SSG Report 2009

Senior Supervisors Group
Risk Management Lessons from

the Global Banking Crisis of 2008
October 21, 2009
RISK MANAGEMENT LESSONS FROM THE GLOBAL BANKING CRISIS OF 2008
CANADA
Office of the Superintendent
SENIOR SUPERVISORS GROUP
of Financial Institutions
FRANCE
Banking Commission October 21, 2009
Mr. Mario Draghi, Chairman
Financial Stability Board
GERMANY Bank for International Settlements
Federal Financial Centralbahnplatz 2
Supervisory Authority CH-4002 Basel
Switzerland
JAPAN
Financial Services Agency Dear Mr. Draghi:
On behalf of the Senior Supervisors Group (SSG), I am writing to convey Risk
SWITZERLAND Management Lessons from the Global Banking Crisis of 2008, a report that reviews in depth
Financial Market the funding and liquidity issues central to the recent crisis and explores critical areas of
Supervisory Authority risk management practice warranting improvement across the financial services industry.
This report is a companion and successor to our first report, Observations on Risk
Management Practices during the Recent Market Turbulence, issued in March 2008.
UNITED KINGDOM
Financial Services Authority The events of 2008 clearly exposed the vulnerabilities of financial firms whose business
models depended too heavily on uninterrupted access to secured financing markets, often
at excessively high leverage levels. This dependence reflected an unrealistic assessment of
UNITED STATES liquidity risks of concentrated positions and an inability to anticipate a dramatic reduction
Board of Governors in the availability of secured funding to support these assets under stressed conditions.
of the Federal Reserve System A major failure that contributed to the development of these business models was weakness
in funds transfer pricing practices for assets that were illiquid or significantly concentrated
Federal Reserve Bank when the firm took on the exposure. Some improvements have been made, but instituting
of New York further necessary improvements in liquidity risk management must remain a key priority
Office of the Comptroller for financial services firms.
of the Currency In the attached report, we identify various other deficiencies in the governance, firm
management, risk management, and internal control programs that contributed to, or were
Securities and Exchange
Commission revealed by, the financial and banking crisis of 2008. Our report highlights a number of
areas of weakness that require further work by the firms to address, including the following
(in addition to the liquidity risk management issues described above):
the failure of some boards of directors and senior managers to establish, measure,
and adhere to a level of risk acceptable to the firm;
compensation programs that conflicted with the control objectives of the firm;
inadequate and often fragmented technological infrastructures that hindered
effective risk identification and measurement; and
institutional arrangements that conferred status and influence on risk takers
at the expense of independent risk managers and control personnel.
In highlighting the areas where firms must make further progress, we seek to raise
awareness of the continuing weaknesses in risk management practice across the industry and
to evaluate critically firms efforts to address these weaknesses. Moreover, the observations
in this report support the ongoing efforts of supervisory agencies to define policies that
enhance financial institution resilience and promote global financial stability.
Transmittal letter
This analysis builds upon the first SSG report, which identified a number of risk
management practices that enabled some global financial services organizations to
withstand market stresses better than others through the end of 2007. The extraordinary
market developments that transpired following the release of the first report prompted the
SSG to launch two new initiatives. First, the group conducted interviews with thirteen firms
at the end of 2008 to review specific funding and liquidity risk management challenges
faced, and lessons learned, during the year. Second, in our supervisory capacities, we asked
twenty global financial institutions in our respective jurisdictions to assess during the first
quarter of 2009 their risk management practices against a compilation of recommendations
and observations drawn from several industry and supervisory studies published in 2008.
During the spring of 2009, SSG members reviewed the assessments and held follow-up
interviews with fifteen of these firms to explore areas of continued weakness, as well as
changes to practice undertaken recently. This report presents the SSGs primary findings
from these initiatives.
In their self-assessments, firms generally indicated that they had either fully or partially
complied with most of the recommendations. SSG members, however, found that the
assessments were, in aggregate, too positive and that firms still had substantial work
to do before they could achieve complete alignment with the recommendations and
observations of the studies. In particular, supervisors believe that a full and ongoing
commitment to risk control by management, as well as the dedication of considerable
resources toward developing the necessary information technology infrastructure, will
be required to ensure that the gaps between actual and recommended practice are closed
in a manner that is robust and, especially important, sustainable.
As with the first report, we are simultaneously releasing our findings to relay the
conclusions of our initiatives to the broader industry and to call attention to critical areas
of risk management in which further effort is warranted.
Sincerely,
William L. Rutledge
Chairman
Transmittal letter
CONTENTS
I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
II. SUMMARY OF KEY OBSERVATIONS AND CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . .2
III. FUNDING AND LIQUIDITY RISK MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

A. Background on Major Funding Stresses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1. General Firm and Market Stresses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
a. Secured Funding/Triparty Repo Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
b. Deposit Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
c. Interbank Deposits, Unsecured Funding, and the Foreign Exchange Swap Market . . . . . . . . . . . . . . . . . . 9
2. Prime Brokerage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3. Unwinding of Securities Lending Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
4. 2a-7 Money Market Mutual Funds and Non-2a-7 Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
B. Funding and Liquidity Risk Management Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1. Risk Management Changes Broadly Applicable to General Firm and Market Stresses . . . . . . . . . . . . . . 13
2. Risk Management Changes Associated with Prime Brokerage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3. Risk Management Changes Associated with Securities Lending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4. Risk Management Changes Associated with Money Market Mutual Funds . . . . . . . . . . . . . . . . . . . . . 18
IV. SUPERVISORY EVALUATION OF SELF-ASSESSMENTS AND CRITICAL AREAS

FOR CONTINUED FIRM IMPROVEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
A. Background on Self-Assessment Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
B. Overview of Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1. Practices Assessed by Firms as Most Aligned with Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . 20
2. Practices Assessed by Firms as Least Aligned with Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . 21
C. Areas for Continued Improvement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1. Board Direction and Senior Management Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2. Articulating Risk Appetite . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3. Compensation Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4. Information Technology Infrastructure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
5. Risk Aggregation and Concentration Identification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
6. Stress Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
7. Counterparty Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
8. Valuation Practices and Loss Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
9. Operations and Market Infrastructure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
10. Liquidity Risk Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
APPENDIX A: SELF-ASSESSMENT: FIRMS REPORTED DEGREE OF ALIGNMENT

WITH RECOMMENDATIONS AND OBSERVATIONS OF INDUSTRY
AND SUPERVISORY STUDIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
APPENDIX B: MEMBERS OF THE SENIOR SUPERVISORS GROUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
I. INTRODUCTION
On March 6, 2008, the Senior Supervisors Group (SSG) firms from Canada, France, Germany, Japan, Switzerland,
released its first report, Observations on Risk Management the United Kingdom, and the United Statesundertook
Practices during the Recent Market Turbulence (the first to evaluate for a second time how weaknesses in firms risk
report). The report conveyed our assessment of the risk management and internal controls may have contributed to
management practices that made some firms better able than the industrys severe distress. In this report, we review key
others to withstand market stresses in the fall of 2007. developments since the first report, share our risk manage-
At that time, firms faced the collapse of the leveraged loan ment observations (primarily on funding and liquidity risk
market, a near total loss of liquidity in the asset-backed issues) for 2008, and discuss the industrys own sense of its
commercial paper market, and a sharp loss in the value of compliance with recommendations put forward in various
subprime mortgages and of certain structured products such supervisory and industry studies in 2008.1
as collateralized debt obligations and securities backed by To capture the industry view, members of the SSG met
subprime mortgages. These and other significant difficulties with senior managers at thirteen of the largest financial
undermined the confidence of investors and counterparties, institutions in late 2008 to review the funding and liquidity
challenged the resilience of highly interconnected global risk challenges they faced that year and the lessons they learned
financial institutions, and destabilized the global financial from these challenges.
system, setting the stage for a deep financial crisis. In late 2008, the SSG members, in our supervisory
Following the release of our first report, the decline in capacity, asked twenty major global financial firms in our
housing prices became even more pronounced, triggering a far respective jurisdictions to assess their risk management
greater loss of value in mortgage-related exposures and other processes to identify any gaps with previously issued industry
financial assets and ultimately leading to a weakening of the or supervisory recommendations. The surveyed financial
global economy. Financial losses and public concern grew to institutions completed these self-assessments during the first
the point that investors doubted the accuracy of firms balance quarter of 2009 and presented the results to both their boards
sheets and ultimately their creditworthiness. Around the of directors and their primary supervisors. The primary
globe, large financial firms failed, were forced to negotiate supervisors then evaluated the quality of the assessments and
their sale to others, or restructured themselves. In other cases, held discussions with the firms on their remediation efforts.
public authorities undertook extraordinary and controversial In light of the continuing stress in the financial markets,
measures to alleviate the stress, not just on financial SSG members held a second round of interviews with fifteen
organizations, but more broadly on their national economies. institutions during the first half of 2009 to explore the broader
In response to the continuing crisis, the SSGa forum lessons learned from recent events.
composed of senior supervisors of major financial services
1
Studies referenced in the exercise include Senior Supervisors Group,
Observations on Risk Management Practices during the Recent Market
Turbulence (March 2008); Financial Stability Forum, Report of the Financial
Stability Forum on Enhancing Market and Institutional Resilience (April 2008);
Institute of International Finance, Final Report of the IIF Committee on Market
Best Practices: Principles of Conduct and Best Practice Recommendations
(July 2008); and Credit Risk Management Policy Group III, Containing
Systemic Risk: The Road to Reform (August 2008). In addition, U.S. firms were
asked to consider recommendations and observations in Presidents Working
Group on Financial Markets, Policy Statement on Financial Market
Developments (March 2008).
1
II. SUMMARY OF KEY OBSERVATIONS AND CONCLUSIONS

Many of the weaknesses highlighted in our first report withstand market stresses absent deposits and sovereign and
continued to contribute to financial strains. Despite the central bank support. Borrowers had taken advantage of the
passage of many months since we published our first survey in opportunity the market afforded to obtain short-term (often
March 2008, we found that a large number of firms had not overnight) financing for assets that should more appropriately
fully addressed the issues raised at that time. The fact that they have been funded with long-term, stable funding. Faced with
had not done so is due in part to the considerable investment uncertainty about the value of specific instruments and
and expertise needed to effect necessary changes across globally mindful of the higher volatility of assets more generally,
active, complex financial institutions, and in part to the lenders demanded substantial cushions, or haircuts, on
increased funding and liquidity risk management challenges the assets they were willing to finance.
that arose over 2008 and into 2009. The four firm-wide risk Firms that were least affected by market developments
management practices that we had identified in our first report had the a priori discipline to resist excessive short-term
as differentiating better performance from worse were: funding. Some larger and more diverse financial institutions
effective firm-wide risk identification and analysis, were able to weather events initially by drawing on other
sources of funding, such as deposits, liquidity pools
consistent application of independent and rigorous consisting of sovereign bonds and, when available, central
valuation practices across the firm, bank lending facilities.
effective management of funding liquidity, capital, Some firms business models also relied on excessive
and the balance sheet, and leverage, which, combined with doubts about the
informative and responsive risk measurement realizable value of the firms assets, heightened solvency
and management reporting. and business-model concerns among the firms creditors
and counterparties. Firms permitted excessive leverage and
Implementing these practices comprehensively across large, reliance on short-term financing to develop over time because
complex organizations requires considerable resources and of a combination of risk governance weaknesses and
expertise, and it was evident that many firms still fell short misaligned incentives (as explained below), incomplete risk
in these areas. capture in management reports, limitations or unintended
In addition, events following the release of our first report consequences of regulatory requirements, and ineffective
in the spring of 2008 exposed further weaknesses at the market discipline. These structural issues affected a wide range
largest financial institutions in corporate governance and of financial institutions, including various U.S. investment
control procedures, as well as in liquidity and capital banks, certain U.S. and U.K. mortgage banks, some German
management processes. In particular, the failure of liquidity Landesbanks, and some banks that had recently completed
risk management practices has been at the heart of the acquisitions that strained their capital base with the assets and
evolving crisis in this period. Funding and liquidity risk risks acquired. However, market stresses affected nearly all
management practices may, moreover, be among the most major global financial institutions, with most requiring some
difficult to adjust under pressure, because they are often form of assistance. In this environment, exceptional official
closely tied to each firms central strategies. sector support was necessary to maintain the viability of the
financial system.
Funding and Market Liquidity Problems The disruption of the secured financing market
The events of 2007-09 demonstrated on a large scale the highlighted a number of issues relating to the U.S.
vulnerabilities of firms whose business models depended triparty market for repurchase agreements (repos).
heavily on uninterrupted access to secured financing Securities dealers often depended on the triparty repo market
markets. Many firms relied on excessive short-term wholesale to fund certain kinds of securitiesincreasingly, as time
financing of long-term illiquid assets, in many cases on a cross- passed, illiquid and hard-to-price securitiesand were
border basisa practice that made it difficult for the firms to consequently vulnerable to disruptions in that market.
