4. Funding Risk
Vulnerabilities from liquidity and maturity mismatches remain low at large banks, but structural vulnerabilities persist at some types of money market funds as well as bond and bank loan mutual funds
In 2020, the total amount of liabilities that are potentially vulnerable to runs, including those of nonbanks, is estimated to have increased 13.6 percent to $17.7 trillion, as shown in table 4; that amount was equivalent to about 85 percent of GDP (figure 4-1). Much of this net increase reflected growth in uninsured deposits and government MMF assets under management. This growth more than offset declines in the second half of the year in the size of prime and tax-exempt MMFs, which are particularly vulnerable to runs. Meanwhile, bond mutual funds continued to grow, on net, in 2020.
As noted in previous Financial Stability Reports, rapid redemptions from MMFs and fixed-income mutual funds contributed to market turmoil at the start of the pandemic, and Federal Reserve actions in the form of emergency lending facilities and regulatory relief provided support to prime and tax-exempt MMFs. Although flows and activities in associated markets have since returned to typical levels, structural vulnerabilities remain at NBFIs such as some types of MMFs as well as bond and bank loan mutual funds. Regulatory agencies are exploring options for reforms that will address these vulnerabilities.
Table 4. Size of Selected Instruments and Institutions
(billions of dollars)
|Average annual growth,
|Total runnable money-like liabilities*||17,716||13.6||4.7|
|Domestic money market funds**||4,333||19.3||5.1|
|Securities lending ***||637||10.1||5.8|
|Bond mutual funds||4,938||11.6||9.0|
Note: The data extend through 2020:Q4. Growth rates are measured from Q4 of the year immediately preceding the period through Q4 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, federal funds, funding-agreement-backed securities, private liquidity funds, offshore money market funds, short-term investment funds, and local government investment pools.
* Average annual growth is from 2003:Q4 to 2020:Q4.
** Average annual growth is from 2001:Q4 to 2020:Q4.
*** Average annual growth is from 2000:Q4 to 2020:Q4.
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 (FRB) staff calculations based on Investment Company Institute data; FRB, Statistical Release H.6, "Money Stock and Debt Measures" (M3 monetary aggregate); FRB, 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.
Domestic banks continue to have high levels of liquid assets and stable funding
Domestic banks maintain large amounts of high-quality liquid assets. They rely only modestly on short-term wholesale funding, in part because of liquidity regulations and supervisory programs introduced after the 2007–09 financial crisis as well as banks' improved understanding and management of their liquidity risks.23
Most recently, liquidity ratios were well above regulatory requirements at most large domestic banks. Liquid assets surged through the fourth quarter of 2020, reflecting an increase in central bank reserve balances (figure 4-2). In addition, domestic banks' reliance on short-term wholesale funding fell sharply last year (figure 4-3). Instead, domestic banks received large deposit inflows throughout the pandemic, in part as a result of fiscal stimulus, precautionary savings, and the reallocation of portfolios toward safe assets by households and businesses.24
To a larger extent than domestic banks, FBOs have an active role in global U.S. dollar funding markets and rely on short-term wholesale funding (see the box "Vulnerabilities in Global U.S. Dollar Funding Markets").
Structural vulnerabilities remain at prime and tax-exempt money market funds
Assets under management at prime and tax-exempt MMFs have declined since the middle of last year, but vulnerabilities at these funds remain and call for structural fixes. In particular, assets under management at prime MMFs declined over the second half of last year, when some large prime funds closed or converted to government funds, and they have continued to decline modestly since then (figure 4-4). However, vulnerabilities associated with liquidity transformation at these funds remain prominent. A fund engages in liquidity transformation by offering daily redemptions to investors even when the fund's underlying assets may be difficult to sell quickly. The President's Working Group on Financial Markets released a report in December 2020 outlining potential reforms to address risks from the MMF sector.25 Subsequently, the SEC issued a request for comment on these potential reforms.26 If properly calibrated, some of these reforms—such as swing pricing, a minimum balance at risk, and capital buffers—could significantly reduce the run risk associated with MMFs. Meanwhile, the Money Market Mutual Fund Liquidity Facility and the Commercial Paper Funding Facility, which were deployed during the COVID-19 pandemic to backstop short-term funding markets, expired at the end of March with no material effect on these markets.
