institutions by Moody's indicates that most surveyed firms believe they are on track in their preparations for LIBOR cessation.1 However, LIBOR use remains predominant despite continued warnings from the official sector that participants should prepare for the risk that it will cease to be published after the end of 2021, and critical work is still needed to ensure that LIBOR cessation does not cause significant financial market disruptions.
The Alternative Reference Rates Committee (ARRC) released Best Practices for Completing the Transition from LIBOR in May.2 The document provides guiding steps and timelines for a smooth transition from LIBOR for floating-rate notes, business loans, consumer loans, securitizations, and derivatives, including recommendations that no new LIBOR floating-rate debt be issued after 2020 and no new LIBOR loans be issued after June 2021. While LIBOR-submitting banks have made a commitment to providing rates through the end of 2021, many of the steps necessary for a smooth transition need to occur much sooner.
Two important milestones in the derivatives market have been reached recently. First, on October 16, 2020, the two main interest rate derivatives clearinghouses (CME and LCH) switched from discounting cleared U.S. dollar swaps using the federal funds rate to using the Secured Overnight Financing Rate (SOFR). The switch has been associated with increased SOFR-based trading activity as market participants seek to hedge discounting exposures. Second, the International Swaps and Derivatives Association (ISDA) supplemented its protocol for derivatives contracts to facilitate the use of risk-free reference rates upon the cessation or nonrepresentativeness of LIBOR. The ISDA protocol has been promoted as the most efficient way for derivatives market participants to mitigate the risks associated with LIBOR discontinuation. These two events will solidify the transition away from LIBOR for derivatives.
Efforts by the U.S. official sector have removed potential impediments to the transition away from LIBOR. Swap margin rules have been amended to permit swaps entered into before an applicable compliance date to retain their legacy status if they are modified to replace LIBOR. Similarly, the Financial Accounting Standards Board provided optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships that reference LIBOR, and the U.S. Department of the Treasury is nearing similar measures in its final rules for tax relief. Consumer-oriented agencies such as the Consumer Financial Protection Bureau (CFPB) and the U.S. Department of Housing and Urban Development have proposed regulatory amendments to facilitate the transition. The CFPB has also updated its consumer handbook for adjustable-rate mortgages (ARMs) to provide guidance to consumers about reference rates.
Issuance and trading activity
Issuance and trading of SOFR-referencing instruments have grown but remain clearly lower than activity referencing LIBOR, although GSEs have been successfully moving to issuance of SOFR-based products. Issuance in the floating-rate note market, in which GSEs have a large presence, was mostly SOFR based in the first half of 2020 (figure A). Fannie Mae and Freddie Mac are accepting SOFR-referenced ARMs and have announced that they will no longer accept LIBOR-referenced ARMs after 2020; Ginnie Mae has announced similar restrictions that will be enacted in early 2021. Loan issuance remains mostly LIBOR based, although inclusion of fallback language is growing.
The trading volume of SOFR derivatives reached a high point in March 2020, as interest rate volatility led to increased derivatives market activity (figures B and C). Since then, the reduction in policy rates and the high degree of certainty that interest rates will stay near zero have contributed to less trading of all types of short-term interest rate derivatives, including SOFR derivatives. Derivatives trading in SOFR-based products increased in October with the switch to SOFR discounting. Market participants appear to be prepared for this switch: Awareness is high, trading systems have been updated, and SOFR trading volumes as a share of total volumes have been growing in the swaps and futures markets, albeit slowly.
The ARRC has had recommended fallback language for new LIBOR issuances in the most commonly used products in place for some time. Use of the ARRC recommendations, or similar language, has been prevalent in floating-rate debt issuance for more than a year and in most syndicated loans. For contracts that either do not address a permanent end to LIBOR or have ambiguous fallback language, interest payment uncertainty could lead to complex problems for parties or courts to sort out and create uncertainty in financial markets. Many financial products and agreements that reference LIBOR are governed by New York law. As a result, the ARRC has proposed New York State legislation that would substitute the recommended benchmark replacement in legacy contracts where the contract language is silent or the fallback provisions prescribe LIBOR use.
1. See Moody's Investors Service (2020), IBOR Phaseout 15 Months Away, but Hurdles Could Stretch beyond Finish Line, sector in-depth report (New York: Moody's, September 22). Return to text
2. See Alternative Reference Rates Committee (2020), "ARRC Announces Best Practices for Completing Transition from LIBOR—Provides Date-Based Guidance, Including When No New LIBOR Activity Should Be Conducted," press release, May 27, https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Press_Release_Best_Practices.pdf. Return to text
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