2
Lenders funded through triparty arrangements significant associated with off-balance-sheet exposures. Firms have
volumes of illiquid securities that they would be prohibited reported that substantial efforts are under way to implement
from retaining should a borrower fail. Clearing agent banks or enhance funds transfer pricing practices, including both
took on significant credit risk by extending intraday credit broadening the scope of business activities subject to transfer
without fully considering whether they would be able to pricing and integrating transfer pricing more deeply with
liquidate collateral should the need arise. Borrowers failed to firm processes.
anticipate the collateral amounts that their clearing agents In addition, many firms are reevaluating how they
would require when faced with providing intraday funding measure their future needs for funding. Before the crisis,
for a weak borrower with a deteriorating collateral pool. most firms relied heavily on a months of [contractual]
Similarly, the bankruptcy of Lehman Brothers coverage metric that did not adequately reflect the
International (Europe)LBIEhighlighted the risks contractual and behavioral demands triggered in a
of relying on the rehypothecation of clients securities stressful market environment. For example, the coverage
as a source of funding. Many counterparties of LBIE elected metric did not capture many of the stresses that developed
to have accounts that allowed Lehman to rehypothecate during the crisis, such as meeting demands for collateral from
securities positions to obtain funding. After LBIE declared clearing agents and counterparties, accepting credit default
bankruptcy, prime brokerage clients sought to withdraw swap (CDS) novations, andeven when not contractually
from these arrangements. However, these clients were deemed required to do sosupporting instruments and vehicles such
unsecured creditors of the estate and found themselves as sponsored funds, structured investment vehicles, and
without access to their positions. The failure of Lehman money market and similar funds. Recognizing the weakness
Brothers generated concern among hedge fund customers of their existing measures of funding needs, firms are now
relating to the fact that, in certain instances, their prime enhancing their calculations of stress needs.
brokerage free credit balances and other assets in the A key lesson of the crisis, drawn by both firms and
United Kingdom were not subject to segregation; in many supervisors, was that complex corporate structures
cases, customers decided to withdraw from these arrange- hindered effective contingency funding. Firms found that
ments. Firms whose U.K. dealer subsidiaries relied on complex corporate structures, often created to arbitrage tax
rehypothecating clients securities to obtain funding did not and regulatory capital frameworks, also imposed significant
recognize that this source of funding would be lost when constraints on the flow of funds across the firm between legal
Lehman Brothers declared bankruptcy. entities. As a result, firms are acknowledging the importance
Firms also failed to realize that two important sources of a bottom-up approach to contingency planning, which
of funding, securities lending and money market funds, includes the preparation of contingency funding plans at the
could impose further demands on firm liquidity during individual legal entity level. This is an area of considerable
periods of stress. Traditional sources of funding, especially supervisory interest going forward.
for European banks, such as securities lending reinvestment
pools and money market mutual funds, faced significant Supervisory Evaluation of Firm Self-Assessments
and immediate pressures to reduce their investment and the Identification of Critical Areas for
positions. These pressures became apparent following Continued Improvement
the announcement of losses in the Primary Fund series Amid rising losses in 2008, numerous public and private
of the Reserve Fund in the United States. sector groups published studies after the first SSG report that
articulated practices or principles thought to be critical to the
Firms Reevaluation of Existing Practices resilience of internationally active financial institutions.
The global financial firms participating in the liquidity and Prompted by general agreement on the benefits of many
self-assessment exercises have begun reevaluating existing of these practices and principles, the SSG members invited
practices at the corporate and business line level. twenty firms to evaluate their practices against the findings
Many firms acknowledged that, if robust funds transfer of these studies.
pricing practices had been in place earlier, they would not Most of the participating firms offered favorable self-
have carried on their trading books the significant levels of assessments, albeit to varying degrees across the set of
illiquid assets that ultimately led to large losses and would recommendations. While the SSG generally agrees with
not have built up significant contingency liquidity risks the relative ranking of compliance with specific
3
recommendations, we believe that absolute rankings were an inadequate and often fragmented infrastructure that
too positive and that substantial work is still needed to hindered effective risk identification and measurement.
achieve full alignment with the existing recommendations
and observations. Two factors in particular drive the gaps A key weakness in governance stemmed from what
between current practices and those advocated by industry several senior managers admitted was a disparity between
the risks that their firms took and those that their boards
groups and supervisors. First, many firms information
of directors perceived the firms to be taking. In addition,
technology (IT) infrastructure is inadequate to monitor risk
supervisors saw insufficient evidence of active board involve-
exposures accurately, a problem long in the making that will
ment in setting the risk appetite for firms in a way that
also take time to remedy. Second, firms need to reexamine the
recognizes the implications of that risk taking. Specifically, only
priority they have traditionally given to revenue-generating
rarely did supervisors see firms share with their boards and
businesses over reporting and control functions.
senior management a) robust measures of risk exposures (and
Section IV below details ten critical areas for improve-
related limits), b) the level of capital that the firm would need
ment that emerged from the self-assessment results and to maintain after sustaining a loss of the magnitude of the risk
interviews and that are broadly relevant across firms. measure, and c) the actions that management could take to
Supervisors believe that considerable work remains in the restore capital after sustaining such a loss. Supervisors believe
areas of governance, incentives, internal controls, and that active board involvement in determining the risk tolerance
infrastructure. The absence of action in some critical areas, of the firm is critical to ensuring that discipline is sustained in
such as the proper alignment of incentives and improvements the face of future market pressures for excessive risk taking.
to firms IT infrastructure, should raise questions for boards Within firms, the stature and influence of revenue
of directors, senior managers, and supervisors about the producers clearly exceeded those of risk management and
effectiveness and sustainability of recent changes. Closing control functions. Belatedly responding to this imbalance,
some of the acknowledged gaps, particularly those associated virtually all firms have strengthened the authority of the risk
with infrastructure, will be resource- and time-intensive. management function and increased the resources devoted
Continued oversight on the part of supervisors and sustained to it. Nevertheless, firms face considerable challenges in
discipline and commitment on the part of firms will both be developing the needed infrastructure and management
required if the necessary investments and adjustments to information systems (MIS).
practice are to be successfully made. Some of the imbalance we noted between risk and
An overarching observation that relates to many of the rewards can be seen in the approaches to remuneration.
areas singled out for improvement is that weaknesses in There is broad recognition that industry compensation
governance, incentives, and infrastructure undermined the practices were driven by the need to attract and retain talent
effectiveness of risk controls and contributed to last years and were often not integrated with the firms control
systemic vulnerability. In the interviews we conducted for environments. Among the critical weaknesses that the firms
this report, we found that many firmsregardless of whether cited are the following:
they required government supportand their supervisors Historical compensation arrangements evidenced
had concluded that the incentives and controls in place both insensitivity to risk and skewed incentives
throughout the industry had failed. These failures reflected to maximize revenues.
four challenges in governance: The accrual of compensation pools historically did
the unwillingness or inability of boards of directors and not reflect all appropriate costs.
senior managers to articulate, measure, and adhere to Schemes for measuring individual performance often
a level of risk acceptable to the firm, failed to take into account true economic profits,
arrangements that favored risk takers at the expense adjusted for all costs and uncertainty.
of independent risk managers and control personnel,
Firms are considering changes to their compensation
compensation plans that conflicted with the control regimesincluding modifications to the accrual of bonus
objectives of the firm, and pools, the allocation of pools to business units and individuals,
4
and the form of compensation paid outwith the goal of While firms reported enhancements to, and increased
better aligning practices with the control objectives of the use of, stress testing to convey risk to senior management
firm. Among the changes that have been, or are being, put and the board of directors, supervisors noted that
in place or considered are: significant gaps remained in firms ability to conduct firm-
tying bonus accrual and performance measurement wide tests. Firms cited significant management support for
more directly to economic profit by incorporating enhancements to stress-testing practicesa reversal of past
the costs of risk, liquidity, and capital; experiences. Nevertheless, most firms still do not have the
ability to perform regular and robust firm-wide stress tests
integrating the input of control functions with
performance evaluations; and easily, although significant efforts are under way to address
this issue.
reviewing deferred compensation plans with an eye Finally, although this report focuses mainly on
toward longer vesting and distribution periods. individual firms efforts to improve their practicesand
Overall, the crisis highlighted the inadequacy of many our assessment of the limitations of those effortswe note
firms IT infrastructures in supporting the broad that the industrys substantial efforts to standardize
management of financial risks. In some cases, the obstacle practices and reduce backlogs of unconfirmed over-the-
to improving risk management systems has been the poor counter (OTC) derivatives positions appear to have
integration of data that has resulted from firms multiple significantly mitigated a substantial systemic risk. Firms
mergers and acquisitions. This problem has been seen as reported progress in streamlining business processes to
affecting firms ability to implement effective transfer pricing, achieve same-day matching, in adopting and implementing
consistently value complex products throughout an organi- standard technology platforms, and in improving collateral
zation, estimate counterparty credit risk (CCR) levels, aggregate management practices and reducing notional amounts of
credit exposures quickly, and perform forward-looking stress CDS outstanding through portfolio compression. Despite
tests. Building more robust infrastructure systems requires a this significant effort to mitigate risk, further improvements
significant commitment of financial and human resources on are needed in key personnels knowledge of financial market
the part of firms, but is viewed as critical to the long-term utilities and communication with settlement infrastructure
sustainability of improvements in risk management. providers.
5
III. FUNDING AND LIQUIDITY RISK MANAGEMENT

Funding and liquidity problems were central to the financial the vulnerability of firms to the loss of secured funding
crisis in the fall of 2008. In this section, we first provide when they have no access to central bank liquidity;
background on the funding challenges experienced by many the critical role of the triparty repo clearing agent; and
financial firms during the crisis, and then discuss observed
and planned changes in funding and liquidity risk the number of ways in which client and investor
management practices. apprehensions about a firms prospects are expressed
not only through falling stock prices and the widening
of credit default swap spreads, but also through the
A. Background on Major Funding Stresses withdrawal of prime brokerage free credit balances and
The unusualand, in some cases, unprecedentedstrains in the increased novations of trades away from the firm.
a range of funding markets were a defining characteristic of the
crisis from March 2008 onward and are therefore a primary Concerns among Bear Stearns prime brokerage clients,
focus of this report. SSG member agencies and the firms triggered by rumors about the firms viability, led to outflows
participating in the SSG exercises were largely in agreement of free credit balances over a short period. Most critically,
concerning the nature of the funding stresses, notwithstanding Bear Stearns faced a sudden and dramatic loss of repo
counterparty confidence, such that the firms secured funding
their differing vantage points and the varying relevance of
base essentially disappeared. While repo financing has always
the observations in this section to individual firms and
been susceptible to rollover risks, Bear Stearns over-reliance
jurisdictions. We do not provide an exhaustive or definitive
on overnight repos to fund less liquid assets proved to be
record of all funding challenges faced by firms during this
particularly problematic. Ultimately, fueled by the firms
period. Rather we focus on the issues and developments
declining stock price and widening credit spreads, lenders
characterized as most fundamental by many of the firms and
unwillingness to provide funding to Bear Stearns even on
those that stood out most prominently to SSG member a secured basis led to its forced sale.
agencies in our supervisory capacities during the crisis. The dynamics of the subsequent Lehman Brothers failure
were similar to the Bear Stearns dynamics just described.
1. General Firm and Market Stresses However, because Lehman Brothers actually entered
The events of 2007-09 underscored the vulnerabilities of those bankruptcy, the firms failure had far greater consequences
firms whose business models were highly dependent on for financial markets:
uninterrupted access to secured funding markets.
Custody of assets and rehypothecation practices were
Beginning in the summer of 2007 and continuing through dominant drivers of contagion, transmitting liquidity
2009, lenders willingness to finance less traditional, harder risks to other firms. In the United Kingdom, there was
to price collateral diminished. In addition, counterparties no provision of central bank liquidity to the main
and creditors sought to lessen their exposure to firms perceived broker-dealer entity, Lehman Brothers International
to be weaker by reducing the amount of credit provided, (Europe), and no agreement was struck to transfer
increasing haircuts on positions financed, and shortening the client business to a third-party purchaser. As a result,
term for which credit was extended. Moreover, secured lenders LBIE filed for bankruptcy while holding significant
tightened their definitions of acceptable collateral. These custody assets that would not be returned to clients for
trends posed particular difficulties for firms that, lacking a long time, and therefore could not be traded or easily
adequate liquidity reserves or contingent sources of funding, hedged by clients. In addition, the failure of LBIE
relied heavily on short-term repo funding collateralized by exposed the significant risks run by hedge funds in
illiquid assets. allowing their prime broker to exercise rehypothecation
The near-collapse of Bear Stearns in March 2008 illustrated rights over their securities.2 Under U.K. law, clients
several important dimensions of the funding crisis: 2
London-based Lehman Brothers International (Europe) filed administration
proceedings on September 15, 2008. On the same day, Lehman Brothers
the drain on firms liquidity created by their reliance Holdings Inc. filed for Chapter 11 bankruptcy in the United States. On
on the short-term secured funding markets to finance September 17, 2008, Barclays announced an agreement to purchase Lehman
long-term illiquid assets; Brothers Inc., the U.S. broker-dealer subsidiary.
6
stand as general creditor for the return of such assets. priced instruments on a short-term basis contributed to a false
The loss of rehypothecated assets and the freezing sense of comfort with firms liquidity positions.
of custody assets created alarm in the hedge fund The triparty repo market grew to be an important source of
community and led to an outflow of positions from funding for broker-dealers and other financial entities that did
similar accounts at other firms. Some firms use not have access to stable deposit pools or lower cost, unsecured
of liquidity from rehypothecated assets to finance lines of credit. The legal structure of the product varied
proprietary positions also exacerbated funding stresses. between the U.S. and European models. In the United States,
Money funds liquidated investments in financial clearing banks (the third party in triparty repo agreements) act
institutions perceived to be vulnerable. The Primary as agents and facilitate the daily unwinding of securities and
Fund series of the Reserve Fund broke the buck cash by providing intraday credit. This intraday funding is
following Lehman Brothers bankruptcy because of its secured by the same securities used the previous night in the
holdings of Lehman commercial paper. When this event triparty repo transactions. Each morning, the clearing banks
was combined with rising concern that certain money have the right to decline to provide intraday funding. They
market mutual funds (MMMFs) might be holding paper might do so if they have credit concerns about a particular
of distressed financial firms, institutional investors began
borrower or are uncertain of their own ability to liquidate
a run, prompting many money funds to liquidate their
collateral without loss in times of volatile market conditions.
investments to honor such redemption requests.
If the clearing bank chooses not to unwind the transaction,
Securities lending cash reinvestment funds also reduced then lenders have the right to liquidate the collateral and the
funding to vulnerable financial institutions. As traditional borrower will not regain its inventory of securities. In the
purchasers of financial institutions debt, cash reinvestment European triparty repo model, by contrast, there is no daily
pools demand for these investments declined, particularly unwinding of the transaction. Instead, borrowers can make
when market forces caused the values/prices of such debt
substitutions into and out of the collateral pool that they have
to decline and become less liquid. Also, reinvestment
posted with the third-party agent provided that they continue
pools need for cash increased dramatically as borrowers
deleveraged, the value of the stocks on loan declined, and to comply with the margin requirements, limits set on asset
beneficial owners withdrew cash collateral from pools quality, concentration limits, and so forth.
experiencing illiquidity and losses. Market events in September-October 2008 highlighted
potential difficulties in the U.S. unwinding mechanism and in
Interbank lending, particularly in Europe, collapsed
both U.S. and European protocols for dealing with troubled
as investors became extremely concerned about
borrowers. From the borrowers perspective, the daily
institutional creditworthiness following the failure of
unwinding of triparty repo transactions and the very short
Lehman Brothers and losses on Washington Mutual
holding company and bank debt.3 maturities of the loans mean that lenders can withdraw from a
particular borrower in a matter of days and often overnight.