Other cash-management vehicles, such as dollar-denominated offshore funds and short-term investment funds, also invest in money market instruments and are vulnerable to runs, and some of these vehicles experienced heavy redemptions in March 2020. Currently, between $400 billion and $1 trillion of these vehicles' assets are in portfolios similar to those of U.S. prime funds, and a new wave of redemptions could destabilize short-term funding markets. The Financial Stability Board's (FSB) Holistic Review of the March Market Turmoilhighlighted vulnerabilities from NBFIs, including from these cash management vehicles. The FSB, coordinating with other international organizations, will continue work that addresses risk factors that amplified stress and furthers an understanding of systemic risks in NBFIs and policies that could address these risks.
Bond and bank loan mutual funds benefited from net inflows but are exposed to risks due to large holdings of illiquid assets
Mutual funds that invest substantially in corporate bonds and bank loans may be particularly exposed to liquidity transformation risks, given the option of daily redemptions and the relative illiquidity of their assets.27 U.S. corporate bonds held by mutual funds increased substantially to $1.8 trillion in the fourth quarter of 2020, well above pre-pandemic levels and about one-sixth of outstanding U.S. corporate bonds (figure 4-5). High-yield bond funds and bank loan mutual funds primarily hold riskier and less liquid corporate debt. By February 2021, total assets under management at these funds rose above pre-pandemic levels (figure 4-6).
The record outflows in March 2020 from mutual funds, including taxable and municipal bond funds, highlighted the structural vulnerabilities in the sector, because some were forced to sell assets even when the corresponding markets were illiquid. Since then, mutual funds have benefited from sizable overall inflows amid improved investor sentiment and several emergency credit facilities that provided a backstop for market liquidity (figure 4-7). These facilities—which included the Primary Market Corporate Credit Facility, the Secondary Market Corporate Credit Facility, and the Municipal Liquidity Facility—expired at the end of 2020 with no notable effect on mutual fund flows.
Central counterparties are less vulnerable to a spike in market volatility
Since the November Financial Stability Report, central counterparty (CCP) collateral requirements have remained high relative to expected market volatility. In addition, CCP cash balances at the Federal Reserve have increased as a share of total resources.28 As a result, CCP vulnerability to a spike in market volatility is lower than it was on the eve of the pandemic. Elevated collateral requirements also mitigate the potential pro-cyclicality of margin calls on trading firms should volatility increase. Nevertheless, in late January, concentrated trading of some meme stocks led to substantial margin increases on equity trades and equity option positions, which challenged some brokers in those markets.
Liquidity risks at life insurers are at post-2008 highs and have been increasing
Over the past decade, the gap has widened between the liquidity of life insurers' assets and the liquidity of their liabilities, potentially making it harder for them to meet a sudden rise in withdrawals and other 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).29 Meanwhile, after dipping during the financial crisis, the share of more easily redeemable liabilities remains above its pre-crisis level, in part due to increasing nontraditional liabilities (figure 4-9).
LIBOR Transition Update
The transition away from LIBOR passed several notable milestones recently. Most important, on March 5, 2021, the LIBOR administrator and regulator provided clarity on the end dates of the publication of LIBORs as representative, panel-based rates. Separately, in January 2021, the International Swaps and Derivatives Association (ISDA) IBOR Fallbacks Protocol took effect, inserting robust fallback language in derivatives contracts referencing LIBOR for parties that adhere to the protocol. In addition, New York State recently enacted legislation proposed by the Alternative Reference Rates Committee (ARRC) that minimizes legal uncertainty and adverse economic effects associated with LIBOR-based contracts that do not have effective fallback language, an important step because of the large number of securities issued under New York State law. With the legislation, these contracts will move to the ARRC's recommended alternative, the Secured Overnight Financing Rate (SOFR), and recommended spread adjustments. Collectively, these actions have solidified the framework for the transition away from LIBOR. Growth in market use of LIBOR alternatives, however, continues to be uneven.