Underpinning many of the dynamics observed in the Bear Significantly, most money market mutual funds (which make
Stearns and Lehman cases were weaknesses in secured funding up the bulk of lenders in this market) may not be permitted
markets that became starkly apparent at the peak of the crisis. to invest directly in the securities that serve as collateral in
their repo transactions, so that the investors might be required
a. Secured Funding/Triparty Repo Transactions to dispose of such collateral as soon as possible upon default of
Risks arose from the increased use of short-term the counterparty. However, while liquidity levels fluctuate
triparty repos to fund longer term illiquid assets and over time, a good percentage of securities financed through
from clearing banks provision of intraday credit. triparty repos are, in fact, illiquid. As such, the forced sales by
these lenders could cause losses and put downward pressures
A substantial reliance by financial institutions on secured
on market prices.
funding markets to finance either lesser quality or less easily
To the clearing banks that must provide intraday funding
3 each morning, the risks and costs of liquidating a large pool of
J.P. Morgan Chase did not purchase the assets or assume the liabilities of the
holding company, nor assume the unsecured senior debt, subordinated debt, collateral are elevated when markets are volatile. As a borrower
or preferred debt of the bankwith the result that Washington Mutuals deteriorates, it is often selling and using its most liquid
bondholders received minimal, if any, recovery value while creditors were collateral elsewhere, and the pool of collateral financed in
moved to reevaluate the risk of holding company and unsecured debt. These
outcomes further heightened investors concerns about the riskiness of bank triparty repo transactions becomes increasingly riskier and less
and holding company debt. liquid. Further, the failure of a major bank is likely to cause
7
the securities held as collateral to fall rapidly in value. While the financial markets. While not principal to the
clearing banks have the right to charge their own haircuts for original transactions, clearing banks should ensure
intraday funding, high liquidity premiums are generally not that the provision of intraday liquidity collateralized
applied. Thus, clearing banks also have an incentive to move by triparty repo securities is executed within an
first, and either notify borrowers that they cannot rely on appropriate risk management framework. Firms
intraday funding or keep triparty repo transactions locked so suggested that this framework should address
that lenders retain the securities (and the liquidation risks). concentrations of securities, potential exposure to
In practice, when faced with the risk of a weak borrower and securities that are of lower credit quality or are illiquid,
a large pool of illiquid assets, the clearing bank will often first and haircut policies. In addition, firms suggested that
seek to obtain additional liquid collateral to reduce its credit credit risk managers independent of the business area
exposure. Such a step represents a further incremental should monitor borrower creditworthiness and
behavior, transaction and collateral trends, and the
demand on the borrowers liquidity resources.
resulting credit exposures in relation to the capital of
Triparty repo transactions bring together three very
the clearing bank. Finally, firms are reviewing their
different types of participants with different abilities to address
risk management reporting, escalation policies, and
the risks associated with these transactions. Moreover, the
collateral liquidation procedures and processes.
disorderly liquidation of a large pool of collateral, concurrent
with the failure of a large borrower, poses systemic risks for the
b. Deposit Trends
financial markets. For these reasons, a collaborative effort to
address the risks that arise with collateral liquidation may be Vulnerable firms faced sustained outflows; firms
the best way to apply the lessons learned. The issues and perceived to be strong gained new deposits.
incentives around triparty repo transactions are complex; Banks perceived by market participants to be more vulnerable
firms noted several areas in which lenders, borrowers, and experienced sharp outflows during the crisis, particularly in
clearing banks could modify their practice: commercial and wealth management deposits. One bank saw
Lenders were funding considerable amounts of harder its deposits decline more than 13 percent during the weeks
to price collateral, much of it with extended tenors that following Lehman Brothers bankruptcy; another bank lost
they would not be able or willing to invest in directly. more than 50 percent of its deposits over a six-month period.
Firms questioned whether lenders have set the correct The subsequent market stress had divergent effects on
investment parameters, such as margins, concentration financial firms that were considered strong or too-big-to-fail
limits, limits on illiquid collateral, and limits on the and others that were perceived as susceptible to the stress.
overall size of the collateral pool, to prevent a borrower Uninsured deposits, in particular, moved to banks perceived
default and the subsequent fire sale liquidation of the to be more financially resilient. Banks that benefited from
collateral from causing material harm to the lender. the flight to quality experienced significant increases in retail
Firms also questioned whether some lenders have the and commercial deposits, drawing in institutional money, in
operational ability to undertake liquidation. particular, that was moving from higher risk institutions and
Several firms noted that many borrowers had relied from uncertain markets. Banks that benefited from deposit
too heavily on short-term triparty repo, particularly inflows primarily placed funds at central banks, assuming that
to fund longer term illiquid assets, without substitute these sudden increases in deposits were transitory. Many
sources of liquidity, and that this was not prudent. of these banks, apprehensive about the creditworthiness of
Several borrowers had no effective limits on the counterparties, were reluctant to lend out their increased
amount of illiquid securities that could be funded balances to firms with significant funding needs.
through triparty repos, and failed to restrict their For relatively stronger firms, assumptions about depositor
overall dependence on this one market. One firm behavior did not change significantly, although firms were
suggested applying a framework that would identify now more focused on maintaining relationships with clients.
alternative sources of funding to allow firms to Competition for deposits increased substantially, according
function if triparty transactions were not renewed to several firms. Pricing and promotions expanded, but firm
with investors at maturity. managers reported that signaling also became a concern. For
Clearing banks for the U.S. triparty repo market are example, the management of one firm believed that it had
pursuing enhancements to their risk controls to prevent experienced large inflows of retail and wholesale deposits
repo transactions from posing undue risks to firms and precisely because the rates offered were low relative to the rates
8
paid by peersa signal to the market that the firm was not in experienced severe difficulties swapping euros or yen for U.S.
distress. Depositors became aware that some of the best rates dollars. This mismatch, which lasted for a relatively long
offered during the eighteen-month crisis came from firms that period, necessitated an expansion of bilateral foreign
soon went out of existence. exchange swap facilities at central banksan arrangement
that allowed firms to cope with their deteriorating access to
c. Interbank Deposits, Unsecured Funding, U.S. dollar funding by drawing on the facilities.
and the Foreign Exchange Swap Market
Counterparty concerns led to the near-cessation 2. Prime Brokerage4
of interbank funding. Firms underestimated the funding vulnerabilities
The funding available was increasingly concentrated created by prime brokerage.
in short-term tenors. The case of Lehman Brothers International (Europe)
The interbank deposit market, a particularly important highlights the contagion risk that rehypothecation
in insolvency proceedings poses for both firms
market for European financial institutions, had only a few
and investors.
large net providers of funds before the liquidity crisis,
according to firm reports, and became an altogether unreliable The near-failure of Bear Stearns highlights the
source of funding during the crisis. In essence, during the frictional liquidity issues that arose as clients
turmoil that followed the Lehman Brothers bankruptcy, few withdrew balances, creating a temporary need
firms were willing to increase their credit exposure to other for funding.
market participants. Most, if not all, firms sought to conserve Asymmetrical unwinding of client positions was
their liquidity and reduce exposures to other institutions that a material drain on liquidity.
they perceived as vulnerable. Central banks began directing Before the crisis, many broker-dealers considered the prime
liquidity into the market and became the counterparty and brokerage business to be either a source of liquidity or a
funds provider of choice for many market participants. Other liquidity-neutral business. As a result, the magnitude and
institutions, including smaller financial firms and those unprecedented severity of events in September-October 2008
thought to be vulnerable to the market crisis, were effectively were largely unanticipated.
shut out of the interbank funding market because of firms
heightened risk awareness. Lehman Brothers International (Europe):
Traditionally a significant source of funds, the term The Contagion Risk of Rehypothecation
issuance of debt obligations (obligations with maturities in Insolvency Proceedings
greater than one year) was only available in limited amounts When LBIE went into administration on September 15,
to some firms during the twelve months ending in mid- 2008, all client assets it held in prime brokerage accounts,
September 2008 and stopped abruptly with the bankruptcy of whether in custody or rehypothecated, were frozen. In the
Lehman Brothers. Subsequently, funding became increasingly United Kingdom, hedge funds could elect to establish
concentrated in short-term tenors, specifically six months or segregated accounts at their prime broker, but in most cases
less. In light of the particular challenges experienced in they entered into prime brokerage agreements that enabled
September-October 2008, managers at several firms were LBIE to rehypothecate clients securities to obtain funding.
pleased that they had had the discipline to build term funding By granting rehypothecation rights over their assets to the
up to a year earlier, even though it had seemed as if they were prime broker, clients typically obtained cheaper margin loan
paying an excessive rate for the funds at the time. pricing. Those assets that had been rehypothecated were not,
The dollar-yen and dollar-euro swap markets dried up after by definition, segregated; thus, hedge fund clients became
Lehmans collapse, posing a particular risk for certain general creditors on the estate with respect to those assets.
European and Japanese firms that had chosen to finance When assets were held in segregated custody arrangements,
illiquid U.S. dollar assets with short-term funding. This
development proved to be especially problematic for some 4
Prime brokerage, a service offered by securities firms to hedge funds and other
European firms that had developed large concentrations of professional investors, may include centralized custody, the execution and
U.S. dollar-denominated assets before the crisis but did not clearance of transactions, margin financing, securities lending, and other
administrative services such as risk reporting. The growth of the hedge fund
have direct access to dollar deposits through U.S. branches or sector over the last decade was supported by a concurrent growth in the prime
subsidiaries. As a result, beginning in September 2008, firms brokerage businesses within the investment banks that serviced these funds.
9
they would not be released to clients quickly, and these assets hedge fund clients for the repayment of free cash balances and
could not be traded or easily hedged in the interim. The scale excess margin. When free cash was not withdrawn totally,
of these issues compelled hedge funds to take account of the numerous requests were received for amounts either to be
level of credit and operational risk that they were exposed to transferred to the U.S. broker-dealer where balances could be
through their prime brokerage relationships. subject to the 15c3-3 lockup protections or to be placed in
Because of these concerns, immediately following LBIEs segregated accounts in the United Kingdom. In both cases, the
default, a number of hedge funds and other prime brokerage U.K. prime broker suffered a loss of cash that could otherwise
clients withdrew their portfolios from remaining prime have been used for financing its balance sheet.
brokers with similar arrangements if these firms were
perceived to be vulnerable. These prime brokers experienced Absolute Loss of Liquidity Associated with the
an extraordinary outflow of funds, causing significant liquidity Asymmetrical Unwinding of Client Positions
and operational stresses. The asymmetrical unwinding of client positions was a
particular challenge, exacerbated by the short selling bans
Free Credit Balances: Frictional Liquidity Issues imposed globally by regulators on financial stocks. Some
in the United States and the Demand for prime brokers had adopted a cross-client portfolio-based
Segregation in the United Kingdom funding model that financed one clients long position by
In March 2008, the clients of Bear Stearns prime brokerage matching it with a second clients short position.6 As one
service became increasingly concerned about the ability of the clients short position was closed out, the other clients long
firm to meet its obligations; the clients sought to move their position had to be refinanced by the prime broker in a highly
accounts to competitors perceived to be of higher credit stressed market for secured funding transactions.
quality and, in the process, to withdraw substantial amounts
of free credit balances.5 This development happened quickly 3. Unwinding of Securities Lending Transactions
at Bear Stearns, with client free credit balances declining A number of U.S. cash collateral reinvestment funds
drastically in the course of one week. experienced reduced liquidity and/or fair market
At that time, when a client of a U.S. broker-dealer value losses as the issuers of certain assets in which
withdrew balances from its account, known as free credit the funds had invested defaulted, as other assets
balances, the broker-dealer had to borrow to finance the experienced decreasing market values, and as the
remaining customer debits. Moreover, the amount of market for such assets froze up. Such reinvestment
customer free credit balances withdrawn was still subject to funds experienced additional pressures as some
segregation, or lockup, under rule 15c3-3 of the Securities borrowers redeemed cash collateral and some lenders
and Exchange Commission (SEC) until the lockup curtailed lending or withdrew (or attempted to
requirement was recalculated. The calculation generally took withdraw) cash collateral.
place weekly before the crisis, but was undertaken more Reinvestment funds were forced to pull back from
frequently, even daily, during the crisis. Thus, prime triparty reinvestments in broker-dealers and other
brokerage arms of firms subject to large customer withdrawals firms. Even though some reinvestment funds
satisfied clients free credit balance withdrawals from the increased the percentage of their holdings invested
investment banks own liquidity until the next 15c3-3 lockup in triparty repo transactions, the overall effect was
calculation was performed. The overnight delay in the release a reduction in the size of investment pools and
of locked-up funds resulted in an additional temporary, or decreased funding to triparty repo borrowers
frictional, loss of liquidity for the period that funds withdrawn on an absolute basis.
were still subject to segregation. Following the failure of LBIE, The severity of the risks associated with securities lending
prime brokers received an enormous number of requests from activitiesas with prime brokeragecaught many
5
participants by surprise. Before the crisis, many market
Hedge funds typically leave free credit balances, or balances in excess of
margin requirements, on account at the prime broker. This is done to signal the
participants considered securities lending to be low-risk and
creditworthiness of the fund to the prime broker, to earn returns directly or liquidity-positive, because cash was typically reinvested in
indirectly provided by the prime broker on these funds, and to ensure adequate
6
funds to address frictions in the movement of balances. A hedge funds decision If the client short position and the rehypothecated long position involved
to leave free credit balances on account at a prime broker will also depend different securities, the prime broker might contract with a third party to
on its perception of the creditworthiness of the prime broker. In turn, prime essentially swap one stock for the other, or otherwise use one clients asset
brokers may make use of this cash, albeit subject to different regulatory as collateral for a third-party stock loan that would cover the other clients
considerations in the United States and United Kingdom. short position.
10
short-term, highly liquid money market instruments that were to decide whether to sell the instruments in an illiquid market
typically over-collateralized. As a result, some beneficial (if that was possible) and realize significant losses, or to retain
owners and firms managing reinvestment funds may have the instruments in the hope of riding out the crisis.
become complacent about the liquidity, credit, market, and
operational risks inherent in securities lending and failed to Impact of Securities Lending Turmoil on
anticipate the severity of the liquidity risks in a highly stressed the Size of Reinvestment Pools and the Volume
market environment. of Funding Available to Repo Borrowers
Until the recent crisis, the securities lending market had Major credit disruptions such as the bankruptcy of Lehman
grown dramatically over the past thirty years, owing in part to Brothers and the large financial losses of AIG, along with the
the increase in the number of hedge funds and others engaged turmoil in closely linked markets, triggered an unwinding of
in short selling (a practice that relies on borrowed securities), securities lending transactions and strained many beneficial
as well as other needs for securities borrowing. Custodial owners and agent lenders securities lending businesses, in
banks and other global financial firms sought to capitalize on some cases significantly. Securities lenders retreated across the
this trend, offering global securities lending services to pension major markets, reducing exposures by recalling securities on
funds, endowments, insurance companies, and other
loan, severely curtailing new loans, and reducing the tenors
institutional investors with large inventories of securities.
of new transactions.
The need to borrow securities also declined as hedge funds
Heightened Awareness of Reinvestment Risks
and other market participants moved to deleverage and to
during the Crisis
preserve cash in the face of falling stock prices, regulatory bans
In the United States, where securities lending transactions on short selling, and rising redemptions of hedge fund shares.
have typically been collateralized by cash,7 risk associated with The values of securities and other types of noncash collateral
the reinvestment of the cash collateral has always existed. For
fell, and certain trades such as long/short equity, convertible
example, if the loan requires the payment of a borrower rebate,
arbitrage, and equity upgrades came to a halt, largely because
there is always a risk that the borrowers rebate rate could
of dramatically reduced demand for less transparent securities.
exceed the reinvestment interest rate. There is also the risk that
As a result of this dynamic and the sharp decline in the value
the instruments in which the cash collateral is invested could
of equity markets, some firms securities lending pools and
become illiquid or incur losses. The beneficial owner, not the
outstanding transactions dropped substantially in September-
borrower, is typically responsible for any losses incurred in the
October 2008 in both the U.S. and European markets. The
cash collateral investments.
unwinding of transactions caused significant liquidity
During the crisis, this risk became a reality as a number of
cash collateral reinvestment vehicles experienced illiquidity pressures and operational challenges.
and losses. The causes for this are varied and remain under The liquidity stress was greatest in the United States, owing
study. In some cases, the cash collateral was invested in debt to its larger emphasis on cash collateralized transactions, and
instruments, including asset-backed commercial paper greatest where the lending programs focus was on volume/
(ABCP), Lehman and other broker commercial paper, and securities finance lending rather than intrinsic value
structured investment vehicles (SIVs). In some cases, the term lending.8 Agent lenders faced a huge demand to return
to maturity of these instruments was longer than that of, for securities to the beneficial owners and cash collateral to
example, instruments found in registered money market
funds. During the crisis, some of these instruments defaulted,
8
The volume/securities finance approach to securities lending in the
United States seeks to lend out as many securities as possible, including
and many experienced a decline in price, value, and liquidity. securities that are not in high demand. When securities not in high demand
A number of these instruments may have been highly rated are lent out, the lender typically must pay the borrower a rebate, which is
and liquid when acquired, but became less highly rated and usually based on the federal funds rate. If the loan requires the payment of a
rebate to the borrower, then the cash collateral reinvestment rate must exceed
increasingly illiquid as market events unfolded. The longer the borrower rebate rate. The intrinsic value approach focuses on lending
their remaining maturity, the more vulnerable the instruments securities that are in high demand, for which the borrower rebate will be
were. Once the instruments became illiquid or incurred losses, smaller or zero. In some cases, the lent security will be in such great demand
that the borrower will pay the lender a rebate. When the borrower rebate is
some beneficial owners and their cash collateral managers had small or nonexistent, the beneficial owner does not need to be as concerned
that the return on cash reinvestment will exceed a borrower rebate or be a
7
Contrast this with Canada and the United Kingdom, where noncash collateral separate profit center, and the cash collateral can be reinvested in very short-
has been the norm in securities lending transactions. term government instruments with the goal of protecting principal.
11
borrowers, along with a high number of margin calls. The 4. 2a-7 Money Market Mutual Funds
funds thus experienced shortages of cash associated with the and Non-2a-7 Funds
overall maturity mismatch of investments, falling asset values MMMFs significantly reduced, or even halted,
and the inability to sell assets into a stressed market, demands their purchases of commercial paper and other
for cash associated with the return of securities from short-term investments as concerns about firms
deleveraging hedge funds, and margin calls, attributable to viability escalated.
declines in equity prices, from borrowers of equity securities.
For banks with sponsored funds, the decline in
The extreme liquidity demands on the funds and their general
the value of the funds investments and the funds
inability to sell assets into a frozen marketas well as potential
inability to liquidate certain investments prompted
reputational riskprompted at least two agent lender firms to bank sponsors to provide support to stabilize net
support their reinvestment funds through cash infusions, asset values and meet redemptions.
purchases of assets, and capital support agreements.
In Europe and elsewhere, the greater prevalence of noncash Withdrawal of Money Market Mutual Funds
collateral facilitated a more rapid unwinding of loans because from the Market
of the absence of cash reinvestment risks. In addition, equity MMMFs are one of the largest buyers of bank short-term
collateral in particular afforded a degree of price transparency liabilities and are a key provider of liquidity to global financial
not observed in certain fixed-income collateral. firms. These funds have come under pressure several times
Operationally, the pullback by the beneficial owners since the summer of 2007 because of losses related to SIVs
contributed substantially to the spike in fails (the failure of and concerns about the assets backing ABCP programs. For
trades to settle) in September 2008. The number of beneficial this reason, firms access to the MMMF investor base was
owners (including many foreign central banks) calling their already reduced in periods prior to the events of September-
securities back for fear of dealing with any broker-dealers October 2008.
reduced the supply of Treasury securities available to make In mid-September, expected losses on Lehman paper
settlement. In response, regulators introduced an economic led to a run on the Primary Fund series of the Reserve Fund
incentive to reduce fails of U.S. Treasury securities with the in the wake of the Lehman bankruptcy.11 News of this
recently implemented Treasury Market Practices Group fails run prompted institutional investors to seek additional
charge. While the measure may lower the risk of fails, it does redemptions in other funds. For example, in the United
not address some of the broader risks associated with States, SEC-registered nongovernment (including prime)
securities lending. funds targeted to institutional investors experienced a
Securities lending cash reinvestment funds (along with 30 percent decline in net assets over the four weeks ending
money market mutual fund investors) are significant lenders October 8, 2008, as investors sought to move cash to
in triparty repos.9 Even as some reinvestment funds increased government money funds.12 According to firms interviewed,
the percentage of their holdings invested in triparty repos, the money market mutual funds quickly retreated from
reduction in the size of securities lending programs and their purchasing financial firm issuances of commercial paper,
investment pools substantially reduced the funding provided ABCP, repo investments, and certificates of deposit following
to triparty repo borrowers on an absolute basis, particularly for the Primary Funds collapse. MMMFs not only reduced
less easily valued forms of collateral.10 purchases of these securities, but also refused to roll the
securities they already held and significantly shortened tenors
of any lending agreements with financial institutions. Firms
9
As noted earlier, the distinguishing feature of a triparty repo transaction
indicated that most of the MMMF sector would not invest in
is that a custodian bank or international clearing organization acts as an
11
intermediary between the lender and the borrower. The triparty agent is The funds breaking of the buck was due to the decline in the value of its
responsible for the administration of the transaction, including collateral Lehman holdings. The resulting drop in net asset value to $0.97 exacerbated
allocation, marking to market, and substitution of collateral. Both the lender redemption activity, which totaled more than $40 billion (approximately
and borrower of cash enter into these transactions to avoid the administrative 67 percent of the funds net assets) in the days surrounding these events.
burden of bilateral repo transactions. The Fund subsequently made five partial pro rata distributions amounting
10
In the aftermath of the crisis, commenurate declines in the repo and to approximately 92 percent of the Funds assets as of the close of business
securities lending markets meant that reinvested cash collateral from securities on September 15, 2008. Approximately $3.5 billion remained in the Fund
lending transactions has continued to be approximately 25 percent of the as of October 2009.
12
approximately $2 trillion triparty market globally. See <http://www.ici.org/pdf/mm_data_2009.pdf>.
12
unsecured commercial paper of financial institutions and 1. Risk Management Changes Broadly
would provide funds only rarely, on an overnight basis and at Applicable to General Firm and
extremely high cost. Several financial firms remarked on the Market Stresses
speed with which short-term funding secured by private label
Firms are seeking to ensure that they have global
assets and other less easily valued assets dried up. MMMFs also control of liquidity by strengthening the role of
requested that firms bid back existing investments to corporate treasury, enhancing the infrastructure
augment the funds cash reserves and to prepare them for to support funding-related MIS and stress testing,
further redemptions. Several of the firms interviewed reported and attempting to tighten limits and build stronger
that bid-back requests were particularly high during the week liquidity buffers.
of September 15, 2008, following the Lehman default.
Particular emphasis is being placed on improving
Contributing to this dynamic were the MMMFs concerns
the funds transfer pricing process.
about both the underlying assets that they were financing and
the creditworthiness of the counterparties to the transaction. The complexity of firm structure complicates
On the other side of most repo transactions are longer dated contingency funding plans.
assets that generally cannot be held by certain money market Almost all of the firms surveyed have sought to strengthen
funds because of tenor restrictions. In the event of a counter- structures and processes to enhance the governance of
party default, these assets would then have to be sold into a liquidity. Firms were taking steps to improve the structure
poorly performing secondary market. of their treasury, liquidity risk management, and related
functions. In addition, they were seeking to enhance liquidity
Sponsors Actions in Support of Their Funds reporting and other forms of communication about liquidity
In addition to facing reduced funding from the MMMF between these areas and the business lines as well as to senior
sector, a significant number of financial firms supervised by management and the boards of directors. Funds transfer
SSG agencies provided some form of support to sponsored pricing processes and many aspects of contingency planning
funds to prevent a possible breaking of the buck scenario. were also being enhanced. An important question for firms
The support provided by these financial institutions to date and supervisors is the extent to which such changes are
has mainly taken the form of asset purchases, capital support formalized into policies and procedures and prove to be
agreements, and direct investments in the fund. A small effective in the management of funding and liquidity risks
number of firms have provided support in the multibillion over time.
dollar range to affiliated funds, but the majority of firms
have provided more limited sums. Treasury/Liquidity Risk Management Structure
Firms observed that the organization and interaction of
B. Funding and Liquidity Risk treasury, risk management, and the businesses lines
Management Observations undermined in some cases the effectiveness of liquidity
In this section, we describe the risk management lessons management during the peak of the crisis in September-
and changes conveyed to supervisors in meetings with October 2008. Firms reported that they were undertaking
management of firms. We begin by addressing broadly changes that reflect this awareness.
applicable changes that many firms were considering, Some firmsparticularly those that attributed a less
including significant attention to funds transfer pricing. comprehensive identification of risk to the fact that risk
We then discuss the changes being made in response to management was not part of the treasury function
specific issues involving secured financing, prime brokerage, were considering moving liquidity risk oversight
and securities lending. responsibilities to the chief risk officer (CRO) or
embedding an autonomous liquidity risk management
unit in treasury.
Firms were moving to more centralized treasury models
to address funding and liquidity issues. Other changes
noted by certain firms were the integration of the
secured financing function with treasury and the
13
separation of cash management activities from the metrics in standard liquidity MIS. By late 2008, liquidity
business line. reports were becoming more comprehensive, according to
Some firms looked to improve coordination between interviewees. These reports better captured information on
such areas as treasury, prime brokerage units, secured discount window collateral, deposit pricing, deposit flows, daily
funding desks, and unsecured funding desks; positions and the outlook, cash surplus and consumption of
coordination between the last two functions is cash, unsecured funding, long-term debt issuance, and changes
especially important because of the risk of losing in balance sheet, capital, and leverage ratios.
secured funding and the need to replace the financing
of assets with unsecured funding. Liquidity Stress Testing
Communication channels between risk control Market conditions and the deteriorating financial state of
functions were also established or strengthened. Some firms exposed weaknesses in firms approaches to liquidity
firms stated that the treasury functions relationship stress testing, particularly with respect to secured borrowing
with credit was critical for the effective evaluation of and contingent funding needs. These deteriorating conditions
liquidity risk and monitoring of counterparty status. underscored the need for greater consideration of the overlap
For example, in one case, margin loans had been between systemic and firm-specific events and longer time
approved only by the credit department; now they horizons, and the connection between stress tests and
are jointly approved by both the credit and funding business-as-usual liquidity management.
functions. Firms sought to enhance scenarios used to stress liquidity
positions, particularly with the overlay of systemic scenarios.