On November 30, 2020, the LIBOR administrator, ICE Benchmark Administration (IBA), announced a market consultation on its proposal to cease publication of the most widely used U.S. dollar (USD) LIBOR tenors immediately after June 30, 2023.1 Following this announcement, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation jointly provided guidance encouraging banks to stop new use of USD LIBOR as soon as practicable and, in any event, by the end of 2021. On March 5, 2021, IBA published its conclusion from its market consultation and, with the U.K. Financial Conduct Authority, confirmed the end dates proposed in November. On March 9, 2021, the Federal Reserve Board reinforced its position with guidance that instructs bank examiners to review supervised firms' planning for, and progress in, moving away from LIBOR during examinations and other supervisory activities in 2021.
The announcements provided clarity on the timing of LIBOR cessation. While supervisory guidance encourages new use of USD LIBOR to wind down this year, the extension of key USD LIBOR tenors through June 2023 will allow a significant portion of legacy contracts to mature naturally.
By the time ISDA's IBOR Fallbacks Protocol took effect on January 25, 2021, almost all major derivatives market participants had adhered to the new protocol, helping to ensure a successful rollout, and adherence has continued to grow since the effective date. ISDA confirmed that the March 5 announcement fixed the spreads to be used in the Fallbacks Protocol. The announcement likewise had the effect of fixing the spreads for LIBOR-based contracts with fallback language recommended by the ARRC.2 However, there is no comparable protocol mechanism for cash products, and, in many cases, there are no effective ways to update fallback language in legacy contracts.
The regulatory clarity provided by the March 5, 2021, announcement still leaves many market participants, including retail borrowers, exposed to contractual uncertainty when USD LIBOR ceases in mid-2023. To promote a smooth transition, New York State recently enacted legislation clarifying that, by operation of law, a SOFR-based rate will replace LIBOR in legacy LIBOR contracts that are ambiguous or silent regarding fallback rates. Most U.S. securities are governed by New York law, so the New York State legislation will reduce transition risks related to inadequate contractual language. Legislation has also been proposed at the federal level to address contracts without a workable fallback that, if enacted, would reduce transition risks on a nationwide basis.
The recently enacted New York State legislation is primarily aimed at securities, which are difficult to amend due to the complexities in reaching agreement among the holders of these instruments, but it also includes a safe harbor that would encourage the use of ARRC fallbacks for consumer products (where the lender tends to have discretion to name a successor rate). Table A illustrates the challenges in replacing LIBOR in legacy contracts that, in many cases, envision a polling process similar to that used to create LIBOR. It is unlikely, however, that the current LIBOR banks would choose to respond to private polling after stepping away from the LIBOR panels.
Table A. Legacy Contract Provisions in the absence of LIBOR
|Financial instruments||Typical existing fallbacks||Typical consent requirements to change fallbacks|
|OTC uncleared derivatives||Bank poll||Consent of counterparties|
|Cleared derivatives||CCP designated successor rate (key CCPs have indicated that they will match ISDA)||None|
|Floating-Rate Notes||Bank poll. If n.a., then fixed rate at last quoted LIBOR||Unanimous consent among bondholders|
|Securitizations||• Bank poll. If n.a., then fixed rate at last quoted LIBOR
• Agency MBS allow issuer selection or fallback to last quoted LIBOR
|Business loans||• Bank poll. If n.a., then alternative base rate (prime rate or fed funds rate plus spread, 300+ basis points above LIBOR)
• Some bilateral loans have no fallback
• Recent syndicated loans allow agent to select a replacement
|• Syndicated loans: unanimous consent of lenders
• Bilateral loans: agreement between borrower and lender
|Mortgages/consumer loans||Lender selection||Chosen by lender|
|Other payments||Other contractual payments (for example, purchase agreements, sales contracts) typically have no fallback provisions||Consent of counterparties|
Note: OTC is over-the counter. CCP is central counterparty. ISDA is International Swaps and Derivatives Association. MBS is mortgage-backed security. n.a. is not available.
Source: Alternative Reference Rate Committee.