Liquidity Management Information Systems As a result, firms have recognized the need to move beyond
Many firms acknowledged shortcomings in their MIS traditional stress tests involving deteriorating credit quality,
infrastructure and in their ability to produce useful reports rating downgrades, and/or historically based scenarios and
during the crisis, recognizing that better-quality and to look increasingly at hypothetical situations that are more
more timely liquidity reporting was essential to effective systemic in nature and longer in duration. Some firms said
management of liquidity and funding issues during a crisis. they were aiming to apply several scenarios to each stress test
In light of this, a number of firms said they were increasing and/or to include both short- and long-term horizons. Firms
their spending on infrastructure, improving their data, and have also focused on improved reporting of stress-test results
strengthening the quality and timeliness of their reporting. and increased coordination between business lines. More
Liquidity reports did not capture fully the risks in several specific examples of change include the following:
key areas, in particular:
Some firms reported a wide range of new scenarios and
secured borrowing and lending, including information stress tests, including the loss of secured funding of
on maturity mismatches and asset liquidity; certain asset classes, a collapse in foreign exchange
derivatives businesses, including collateral outflows swaps, operational crisis, counterparty failure, mutual
resulting from rating changes and asset price fund redemptions, and ABCP illiquidity.
movements; and Stress-testing time horizons varied significantly. For
off-balance-sheet funding vehicles and certain non- example, one firm applied a one-month horizon for
contractual obligations, providing greater transparency a firm-specific scenario and a two-week horizon for a
into contingency funding risks. market scenario. Another firm applied time horizons
from three to six months, to one yearthe latter
During the crisis, liquidity reports were produced reflecting the reality for many firms of prolonged
increasingly on a daily and intraday basis to enable firms to stressed conditions during the crisis.
better assess the funding flows of major asset and liability Firms cited the importance of reviewing and retesting
categories, in turn highlighting areas more vulnerable to assumptions associated with stress tests. Market
funding draws or withdrawals. Most firms felt that the speed stresses during the crisis yielded additional
of information became critical to managing through the peak information on the behavior of various on- and off-
period of the crisis. balance-sheet items during an event. For example,
Firms said they undertook improvements to liquidity gap firms revised their assumptions about the availability
management reports as well as to key ratios and stress-testing of term funding and/or securitizations during a crisis,
14
as well as the ability to continue to obtain secured plans did not include all relevant scenarios of this kind,
funding of certain asset classes, the extent to which suggesting that work remains for firms to identify
haircuts can vary across different forms of collateral, potential noncontractual contingencies.
and the ability to monetize less liquid collateral.
However, some firms observed that other assumptions Liquidity Cushions and Limit Structures
might have been too extreme. For instance, the Interviewed firms typically calculated and maintained a
assumptions of no liquidity in the residential measurable funding cushion, such as months of coverage,
mortgage market or of significant draws on loan which is conceptually similar to rating agencies twelve-month
commitments seemed to overstate the risks in those
liquidity alternatives analyses. Some institutions were required
exposures during this crisis. Nonetheless, most firms
to maintain a liquidity cushion that could withstand the loss
own data reflected a survivors bias; that is, because
of unsecured funding for one year. Many institutions found
the firms did not fail, there were no data on behavior
under severe firm-specific duress. that this metric did not capture important elements of stress
that the organizations faced, such as the loss of secured
Firms reported the need to analyze deposits more funding and demands for collateral to support clearing and
thoroughly to better understand which deposits were settlement activity and to mitigate the risks of accepting
more likely to leave. A more granular analysis was novations. Some firms said they were looking to complement
needed to evaluate the differing vulnerabilities of their traditional time-to-funding measures with stress-
insured versus uninsured, international versus domestic, coverage measures.
and corporate versus retail deposits, as well as those of
The liquidity crisis underscored for many firms the
high-net-worth customers. One firm modeled a full
importance of holding sizable unencumbered liquidity
depositor run, noting that the main constraints to
pools, diversifying funding sources, and maintaining limit
outflow were operational, such as website crashes or
structures and approval requirements that are appropriate for
cash machine depletions.
a firms risk appetite and liquidity risk profile. Most firms
Most firms believed that they were now effectively said they tightened or strengthened funding-related limits
identifying legally binding contingencies. Following the and approvals and developed a greater appreciation for the
initial awareness of significant ABCP issues starting in importance of diversifying funding sources and maturities.
August 2007, firms have anticipated better ABCP Firms generally set or tightened limits on wholesale funding
conduit onboarding. In terms of loan commitments, and on the type of wholesale funding collateral, tenor, and
firms have studied draws closely, but they generally did
domicile. In some instances, firms significantly reduced
not see them as a primary issue during the crisis as of
limits, and senior management had to approve all material
late 2008. Firms did not attribute corporate draw-
funding transactions during peak periods of the crisis. At
downs to the obligors concern about the banking firms
some firms, material new credit extensions now require
own liquidity. Instead, interviewed firms generally
believed that corporate draw-downs were driven more treasury function approval.
by adverse changes in macroeconomic conditions. The crisis emphasized for firms the need to strengthen
More broadly, firms were considering how to overlay collateral management and securities financing practices given
behavioral assumptions on contractual requirements. the degree to which counterparty acceptance of less liquid
For instance, firms were reviewing their assumptions collateral types can decline and haircuts and other terms can
about loan renewals, as the crisis had highlighted the tighten in times of stress. Ultimately, following the failure of
importance of considering potential signaling effects Lehman Brothers, many major firms required access to central
about the availability of funds for such renewals. bank liquidity facilities.
Many firms reported a need to identify and prepare
more effectively for noncontractual contingencies.
Funds Transfer Pricing
Several of these reputational contingencies were still Managers acknowledged that if robust funds transfer pricing
not accounted for in some firms planning scenarios. practices had been in place earlier, and if the systems had
These contingencies included the provision of support charged not just for funding but for liquidity risks, their firms
to money market funds, tender option bonds, and would not have carried the significant levels of illiquid assets
auction rate securities as well as the need to support on their trading books and the significant risks that were held
secondary markets in assets as a market maker or in off balance sheet that ultimately led to sizable losses. Most
secondary bids for paper. Most contingency funding firms reported that funds transfer pricing mechanisms have
15
become more robust, with refined charges for the provision structures, which were often created to arbitrage tax and
of liquidity, including contingent liquidity, and/or better regulatory capital frameworks, also created significant
alignment of incentives in business lines with established constraints on the flow of funds across the firm between legal
risk appetite. entities. Treasurers had often devised contingent funding
Firms said they were increasing the scope of business plans on a consolidated basis and failed to recognize the
activities covered in funds transfer pricingincluding off- constraints on funds flow created by legal complexity. In some
balance-sheet exposuresand applying funds transfer pricing cases, the complexity of the organizational structure prevented
more comprehensively across business lines and down to trading firms from readily accessing secondary sources of liquidity,
desk levels and beyond, where appropriate. Liquidity premiums such as central bank discount facilities. As a result, firms
have been added to certain activities to encourage stable acknowledged the importance of a bottom-up approach
funding. In addition, penalties have been assigned to discourage to contingency planning, which includes the preparation of
dependence on the parent or on short-term unsecured funds. contingency funding plans at the individual legal entity level.
Firms said they were working to integrate funds transfer pricing
practices more fully into the overall liquidity risk management 2. Risk Management Changes Associated
structure to ensure that established costs and incentives are with Prime Brokerage
having the desired effect and to avoid producing unintended Internal limits are being established on the use of
arbitrage opportunities. Two firms were considering ways to rehypothecated client collateral and free credit
charge businesses for stressed funding risk, as measured by their balances.
maximum cash outflow metrics. Firms are strengthening controls over client balance
Some treasurers transfer priced funds based on the expected transfers.
holding period of the positionsirrespective of the position
Dealers and clients are discussing the segregation
term or maturity. In many cases, the stated holding period was
of initial margins.
short term (trading) and the asset liquidity was unquestioned.
As value and liquidity dissipated, the effective funding Limits on Rehypothecation of Client Securities
mismatch grew.
Growing out of the LBIE experience, documentation and
Firms found that increasing the cost of funds did not always
contractual rights were subsequently renegotiated with
work to control the balance sheet, as many trading desks and
hedge fund clients. In particular, limits were imposed on
businesses had developed their own funding sources. For rehypothecation rights and caps were agreed to in international
example, one firm found that upon receiving a higher cost of prime broker agreements where previously none had existed.
funds from corporate treasury, the prime brokerage unit Such rehypothecation caps were typically set at levels to cover
would in turn offer clients a lower but attractive yield on margin debits and collateral haircuts and to allow for
deposits. In this case, prime brokerage would become a source operational friction. There was also a push by prime brokers
of funding that would resell these funds to treasuryreducing to ensure that client service and operational expectations were
the funds required from other sources. The prime brokerage aligned with contractual provisions contained in governing
funds, however, were extremely credit sensitive and departed agreements. Some hedge funds arranged to transfer
from the firm at the first sign of distress. Some treasurers have unencumbered securities that exceeded rehypothecation caps
introduced a bid/offer mechanism in transfer pricing in order out of prime broker accounts and into custodian or triparty
to account for the likelihood that business units will source accounts. In response, some firms said they have developed their
their own liquidity and arbitrage treasury. own bankruptcy remote or custody solutions to address client
demands for asset protection. In other cases, firms have
Contingency Funding Plans established tight internal limits on their own reliance on
Most firms contingency funding plans were, to some degree, rehypothecated client collateral.
inadequate for the events of the second half of 2008. Firms
generally agreed on the need to enhance their plans, which had Enhanced Controls over Requests for Balance
become overly focused on institution-specific events often Transfers and Financing Commitments
typified by credit rating downgrades by the rating agencies. During the period of crisis that followed Lehmans failure, the
A key lesson of the crisis, observed by firms and senior management of some firms said they became actively
supervisors, was that complex corporate structures hindered engaged in centrally monitoring and controlling firm-wide
effective contingency funding. Firms found that these liquidity and the status of funding on a real-time basis. This
16
became especially important for firms with significant prime Segregation of Margin
brokerage operations, where previously cash management had A number of prime brokerage clients requested that
been conducted locally within the business unit. Because of independent amounts (initial margin) under the International
the client service orientation of prime brokerage operations, Swaps and Derivatives Associations Credit Support Annex
client requests for immediate or real-time balance transfers be held in segregated accounts. The purpose was to mitigate
were often met without consideration for the frictional impact client exposure to a dealers failure. Although some requests
on the liquidity profile of the business. were met, overall the banks resisted these moves. Of note,
In addition to implementing new controls on outflows of there was a pricing implication associated with locking up
funds, senior management imposed additional restrictions on initial margin, as these amounts are generally used for liquidity
accepting new transactions with funding implications. These purposes, such as posting margin by the banks to clearing
restrictions placed a low or even zero limit on the amount of houses to cover exchange margining requirements. Many
client financing that the sales force could commit to without investment banks said the number of these requests declined
explicit senior management approval. as credit concerns eased. Still, as a result of the observed prime
brokerage stresses in 2008, prime brokers started to provide
hedge funds with more frequent (sometimes daily) and
Reduced Reliance on Free Credit Balances
comprehensive management information presenting details
Following the experiences associated with Bear Stearnsand
and usage of all rehypothecated assets.
with growing market awareness of the magnitude of free credit
balance outflows experienced by Bear Stearns prior to its 3. Risk Management Changes Associated
acquisitionprime brokers have taken steps to adjust their with Securities Lending
assumptions on stress outflows, including their assumptions of
the impact of severe market events on the level of free credit Beneficial owners tightened reinvestment guidelines
applied by agents and are becoming more
balances. By fall 2008, firms were able to accommodate these
discriminating in their choice of counterparties.
outflows more effectively.
Returns provided to prime brokerage clients on free credit Firms are strengthening controls over commingled
balances were repriced by international prime brokers when accounts; additionally, there has been some
their value as a relatively inexpensive source of funding migration of clients from commingled to separate
accounts.
diminished. This reassessment of value has largely been driven
by internal controls and new risk-based funds transfer pricing Firms have responded to the new environment following
arrangements established by centralized corporate treasury September and October 2008 by undertaking formal and
functions. The repricing has reduced the level of returns that informal changes to risk management and control practices.
hedge funds achieve on free credit balances. Firms have focused most on improving collateral and CCR
Before the crisis, firms recognized that free credit balances management and on strengthening liquidity in their
could be drawn down quickly. However, some firms were reinvestment funds. In addition, according to some, there
unprepared for the scale and immediacy of the outflows of has been a significant shift to intrinsic value lending by
client portfolios and cash balances following the Lehman beneficial owners that previously may have taken a volume/
securities finance approach.13
Brothers default. Consequently, internal reporting and
transfer pricing had to be adapted to take account of this new
Higher Standards for Acceptable Collateral
liquidity risk profile. The latter change was necessary in
order to reduce reliance on this relatively unstable, noncore Beneficial owners and their agent lenders were establishing more
source of funding. conservative guidelines for their reinvestment programs.
Outside of the United States, participants reported a move away
Most prime brokers are making adjustments to transfer
from non-central-bankeligible forms of collateral, such as
pricing and management reporting arrangements. The adjust-
equities and convertibles, and other asset classes generally
ments are intended to ensure that tight controls are placed on
perceived to hold greater credit and liquidity risk. Securities
the financing side of the business and that liquidity risk pertain-
ing to the prime brokerage business is within limits so that such 13
For an explanation of the intrinsic value and volume/securities finance
risk does not impair the firms overall liquidity risk profile. approaches to securities lending, see footnote 8.
17
lacking transparencyfor example, collateralized debt Some managers of cash collateral reinvestment funds also
obligations and private-label mortgage-backed securitieswere imposed controls to restrict or slow cash redemptions by
among the least desirable forms of collateral since September 2008. permitting beneficial owners to redeem in cash only for
Agents have engaged in more rigorous collateral reviews ordinary course redemptions (that is, to pay back borrowers),
for example, CUSIP-by-CUSIP assessments in some cases and required beneficial owners to maintain then-current
(despite the prohibitive expense that some see)and in the levels of lending or the beneficial owners would be
establishment of a formal funding review of collateral in completely redeemed out in-kind.
addition to a credit review. One practice among cash collateral reinvestment funds
that sustained losses was to lock down the losses in a manner
Higher Liquidity Targets that ensured a fair distribution of losses across the full investor
Prior to the onset of financial stress, some cash reinvestment base while allowing shareholders to redeem a vertical slice
fund managers sought higher yields in a low-interest-rate of fund investments.14 In some instances, concerns about the
environment by investing in somewhat riskier assets that were effectiveness of these controls, including the timing or fairness
of their application, have been the focus of lawsuits against
still considered safe. Many of these securities proved to be
agent lenders and have underscored the importance to firms
illiquid during the crisis. As a result, agent lenders sought to
of reviewing controls to protect themselves against legal and
increase the overall liquidity in their cash reinvestment funds
reputational risks.
as conditions deteriorated.
Overnight liquidity ratios in cash reinvestment funds
4. Risk Management Changes Associated
varied as of December 2008, but in some cases they ranged
with Money Market Mutual Funds
between 20 and 30 percent, compared with approximately
10 percent prior to the financial crisis. As of December 2008, Sponsored funds are revisiting the adequacy of their
improvements in such ratios were attributed to maturing liquidity buffers to protect against extreme tail
events; while such events were not typical before the
assets, new reinvestment business, and, in certain cases,
crisis, several firms were incorporating into their
sponsor support, and less to successful asset sales. Going
contingency funding plans support for MMMFs
forward, some firms are targeting higher overnight liquidity and/or conducting some form of stress testing by
ratios, in the range of 30 to 50 percent of the funds asset value. the September-October 2008 period.
Several sponsoring firms said they revised their assumptions
Greater Counterparty Focus
about the reliability of funding from MMMFs in an extreme
Beneficial owners and agent lenders were much more focused
scenario. Several firms said they focused on the level of
on counterparty risk and daylight exposures than they were
liquidity in their funds, and several sources improved their
before the crisis. Some agent lenders noted the importance contingency planning. The MMMF crisis underscored
of diversifying counterparties for the purposes of their own the need for greater consideration of leading practices in
transactions. investment management appropriate for funds with a stable
Agent lenders said their existing credit concentration limits net asset value (NAV).15 Events during the crisis also
have generally not been faulted for significant losses in reinforced the importance of transparency to investors on
reinvestment funds. However, dramatic reductions in the the composition of portfolio holdings, particularly if firms
size of firms reinvestment books resulted in larger counter- are promising shareholders a stable NAV.
party exposures exceeding issuer concentration limits in the
aftermath of the crisis. As a result, fund managers were unable
14
A vertical slice is the pro-rata portion of the funds holdings received by
an investor.
to purchase additional investments involving exposure to these 15
Under paragraph (c)(7)(ii) of SEC Rule 2a-7, the firms board must adopt (and
counterparties. periodically review) written procedures requiring the fund to calculate the extent
of any deviation between the funds NAV, determined by reference to the
Controls over Commingled Accounts amortized cost, and the market value of the portfolio at such intervals as the
board of directors determines appropriate and reasonable in light of current
Agent lenders reported strengthened controls over market conditions. If the deviation exceeds 50 basis points, the board shall
commingled reinvestment funds because of risks that surfaced promptly consider what action, if any it should take. (Under Rule 2a-7(c)(1),
a money market fund is able to rely on the amortized cost method of valuation
in 2008. Commingled funds tended to have higher targeted
only as long as the board believes it fairly reflects the market-based NAV.) The
liquidity levels, for example, approximately 50 percent of total 50 basis point threshold is a trigger for when the board must get involved; it does
net assets at one firm with significant commingled accounts. not require the board to take any particular action.
18
Adequacy of Liquidity Buffers liquidity demands on their business lines and on the
One large sponsor noted that liquidity in its MMMFs tended consolidated firm.
to be approximately 10 percent of total net assets prior to the
crisis and was subsequently raised to 25 to 35 percent. This Proposed Regulatory Reform
move appeared consistent with the broader trend among funds Several amendments to Rule 2a-7 and related rules governing
to improve their liquidity profiles. money market funds are being considered in the United States.
These changes are designed to enhance the resilience of funds to
Contingency Planning withstand short-term market turbulence and to provide greater
A few firms did incorporate fund support into their protection for investors. The amendments would require funds
contingency funding plans (CFPs) before the crisis. Others to maintain a portion of their portfolios in instruments that can
had little or no reference to fund support in their CFPs be readily converted into cash, to reduce exposure to long-term
prior to the September-October 2008 period. Regardless debt, and to limit investments to the highest quality securities.
of prior approach, sponsoring firms did not anticipate the The modifications under consideration would also permit funds
franchise and reputational risks associated with the run on that have broken the buck to suspend redemptions to allow
MMMFs, and were generally unprepared for the extent of for the orderly liquidation of fund assets.
19
IV. SUPERVISORY EVALUATION OF SELF-ASSESSMENTS AND CRITICAL AREAS

FOR CONTINUED FIRM IMPROVEMENTS
A. Background on Self-Assessment Exercise B. Overview of Results

Twenty firms were asked to benchmark their Firms overall consider themselves well aligned
practices to industry standards. with recommendations and observations, although
In November 2008, supervisors asked twenty major global to varying degrees across the set.
financial firms to conduct self-assessments of their current risk Supervisors see more extensive gaps that still need
management practices. Supervisors asked firms to benchmark to be closed.
their practices against the recommendations and observations Supervisors found that many of the firms submitted thoughtful
of five industry and supervisory studies published in 2008.16 and substantive responses to the self-assessment exercise, but
Taken together, these studies identified a wide range of supervisors did not always agree with the firms conclusions.
1) risk management control weaknesses that contributed Participating firms in aggregate were considerably more
considerably to reducing firms financial resilience during the favorable in assessing their alignment with recommendations
ongoing financial crisis and 2) risk management practices and observations than were their supervisors. Some of the
believed to have enhanced firms abilities to withstand future differences arose because firms were giving themselves full credit
market turbulence. for enhancements planned or only partially completed. While
As instructed, the firms completed the self-assessments, supervisors acknowledge some progress over the last twelve
presented the findings to their boards of directors, and months since the crisis began, they see a clear need for broad-
submitted the self-assessments to their primary supervisors scale further remediation and believe that firms have to take
during the first quarter of 2009.17 Supervisors reviewed, significant additional action to institutionalize the recent
aggregated, analyzed, and discussed the results. Senior changes that have been made. Supervisory views were generally
Supervisors Group member agencies subsequently more critical than those of the firms on the current state of
participated in interviews to discuss the lessons that firms board and senior management oversight, articulation of risk
learned from the crisis and the changes made to their risk appetite, incentives, controls, and IT infrastructure. These
management practices since the issuance of the first SSG issues are discussed in detail below.
report in March 2008. Notably, and commendably, a few
firms had already conducted self-assessments against several 1. Practices Assessed by Firms as Most
of these industry reports prior to the supervisory request. Aligned with Recommendations
The observations in this report represent the collective
Firms rated their practices regarding governance and certain
view of the SSG. This collective view is based on the SSGs
aspects of liquidity monitoring and planning as those that
evaluation of the self-assessment submissions, bilateral
were most aligned with recommendations (Table 1). Notably,
supervisory discussions with the firms, and fifteen collective
firms determined that they have made the most progress
supervisory interviews conducted with a sample of the firms
on governance and liquidity topics. These areas may have
that completed the self-assessments.18
received the most attention because of the leading roles they
played in earlier events. Many of the changes cited by firms
represent low-hanging fruit that could be made quickly
without substantial investments in new infrastructure.
16
See footnote 1 for a list of the studies. 18
It is important to note that the observations reported here are based on the
17
The SSG compiled the recommendations and observations of these reports firms submissions. The supervisors did not validate these submissions and, at
in a suggested template. The recommendations and observations were times, had views that differed from an individual firms assertions. Some firms
organized by theme and clustered according to subthemes to create thirty-two may have held themselves to a higher or lower standard than their peers in
assessment topics. For each assessment topic, firms were asked to review the list assessing the state of their controls. Nevertheless, the SSG members believe
of recommendations and observations and indicate if the firms practices were that, in aggregate, the relative order of alignment of firm practices with specific
fully, partially, or not aligned with them. A copy of the template is included in topics that emerged from the self-assessment exercise was broadly
the supplement to this report. representative of the state of industry practice.
20
Table 1
Assessment Topics with Which Firms Consider Themselves Most Aligned*
Number of Firms
Assessment Topic Fully Aligned Partially Aligned Not Aligned NA/NR
Governance: Roles and responsibilities 20 0 0 0
Governance: Policies 20 0 0 0
Governance: Internal coordination and communication 20 0 0 0
Governance: Risk committee 19 1 0 0
Disclosure and transparency: Risk disclosure
and transparency 16 3 0 1
Governance: Role of the chief risk officer 16 2 0 2
Liquidity risk: Monitoring and planning 18 2 0 0
Liquidity risk: Funding and reserve management 17 3 0 0
*Firms assessed their risk management practices as being fully aligned with (assigned a 3), partially aligned with (2), not aligned with (1), or not
applicable to (NA) the individual recommendations and observations underlying each assessment topic. NR indicates no response. Firms overall
alignment with each assessment topic is based on an average of their alignment with the individual recommendations and observations. In total,
the self-assessment template included 188 recommendations and observations and 32 assessment topics.
Table 2
Assessment Topics with Which Firms Consider Themselves Least Aligned*
Number of Firms
Identification and measurement: Monitoring 6 12 1 1
Liquidity risk: Transfer pricing 7 13 0 0
Counterparty risk: Risk monitoring and mitigation 9 11 0 0
Counterparty risk: Close-out practices 7 13 0 0
Identification and measurement: Concentration risk 7 13 0 0
Stress testing: Scope of scenarios 7 13 0 0
Identification and measurement: New products 7 11 1 1
Stress testing: Governance 10 9 0 1
applicable to (NA) the individual recommendations and observations underlying each assessment topic. NR indicates no response. Firms overall
alignment with each assessment topic is based on an average of their alignment with the individual recommendations and observations. In total,
the self-assessment template included 188 recommendations and observations and 32 assessment topics.
2. Practices Assessed by Firms as Least associated with closing the gaps as more critical and difficult
Aligned with Recommendations than do the firms, in aggregate, and note that resolution of
Firms rated their practices associated with identification each of these areas will likely require substantial investments
and measurement of risk, transfer pricing, counterparty in technological infrastructure. Failure to address these
monitoring, and stress testing as those that were least aligned weaknesses will potentially undermine the effectiveness of
with recommendations (Table 2). The supervisors agree with practices viewed as aligned with the recommendations.
this assessment. Supervisors, however, view the challenges
21
C. Areas for Continued Improvement stress testing, and credit and counterparty risk management,
Ten critical areas of needed improvement that are broadly can also be attributed to the weak condition of many firms
relevant across firms emerged from the self-assessment results IT infrastructure. While considered central to sound firm
and interviews. Supervisors believe that considerable work governance and risk management, the areas of continued
remains in these areas, encompassing governance, incentives, improvement addressed here are not exhaustive. Firms and
internal controls, and infrastructure. The absence of action in supervisors have identified a broad range of remediation needs
some critical areas, such as the alignment of incentives and in addition to these areas, many of which are addressed in the
infrastructure-related matters, should raise questions for SSGs first report. Additionally, the relevance and priority
boards of directors, senior managers, and supervisors about the of improvement needs noted below may differ across
effectiveness and sustainability of recent changes. Supervisors institutions.
will critically evaluate the progress on these and other issues.
Firms have reported progress in their alignment with 1. Board Direction and Senior
some industry standards related to areas explored below, Management Oversight
such as those associated with corporate governance and with Firms are generally undertaking adjustments to
liquidity planning and monitoring. The SSG believes that increase board and executive engagement and to
some of the noted adjustments, such as modifications of strengthen the resources, stature, and authority of
reporting lines or expanded metrics in liquidity reports, risk management; however, it is not yet clear whether
may represent less time- and resource-intensive actions, these changes have contributed to stronger
or low-hanging fruit. Such changes must be ingrained governance.
in firm culture and must be validated by boards, Although firms reported that they had been operating for
senior management, auditors, and supervisors as to their some time with a relatively high level of alignment with
effectiveness in bringing about desired results. existing industry and supervisory expectations on governance,
In key areas explored, supervisors remain unconvinced that many have recently undertaken significant changes related to:
firms are undertaking the full scope and depth of needed
increasing board and senior management engagement
improvements, irrespective of the self-assessment results.
in risk management;
Further, if left unaddressed, certain gaps could potentially
undermine the effectiveness of progress already made. For improving risk reporting to the board and senior
example, the postponement of needed IT infrastructure management;
investment may limit firms ability to bring about meaningful strengthening committee charters and the role of
change in liquidity planning and monitoring, including the auditors and risk managers, including the chief risk
timeliness and comprehensiveness of MIS reports, and firms officers membership on management committees; and
ability to develop a centralized, aggregated view of their incorporating finance into the risk management
liquidity needs. More broadly, weaknesses in risk capture processes.
and misaligned incentives have the potential to limit the
effectiveness of oversight and controls, particularly those Many changes that firms have undertaken are
associated with recent enhancements to practices. organizational and appear to have been relatively easy to
Closing some of the acknowledged gaps, particularly those implement. Less clear is whether these organizational changes
associated with infrastructure, is a resource- and time- willwithout further effortimprove future governance
intensive process. Continued oversight by supervisors and practices.
concerted discipline and commitment by firms will be While firms reported alignment with recommendations on
required to undertake the needed investments and the need for boards of directors to have technical expertise
adjustments to practices. sufficient to understand risk management issues, the
Some of the highlighted areas of greatest need, such as assessments provided little supporting information. Only a
board and management oversight, articulation of risk appetite, few firms offered clear evidence of improvements in their
and compensation practices, are potentially a result of the board members financial or more specific banking business
aforementioned imbalance between the stature and resources expertise, primarily noting recent appointments of new board
allocated to firms revenue-generating businesses and those members with such relevant knowledge. Several firms also
afforded to the reporting and control functions. Other areas, discussed recent efforts to train board members to better
such as risk aggregation and concentration identification, understand complex risks through orientation, seminars,
22
individual tutorials, modules, or the engagement of third boards of directors reportedly approve risk appetites and
parties. strategies as articulated by management, most firms did not
Firms said they grappled with increased expectations for present much evidence of active board involvement in
boards of directors. Several firms acknowledged that the overseeing the setting or monitoring of the companys risk
increased accountability and expectations of board members appetite or of board understanding of the firms current risk
are inconsistent with the historical depth of their interaction position relative to its risk appetite. In several cases, firms
with the firm. Because of the greater demands on people admitted a disparity between the risks that the firm took and
assuming this role, some firms are concerned that those that the board perceived it to be taking. Many firms
knowledgeable and competent executives may be deterred indicated that they are in the process of revamping the way
from becoming board members. Several firms also suggested information is presented to their boards.
that the expanded expectations of board members appear Firms said they were expanding the range of metrics for
increasingly to overlap with responsibilities assigned to firm measuring risk appetite. Several firms that had previously
management. calibrated limits to capital metrics were now focusing more on
Firms indicated that they are reviewing closely the processes the level of quarterly earnings. Conversely, other firms were
by which chief executives, other senior officers, and the board now paying more attention to tail risks. These additional
of directors engage in risk management. Some firms are areas of focus, as well as the intense market interest in financial
observing increased rigor and sophistication in the dialogue institutions risk profiles since the onset of the crisis,
taking place at senior levels about risk management practices. underscore the need for firms to apply multiple measures
Virtually all firms have strengthened their risk management of risk appetite, to develop a range of perspectives, and to
functions. Having gained a better understanding of the costs consider a broad distribution of possible outcomes. These
of failure, boards of directors and senior managers have changes also suggest a need for firms to consider further what
given their risk management functions greater resources, management actions are realistically feasible for restoring
independence, authority, and influence.
capital or reducing risk in adverse environments.