The unanimous consent required to change multiparty contracts is an especially high hurdle for Floating Rate Notes (FRNs) and securitizations. While legislation provides contractual clarity, it does not eliminate the need for operational changes in interest rates for payments after June 30, 2023.
Issuance and trading activity
The move to SOFR margining and discounting by major clearinghouses in October 2020 led to a sustained increase in SOFR swaps trading, with growth particularly strong for longer-dated swaps (figure A). In the futures markets, the return to the zero lower bound has damped trading in all short-end derivatives, but SOFR-referencing contracts have maintained their market share (figure B).
Open interest in SOFR derivatives stands at $6 trillion, which signals good market development but is still modest relative to the open interest in derivatives referencing LIBOR or the effective fed funds rate (figure C). While the increased SOFR derivatives activity at longer maturities is a positive sign, limited growth in short-dated SOFR derivatives, and the continued use of LIBOR derivatives, led the ARRC to note that it may not be able to recommend a forward-looking term SOFR rate by midyear. The ARRC also noted that it had envisioned a limited application of SOFR term rates and encouraged market participants to make use of the existing forms of SOFR.
The use of SOFR in cash markets has grown appreciably in certain products, but progress has been slow in other areas. SOFR FRN issuance is now greater than that for LIBOR as a result of GSE and bank issuance. The first nonfinancial corporate SOFR FRN issuance took place in February 2021. Consumer loans have also begun to actively transition from LIBOR: Fannie Mae and Freddie Mac began accepting SOFR adjustable-rate mortgages (ARMs) in 2020 and stopped accepting new LIBOR ARMs at the start of this year.
The business loan market, however, continues to predominantly reference LIBOR. A recently published progress report from the ARRC included responses to a survey of nonfinancial corporate borrowers indicating that most banks are not yet offering LIBOR alternatives or communicating about the alternatives that they will offer. Given the size of the business loan market and the need for borrower preparedness, the reported lack of communication is a concern.
The ARRC has pointed to securitizations as another area where the transition from LIBOR has been slow. Although Freddie Mac has issued several successful SOFR securitizations, most new securitizations continue to reference LIBOR.
1. The announced consultation followed a mid-November proposal to cease publication of sterling, yen, Swiss franc, and euro LIBORs at the end of 2021. Return to text
2. ISDA's spread adjustments are based on the historical five-year median difference between each specific LIBOR currency and tenor and the associated fallback rate, which, in the case of USD LIBOR, will be a compound average of SOFR. The ARRC has stated that its recommended spread adjustments for cash products will match those of ISDA, although certain technical adjustments will be made to the ARRC's recommendations for consumer products to ensure that consumers do not see a jump in rates at the time of the USD LIBOR cessation. Return to text
Vulnerabilities in Global U.S. Dollar Funding Markets
The U.S. dollar is the leading global funding and investment currency, is used widely for trade and other international transactions, and currently accounts for almost half (more than $22 trillion) of outstanding cross‐border bank credit and international debt securities. The wide use of the dollar generates significant benefits to both U.S. and foreign residents: It expands the sources of funding to businesses and households; deepens the market for dollar‐denominated securities, including U.S. government debt; and can reduce transaction costs for international trade in goods and services. The international role of the dollar has significant benefits, but it also provides a conduit through which stresses can be transmitted across borders. Although there are other sources of vulnerabilities in global dollar funding markets, this discussion focuses on the role of FBOs (foreign banks that have U.S. offices) in these markets, the way FBOs may transmit stress in these markets to the United States, and the role of central bank liquidity swap line arrangements in alleviating those stresses.1
Foreign banking organizations are key participants in lending and borrowing in dollars in the United States and abroad