Organizational changes have focused on strengthening
Many firms acknowledged that a conditional value-at-risk
the chief risk officer position, with the introduction of more
measure, using historical volatilities and correlations over
independent reporting lines, greater stature and authority on
a short period, does not generate the extreme outcomes
management and other committees, and, at a number of firms,
necessary for the estimation and allocation of capital. Most
direct involvement in business line compensation decisions.
firms are reviewing their use of economic capital risk
At most firms, risk management personnel assigned to
measurement models in the wake of the crisis as well as
business lines now formally report to the firms chief risk
expanding their use of these models. At least one firm said
officer and, in many cases, retain a weaker, dotted-line
it has increased its internal charges on trading assets relative
reporting responsibility with the business line executive. A few
to the same position held on the banking book.
outlier firms, however, have yet to sever the joint reporting
Supervisors view board direction as critical to sustaining
lines of risk management personnel to both the business line
a disciplined risk appetite for the firm when faced with market
and the independent risk management function.
demands for increased risk taking. While the industry has
not settled on a common way of expressing risk appetite,
2. Articulating Risk Appetite
supervisors do see particular opportunities for needed
Supervisors see insufficient evidence of board improvement, which firms have undertaken to varying
involvement in setting and monitoring adherence degrees:
to firms risk appetite.
firms rarely compile for their boards and senior
Risk appetite statements are generally not management relevant measures of risk (for example,
sufficiently robust; such statements rarely reflect a based on economic capital or stress tests), a view of
suitably wide range of measures and lack actionable how risk levels compare with limits, the level of capital
elements that clearly articulate firms intended that the firm would need to maintain after sustaining
responses to losses of capital and breaches in limits. a loss of the magnitude of the risk measure, and the
Most firms acknowledged some need for improvement in their actions that management could take to restore capital
procedures for setting and monitoring risk appetite. While after sustaining a loss;
23
few boards are willing to address risk appetite in a need for change. These firms cited industry competition for
manner that not only clearly articulates individual risk talent as an obstacle to change. They believed that modifying
limits but expresses the sum total of these limits as an compensation practices to be more conservative would lead
overall risk appetite for the firm; to competitive disadvantages.
firms risk appetite statements often lack actionable All firms, however, felt that compensation incentives
elements that reflect their intended response to a range needed to be reconsidered as part of the firms control
of possible events, such as a loss of capital or a breach framework. Firms appeared to be exploring changes to all
of limits; components of their compensation regimes: the accrual of
bonus pools, allocation of pools to business units and
few firms present their boards with a dynamic, or
flow, view of the capital account that details the individuals, and the form of compensation paid out, with
sources of capital generation as well as the proposed a goal of better aligning practices with control objectives.
uses of capital. Some frequently noted issues were:
Historical compensation arrangements were generally
3. Compensation Practices not sensitive to risk and skewed incentives to
Most firms recognize that past compensation maximize revenues. Firms generally acknowledged,
practices were driven by the need to attract and and supervisors agreed, that compensation practices
retain staff and were often not integrated within have been insensitive to the levels of risk taken to
firms control environments. generate income and to costs associated with the
long-term commitment of funds required to hold
Firms note the need to align better compensation illiquid assets. Firms largely acknowledged that
with the risk appetite and are considering initial current compensation practices, or those in place prior
steps in this direction. to the crisis, created strong incentives to maximize
Supervisors are concerned about the durability revenues rather than risk-, capital-, and liquidity-
of proposed changes. adjusted earnings.
Most firms recognized the need to improve incentive and Accrual of compensation pools historically did not
compensation policies. Many indicated in self-assessments and reflect all appropriate costs. In many cases, industry
subsequent interviews that they were working toward that goal. practice previously defined the pool of funds available
For example, one firm determined that there was a lack of for distribution as incentive compensation in any year
to be a simple percentage accrual of net revenues,
corporate oversight of compensation plans. Upon review, the
excluding many expenses and the costs of liquidity and
firm found that it had more than 150 different plans, and set
capital. Several firms indicated that aggregate incentive
a goal of substantially reducing this number. This firms risk
compensation pools will no longer represent a simple
management function reviewed all of its compensation accrual of top-line revenues but instead will be a
programs and found that incentives were in some cases function of the bottom-line return on risk the firm
misaligned, with no adequate deferral or claw-back arrange- achieves. Others indicated that they would now base
ments. (The claw-back is an explicit statement by management the aggregate pool on profit and use net income, rather
that some portion of deferred compensation granted may be than net revenue, for accruals.
withdrawn prior to vesting, at the discretion of management.)
Individual performance measurement schemes have
Firms undertaking these changes suggested that the
often not reflected true economic profits, adjusted
incentives created by industry compensation practices were for known costs and uncertainty. At many firms,
key contributors to the failure to ensure that the risk taken was performance measurement schemes used to distribute
properly controlled. In addition, they said compensation the bonus pool did not incorporate the costs of the
practices were inconsistent with the earning power and capital capital and liquidity employed in the generation
of the business and that competition to retain people led to of revenue. Moreover, revenues contributing to
some of this inconsistency. performance measurement schemes were often
Other firms, particularly a few that have fared specifically constructed by management and, in some
comparatively well over the last two years, remained relatively cases, excluded material risks to the firm. In other
comfortable with their compensation practices and saw little cases, future potential revenues whose realization
24
remained highly uncertain were incorporated into Firms are constrained in their ability to effectively
current-year performance income. aggregate and monitor exposures across counter-
parties, businesses, risk strands, and other
As a result, firms are considering changes to their practices: dimensions because of ineffective information
Recognizing these weaknesses, most firms that had not technology and supporting infrastructure.
integrated performance measurement schemes with the Many firms, in their self-assessment submissions and in
costs of liquidity and capital were now implementing subsequent discussions, said they are making considerable
these practices. Firms said they were developing the investments in risk management infrastructure. Many
transfer pricing mechanisms to ensure that internal projects, however, are in the planning stages or in the infancy
performance measurement schemes included both the of execution, with significant work remaining.
cost of capital employed in the generation of revenues One challenge to improving risk management systems has
and the cost of funds consistent with the liquidity of
been poor integration resulting from multiple mergers and
the positions funded. Liquidity surcharges based on the
acquisitions. One firm suggested that acquisitions over the
characteristics of positions funded were to be added
years have produced an environment in which static data
to the transfer-priced cost of funds.
are largely disaggregated. Another firm echoed this view,
Some firms found that performance evaluations lacked reporting that certain products and lines of business have
the input of control functions, a practice that the firms not been included in data aggregation and analysis processes.
are now looking to change. The chief risk officer is now A third firm reported that having two systems for the same
involved directly in business-line compensation business results in duplication of processes.
decisions at a number of firms. Additionally, certain
Another critical infrastructure concern during recent
firms are now engaging risk or compliance personnel
market events was the ability of firms to process record-high
in compensation decisions at the sub-business level.
volumes of product transactions during periods of market
Deferred compensation plans are being reviewed stress. Transactions in equities, foreign exchange, government
by firms with an eye toward longer vesting and securities, and other instruments spiked sharply during the
distribution periods, although views on the market disruption, taxing some firms systems. Proactive firms
effectiveness of deferred compensation measures varied. are responding to this challenge by adding capacity to key
Some firms were exploring extending the length of the system platforms to ensure that they can process volumes
deferral beyond the conventional two-to-three-year
well in excess of previous peak levels.
period. One firm stated that executive compensation
should have a deferral component that mimics the tail
risk assumed by the firm. However, some firms felt that
5. Risk Aggregation and Concentration
the deferred vesting and delivery of some portion of Identification
compensation in the form of restricted stock or stock Self-assessment responses suggest that identification
options has had little impact on individual bankers of risk concentrations is an area of weakness;
and traders beyond motivating retention. firms are looking to automate identification of
Several firms have attempted to align compensation concentrations by counterparty, product, geography,
with longer term performance by implementing a and other classes.
claw-back provision in deferred compensation as a Data aggregation remained a central issue limiting firms risk
standard part of their compensation practices. Where management capabilities, most notably in the management of
claw-back provisions existed in the past, they were CCR. Many firms lacked the ability to aggregate exposures,
typically very limited, that is, to cases of material particularly gross and net exposures to institutional
misstatement or illegal activities. Firms considering counterparties, in a matter of hours. This challenge includes
expanded use of claw-backs are working to develop the aggregation of exposures at the legal entity level. A number
standards for when a claw-back may be invoked. of firms also experienced difficulties integrating credit and
market risks at the enterprise level and evaluating the two
4. Information Technology Infrastructure jointly in a consistent manner. Fragmented infrastructure and
The importance of a resilient IT environment with an overreliance on manual data compilation were among the
sufficient processing capacity in periods of stress is factors impairing firms ability in this regard. In addition,
becoming increasingly evident. firms noted off-line trades that were not captured
25
in the main exposure model, but that represented a participants noted significant efforts under way to develop
disproportionately large percentage of their overall measured such tests. However, much of the progress to date appeared
CCR exposure. Excluding these add-ons diminishes the to be short-term and tactical in response to increased interest
reliability of aggregate measures. on the part of management and requests from firms boards
One firm noted that it had the ability to aggregate data to to conduct specific scenarios, as opposed to progress that is
a single large counterparty within a day; however, during some strategic and forward-looking.
periods in fall 2008, information was needed on a dozen or While more firms now perform stress tests based on
more counterparties that were of concern. Two-thirds of firms hypothetical scenarios, many others still do not have the
indicated that they were only partially aligned with regard necessary infrastructure to allow them to develop easily and
to the capacity to estimate asset class concentrations and consider forward-looking scenarios, representing a significant
institutional counterparty exposures within hours. weakness for the industry as a whole. Even when forward-
Two-thirds of firms responded that they were only partially looking stress tests are conducted, the process is resource-
aligned with the recommendations that credit risks be viewed intensive, owing to infrastructure limitations. Reverse stress
in aggregate, that consideration be given to the effects of testing, a forward-looking approach advocated in CRMPGIII
correlations between exposures, and that counterparty risk (p. 84),19 was reported to still be in its infancy; only two firms
consider the size and direction of positions a counterparty has indicated that they run a reverse stress test designed to identify
with other firms. Many firms cited large-scale IT projects scenarios or risk factors that can cause a significant stress event
planned or under way to address these infrastructure and for the firm or business line.
aggregation deficiencies. In the past, many such projects have Firms repeatedly cited credibility as the primary criterion
fallen behind schedule because of inadequate investment and for stress and scenario analysis to influence management
behavior, even after the events of September-October 2008.
resources. In the current environment, these projects will
For this reason, the most common stress tests conducted have
require a significant dedication of funds, sponsorship, and
generally been those subjecting trading or credit accounts
commitment from the board and senior management during
to extreme historic events. Still, some firms are relying
challenging economic times to ensure that technology
increasingly on research and economic teams to forecast events
platforms are constructed to handle unexpected spikes in
that risk teams can then simulate.
volumes and to effectively produce aggregated data and
appropriate management information for credit, liquidity,
7. Counterparty Risk Management
market, and other risk metrics.
Flexibility in some firms CCR management systems
6. Stress Testing proved particularly valuable; in contrast, the
inability of other firms CCR systems to identify
Firms report enhancements to and increased use of directional risk drivers limited these institutions
stress testing to convey risk to senior management responsiveness to sharp changes in exposures.
and boards, although significant gaps remain in their
ability to conduct firm-wide tests; credibility of The range of significant counterparty concerns during the
extreme scenarios, despite recent events, remains financial crisis illustrates the value of flexible risk systems that
an issue for some firms. permit firms to drill down and understand how their
exposures would react as market conditions change. The
Firms reported that they have been developing and flexibility and drill-down capabilities of models and systems
implementing more robust stress-testing regimes and are facilitate a nuanced understanding of specific risk drivers
placing a greater reliance on these tools. In contrast to the past, within particular exposures. In addition to risk monitoring,
firms now report significant management buy-in to these capabilities enable firms to more effectively determine
enhancements. According to the self-assessment results, most desired changes to their hedging in response to changes in risk
firms made some improvement in the frequency, flexibility, exposure. Of note, firms that had well-developed systems in
and number of scenarios and risk types in their stress testing place were able to hedge or flatten risk proactively and were
as well as increased their senior managements involvement able to react quickly to sharp changes in exposures.
in stress-testing programs.
Nevertheless, interviews confirm that most respondents
19
still do not have regular, robust, firm-wide stress tests. Many See <http://www.crmpolicygroup.org/docs/CRMPG-III.pdf>.