Global economic activity depends on credit and payments flowing smoothly and efficiently, and the central role of the dollar in international finance means that well‐functioning dollar funding in the United States and abroad plays a critical role. FBOs serve as important conduits of dollar funding to and from U.S. and foreign businesses, governments, households, and NBFIs. Foreign banks, primarily FBOs, supply $15 trillion of dollar‐denominated credit (equivalent to more than 17 percent of world GDP), which is about half of the total global dollar credit outstanding of banks.2 FBOs are the principal dollar lenders to non‐U.S. residents and also supply more than one‐third of dollar bank credit outstanding to U.S. residents (figure A). For example, the U.S. offices of FBOs supply almost one‐fourth of total C&I lending by commercial banks and U.S. branches of FBOs in the United States. FBOs are also large borrowers in U.S. short‐term dollar funding markets, accounting for the majority of outstanding repurchase agreement (repo) borrowing, commercial paper, and negotiable certificates of deposit in U.S. markets (figure B).3
Foreign banking organizations can transmit funding stresses to the United States
FBOs, in general, rely less on insured U.S. retail deposits and thus depend more on wholesale funding markets to finance their dollar assets than do U.S. banks. Moreover, a large and growing fraction of the dollar liabilities of FBOs are supplied by non‐U.S. residents (figure C).4 While the adoption of liquidity requirements has improved the resilience of the intermediate holding companies (IHCs) of foreign banks, these requirements do not currently apply in full to their U.S. branches, although these branches are subject to the consolidated liquidity requirements established by their home country regulators.5 If dollar funding markets seize up, FBOs can be disproportionately affected. In cases when FBOs cannot roll over dollar funding, they may abruptly reduce lending to U.S. households and businesses or liquidate holdings of U.S. assets, thereby transmitting stresses to the U.S. economy.
Swap lines relieved stresses in dollar funding markets in March 2020
The COVID‐19 shock hit U.S. and global dollar funding markets simultaneously. Specifically, stresses in U.S. money markets reduced access to U.S. short‐term wholesale financing for FBOs, while the cost of offshore dollar funding spiked. At the same time, the dollar funding needs of FBOs jumped as U.S. customers drew on credit lines, and the demand for hedging U.S. dollar exposures increased.
The enhancement and expansion of the Federal Reserve's dollar liquidity swap line arrangements with foreign central banks relieved stresses for FBOs.6 These arrangements with foreign central banks helped restore stability in dollar funding markets and limit additional spillovers to other financial markets in the United States and abroad. Additionally, the Federal Reserve introduced the temporary FIMA (Foreign and International Monetary Authorities) Repo Facility, which allows foreign and international monetary authorities to temporarily exchange their Treasury securities with the Federal Reserve for U.S. dollars (a repurchase agreement), thus giving these authorities access to dollar liquidity when needed. This facility provides a reliable source of dollar liquidity to a broad range of countries, many of which do not have swap line arrangements with the Federal Reserve. Although draws on the FIMA Repo Facility have been small, the facility can still provide significant benefits to market functioning by eliminating the need for its users to sell U.S. assets, including Treasury securities, in order to build up precautionary dollar liquidity.
Swap line usage supported credit to U.S. businesses and confidence in dollar markets
During the spring 2020 COVID‐19 shock, FBOs borrowed dollars in foreign central banks' dollar auctions, which were funded by those central banks' liquidity swap lines with the Federal Reserve. Use of the dollar auctions helped FBOs fulfill their credit commitments to U.S. businesses and boost their liquid asset buffers without having to sell dollar assets or further strain offshore dollar funding markets. FBOs headquartered in the euro area and Japan accounted for the majority of swap‐line‐funded dollars auctioned in spring 2020 (figure D). These foreign banks lent their U.S. offices a large amount of the funds obtained in the auctions.7
In figure E, this lending is reflected in the increased net borrowing from abroad by U.S. offices of European and Asian FBOs in March 2020 (the blue bars), which amounts to more than three‐fourths of the dollars auctioned that month (the tan bars). In part, U.S. branches of FBOs used these dollars to increase their reserve balances at the Federal Reserve (reserve balances are a primary component of "cash," the red bars). Amid the volatile environment of COVID‐19, these reserves gave market participants confidence that FBOs would be able to manage further shocks to dollar funding or credit demand without adverse effects. Dollars obtained from the auctions also supported increased lending by U.S. branches of FBOs to U.S. businesses (the pink bars) as U.S. customers drew their credit lines.8
1. Foreign banks are entities organized under the laws of a foreign country that engage directly in the business of banking outside the United States. FBOs include foreign banks that control a bank or operate a branch or agency in the United States. A regulatory definition of an FBO is available on the Electronic Code of Federal Regulations website at https://www.ecfr.gov/cgi‐bin/text‐idx?SID=d37ef2568e628d9d079d528521151085&mc=true&node=se12.2.211_121&rgn=div8. Return to text
2. This fraction measures the global dollar credit (assets) of FBOs ($15 trillion) as a proportion of the global dollar credit of all banks, which, in contrast to the cross‐border credit mentioned in the preceding paragraph, includes the dollar credit from U.S. banks to U.S. residents and excludes credit from nonbanks (such as nonbank investors' holdings of securities). Return to text
3. Figure B refers to foreign borrowers, but these are primarily FBOs. Return to text
4. Figure C refers to all foreign banks, but FBOs account for the bulk of foreign bank liabilities. Return to text
5. Large FBOs with $50 billion or more in U.S. non-branch assets are required under the rules implementing the Dodd-Frank Act's enhanced prudential standards to place virtually all of their U.S. subsidiaries under a top-tier U.S. IHC. Branches of FBOs are not required to be part of the IHC. Return to text
6. The Federal Reserve's swap lines are with foreign central banks, which then provide dollars to FBOs in their jurisdictions via their dollar operations. Return to text
7. Technically, dollars obtained through auctions funded by swap lines are credited either to a correspondent bank in the United States that hosts an account for the foreign bank or, more commonly, to the U.S. branch of the borrowing FBO. In the latter case, the funds are immediately recorded as lending from the foreign parent bank to the U.S. branch. Nonetheless, the relationship shown in figure E, where the amounts of swap drawings are similar to the amounts of increased borrowing from abroad and assets held by U.S. offices of FBOs for March 2020, is not mechanical or inevitable. Rather than funds being remitted from the FBO's branch to the parent bank, these funds remained on the balance sheets of U.S. branches days and weeks after being credited and were used largely to fund U.S. lending and reserve balances at the Federal Reserve. Return to text
8. The pink bars in figure E represent the change in all loans by U.S. branches of FBOs, but a large majority of the change is in C&I loans to U.S. addressees. Return to text
23. The large increase in uninsured deposits shown in table 4 is mostly excluded from this definition of short-term wholesale funding. Return to text
24. Much of the increase in bank deposits was driven by insured retail deposits and operational corporate deposits, which are relatively stable sources of funding. For other deposit types, the outflow risk is largely offset by the increase in banks' high-quality liquid assets, which stand at historically high levels. Return to text
25. See U.S. Department of the Treasury (2020), "President's Working Group on Financial Markets Releases Report on Money Market Funds," press release, December 22, https://home.treasury.gov/news/press-releases/sm1219. Return to text
26. See U.S. Securities and Exchange Commission (2021), "SEC Requests Comment on Potential Money Market Fund Reform Options Highlighted in President's Working Group Report," press release, February4, https://www.sec.gov/news/press-release/2021-25. Return to text
27. See Kenechukwu Anadu and Fang Cai (2019), "Liquidity Transformation Risks in U.S. Bank Loan and High-Yield Mutual Funds," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, August9), https://www.federalreserve.gov/econres/notes/feds-notes/liquidity-transformation-risks-in-US-bank-loan-and-high-yield-mutual-funds-20190809.htm. Return to text
28. CCPs' financial resources include cash and collateral with low credit, liquidity, and market risks. Clearing members post these assets to the CCP to satisfy initial margin and default fund requirements. These resources are available to the CCPs to cover losses in the event that a clearing member defaults. Return to text
29. Life insurers' assets and liabilities are divided between the general account and separate accounts. In the separate accounts, each policyholder selects a portfolio of assets from a menu offered by the insurer, and the performance of that portfolio is reflected in the value of the insurer's liability to that policyholder. The assets in the general account are pooled and selected by the insurer to meet future payment obligations to all general account policy and other liability holders, with any remainder becoming profit for the insurance company. Return to text