26
Firms still focus on current and potential exposure as the the same price. Multiple systems and valuation models with
primary measures of CCR but, because of the crisis, they have differing pricing sources for the same product set were
been investing more heavily in counterparty stress-testing obstacles to achieving consistency, according to firms.
capabilities. The integration of stress testing as a meaningful Some firms cited issues in ensuring that price-sensitivity
concentration management tool will continue to be a focus analysis was performed consistently and formally across all
going forward. In addition, some firms are developing other financial instruments. Several firms acknowledged that they
measures of risk to complement potential exposure measures did not devote sufficient analytical resources to checking
and stress testing, but these efforts are still nascent and in some valuations and making adjustments during periods of low
cases informal. Many firms recognize that potential exposure liquidity and to establishing a specialized financial control
and stress-testing measures are not designed to capture all staff to perform fundamental analysis of underlying positions
forms of counterparty credit risk. In response, they place and to enforce discipline internally in marking their assets to
value on utilizing additional risk analysis, such as crowded their established prices.
trade analysis, wrong-way risk identification, jump-to- One firm has increased the rigor of its profit-and-loss
default loss estimations, and credit valuation adjustment explanation process. Risk management must now explain the
sensitivities. profit and loss to senior management, complementing the
traditional controllers explanation. This firm stated that risk
8. Valuation Practices and Loss Recognition managers have a different perspective than that of controllers
The loss of confidence among creditors, counter- and can better tie profit and loss to risk positions.
parties, and clients in firms valuation practices Based on the interviews, firms gained a new appreciation
for certain assets during the crisis contributed for the importance of timely recognition of losses. A lesson
directly to the withdrawal of funding and other learned by some firms was to maintain and adhere as much
liquidity drains on firms in varying forms. as possible to asset disposal schedules, even if at less
desirable prices, in order to reduce the likelihood of much
Many firms are reviewing the oversight of their
larger losses.
valuation function and working to increase the rigor
of processes associated with, for example, enforcing
uniform pricing across the firm, valuing models,
9. Operations and Market Infrastructure
and escalating valuation disputes; nonetheless, Firms are making substantial progress standardizing
substantial work remains for firms to adhere to practices, reducing backlogs of unconfirmed OTC
industry standards for valuation practices. derivatives positions, and improving collateral
From a risk management and governance perspective, the management techniques.
finance department plays an essential corporate control role Notwithstanding the significant efforts by firms
in underpinning the effectiveness of valuation practices and to mitigate risk, work remains to improve key
robust loss recognition. Several firms expressed agreement that personnels detailed knowledge of financial market
the finance department, and the areas responsible for carrying utilities and communication with settlement
out key valuation processes, must be independent and infrastructure providers.
maintain sufficient stature and influence in the firm. For Many firms expressed a better appreciation for the
example, several firms noted that if there is a difference in operations and risk-reduction benefits provided by the
views between control and business personnel over a valuation financial market utilities. In light of the importance of
in the absence of a clearly established, market-based price, payment and settlement, chief risk officers and other key
escalation processes must be clear and the control functions decision-makers were working to refresh their knowledge of
view must ultimately prevail. utilities such that, when institutions are informed of time-
Based on the self-assessment results, most firms did sensitive issues, they have a baseline understanding of the
have some mechanisms in place to enforce uniform pricing systems in question. A few firms stated that front-office and
across legal entities and to decrease material valuation risk management personnel lacked sufficiently detailed
inconsistencies, yet some firms were uncertain that the same knowledge of the processes of financial market utilities and
instrument held by different business units was marked at that the firms were working to establish awareness at the staff
27
and senior executive levels. Overall, firms cited the treasury, liquidity risk management, and related functions,
importance of effective communication between firms and and to enhance liquidity reporting and other forms of
settlement infrastructure providers. communication for the entire firm. Funds transfer pricing
In OTC derivatives, firms reported progress streamlining processes and many aspects of contingency planning are being
business processes toward the goal of same-day matching, enhanced. It is important to note that no firms contingency
adoption, and implementation of standard technology plan proved fully effective during the crisis. Among a range
platforms as well as improving collateral management of issues, firms found that stress scenarios should overlay
practices and reducing notional amounts of outstanding CDS firm-specific shocks with systemic shocks. Firms also learned
transactions through portfolio compression. that complex corporate structures, by constraining the flow
On a positive note, as the SSG has previously reported, of funds between legal entities, hindered their ability to
the processes around the resolution of Lehmans OTC effectively manage firm-wide funding needs during the crisis.
derivatives book were far less disruptive than regulators Section III provides an elaborate discussion of firms reported
and market participants had feared. Substantial industry enhancements to funding and liquidity risk management
efforts to standardize practices and reduce backlogs of practices as a result of lessons from the crisis.
unconfirmed positions appear to have significantly Some of the changes that firms have made are among the
mitigated a substantial risk. Out of the approximately more easily achievable enhancements, such as organizational
efforts to improve the coordination and interaction between
900,000 Lehman OTC derivatives transactions, only a very
the treasury function, the risk management function, and the
few have been disputed to date, an indication that efforts
business lines. The extent to which such changes are
to reduce unconfirmed trades have had a positive impact.
formalized into policies and proceduresand more
important, ingrained into the corporate culturewill
10. Liquidity Risk Management
determine their sustainability and effectiveness. Other
As a result of lessons from the crisis, firms are making structural changessuch as improvements to firms liquidity
meaningful progress improving funding and reports, collateral management practices, and funds transfer
liquidity risk management practices, but supervisors pricingare more resource- and time-intensive. Concerted
and some firms acknowledge that substantial work discipline and commitment on the part of boards of directors,
remains to align fully with industry standards. senior management, and supervisors will be required to
Almost all firms have sought to strengthen structures and undertake the IT infrastructure investments needed to support
processes to enhance firm-wide governance of liquidity. these changes and to continue to improve the robustness of
Firms have taken steps to improve the structure of their these liquidity risk management systems.
28
Appendix A
Self-Assessment: Firms Reported Degree of Alignment with Recommendations and Observations
of Industry and Supervisory Studies*
Number of Firms
Governance
Policies 20 0 0 0
Roles and responsibilities 20 0 0 0
Internal coordination and communication 20 0 0 0
Risk committee 19 1 0 0
Risk appetite 13 7 0 0
Incentives and compensation 14 4 0 2
Role of the chief risk officer 16 2 0 2
Resources 17 3 0 0
Identification and measurement
Scope and procedures 10 10 0 0
Metrics 13 7 0 0
Monitoring 6 12 1 1
New products 7 11 1 1
Concentration risk 7 13 0 0
Counterparty risk
Close-out practices 7 13 0 0
Risk monitoring and mitigation 9 11 0 0
Liquidity risk
Funding and reserve management 17 3 0 0
Monitoring and planning 18 2 0 0
Transfer pricing 7 13 0 0
Market risk
Valuations: Oversight, accountability, policies, and procedures 17 2 0 1
Valuations: Metrics and analysis 13 6 0 1
Trading patterns 12 4 0 4
Market infrastructure 10 7 0 3
Origination standards 15 3 0 2
Securitization and complex products
Appropriate investors 12 4 0 4
Documentation 9 6 0 5
Risk management 12 7 0 1
Stress testing
Scope of scenarios 7 13 0 0
Governance 10 9 0 1
Disclosure and transparency
Prospectus disclosure 8 4 0 8
Standardization and increased transparency 11 5 0 4
Risk disclosure and transparency 16 3 0 1
Valuations disclosure and transparency 12 4 1 3
applicable to (NA) the individual recommendations and observations underlying each assessment topic. NR indicates no response. Firms overall alignment
with each assessment topic is based on an average of their alignment with the individual recommendations and observations. In total, the self-assessment
template included 188 recommendations and observations and 32 assessment topics. The results reported here are based on the firms own assessments of
their risk management practices. Some firms may have held themselves to a higher or lower standard than their peers in assessing the state of their controls.
29
Appendix B
Members of the Senior Supervisors Group
CANADA UNITED KINGDOM

Office of the Superintendent of Financial Institutions Financial Services Authority
Kent Andrews Andy Murfin
Chris Elgar Nicholas Newland
Ted Price Simon Stockwell
Mark White
UNITED STATES
FRANCE Board of Governors of the Federal Reserve System
Banking Commission Mary Arnett
Didier Elbaum Jon D. Greenlee
Patrick Montagner
Guy Levy-Rueff Federal Reserve Bank of New York
Frdric Visnovsky Arthur G. Angulo
Brian L. Peters
William L. Rutledge (Chairman)
GERMANY Marc R. Saidenberg
Federal Financial Supervisory Authority
Claudia Grund Office of the Comptroller of the Currency
Ludger Hanenberg Mike Brosnan
Kathy E. Dick
Kurt Wilhelm
JAPAN
Financial Services Agency Securities and Exchange Commission
Tomoko Amaya Denise Landers
Toshiyuki Miyoshi Michael A. Macchiaroli
Yu Ozaki
Yasushi Shiina
SWITZERLAND
Financial Market Supervisory Authority
Tim Frech
Roland Goetschmann
Daniel Sigrist
Secretariat
Alexa Philo, Morgan Bushey, Brian Begalle, Jeanmarie Davis, Clinton Lively, and Jainaryan Sooklal,
all of the Federal Reserve Bank of New York, and Kerri Corn of the Office of the Comptroller of the Currency
30
Glossary
Term Definition*
2a-7 funds 2a-7 money market funds are U.S. open-end management investment companies that are
registered under the Investment Company Act and regulated under Rule 2a-7 under the Act.
Unlike other investment companies, 2a-7 funds are able to use the amortized cost method of
valuing their portfolio securities rather than mark-to-market valuation, which allows them to
maintain a stable net asset value, typically U.S. $1.00 per share.
Asset-backed commercial paper A short-term investment that encompasses the use of a special purpose vehicle or conduit;
the conduit serves as the commercial paper issuer. The commercial paper is backed by
physical assets such as homes, automobiles, or other physical property.
Bid-back request An investors request to a borrower to unwind a transaction earlier than contractually
agreed upon.
Break-the-buck A condition that occurs when a money market fund determines to discontinue the use of the
amortized cost method of valuing its portfolio securities and to reprice the funds shares below
$1.00 per share.
Claw-back A provision in a law or contract that limits or reverses a payment or distribution for
specified reasons.
Commingled funds In securities lending, commingled funds refer to a pooling of cash collateral from multiple
beneficial owners/lenders that is then used to purchase securities.
Contingency funding plan A comprehensive plan that financial institutions have in place to maintain sufficient liquidity
resources in a contingency scenario. Contingency funding plans typically include cash flow
projections that estimate funding needs under adverse conditions, and should present courses
of action for addressing unexpected short-, medium-, and long-term liquidity needs.
Credit default swap An agreement between two parties in which the seller provides protection to the buyer against
nonpayment of unsecured corporate or sovereign debt. The protected party pays an initial
or ongoing scheduled fee in exchange for a guarantee that, if a bond/loan goes into default,
the protection seller will provide compensation.
Credit valuation adjustment The mark-to-market estimate of the counterparty credit risk from a firms derivatives
exposures.
CUSIP number A number identifying all stocks and registered bonds, assigned by the Committee on Uniform
Securities Identification Procedures (CUSIP). Brokers use a securitys CUSIP number to obtain
further information on the security; the number is also listed on trade confirmation tickets.
The CUSIP system makes it easier to settle and clear trades. Foreign securities use a similar
identification system: the CUSIP International Numbering System, or CINS.
Daylight exposure Credit extended for a period of less than one day. In a credit transfer system with end-of-day
final settlement, daylight credit in effect is extended by a receiving institution if it accepts
and acts on a payment order even though it will not receive final funds until the end of
the business day.
Free credit balance The cash held by a broker in a customers margin account that can be withdrawn by the
customer at any time without restriction. This balance is calculated as the total remaining
money in a margin account after margin requirements, short-sale proceeds, and special
miscellaneous accounts are taken into consideration.
Funds transfer pricing An internal cost-accounting system or methodology that transfers a cost-of-funds expense
to profit centers that generate assets requiring funding and a funds credit to profit centers
that provide funding.
Haircut The percentage by which an assets fair market value is reduced for the purpose of calculating
lendable value/borrowing capacity.
Interbank deposit Any deposit held by one bank for another bank. In most cases, the bank for which the deposit
is held is known as the correspondent bank. The interbank deposit arrangement
requires both banks to hold a due to account for the other.
Net asset value An investment companys total assets minus its total liabilities.
*Based on publicly available and supervisory sources.
31
Glossary (Continued)
Term Definition*
Novation An agreement to replace one party to a contract with a new one. The novation transfers
rights as well as duties and requires the consent of both the original and new parties.
OTC derivatives market The over-the-counter, or OTC, market where derivatives transactions are executed directly
between two parties through a telephone or computer network, without use of an exchange.
A derivative is a financial contract (usually a bilateral contract) whose value is derived from
another asset, index, event, or condition.
Portfolio compression A market-wide exercise to reduce the gross notional outstanding and trade population by
eliminating offsetting trade positions within the same product types and across multiple
counterparties. Portfolio compression thus reduces the counterparty credit exposure and
operational risk attached to superfluous outstanding trade positions that offer no additional
economic benefits. Currently, credit and interest rate derivatives have regular cycles for
portfolio compression.
Prime brokerage A service offered by securities firms to hedge funds and other professional investors. Prime
brokerage may include execution/clearance of transactions, margin financing, centralized
custody, securities lending, and other administrative services such as risk reporting. The
growth of the hedge fund sector over the last decade was supported by concurrent growth
in the prime brokerage business of the investment banks that service these funds.
Rehypothecation A practice in which a prime broker can take control, and in some jurisdictions legal title,
over a clients assets, subject to an obligation to return the same or economically similar assets
at a future time. By taking legal title over the assets, the prime broker is free to utilize the assets
as it sees fit, including the sale of such assets or the pledging of them as security for amounts
borrowed from counterparties. In practice, rehypothecation rights are used by prime brokers
to obtain secured funding to finance margin loans provided to clients; however, such rights
also enable prime brokers to cross-fund other positions on a portfolio basis in certain
circumstances. The secured funding obtained through rehypothecation rights enables a
prime brokerage business to be largely self-financing, as loans to clients are funded through
rehypothecation of client assets.
Repurchase agreement An agreement between a seller and a buyer of securities in which the seller agrees to repurchase
the securities at an agreed-upon price, usually at a stated time.
Reverse stress test A stress test in which the starting point of the analysis is an assumption that over a short period
of time, an institution incurs a very large, multi-billion-dollar loss. The analysis then works
backward to identify how such a loss could occur given actual positions and exposures
prevailing when the stress test was conducted. If the assumed loss were truly large, it is
highly likely that the possible sequence of events producing the loss would entail elements
of contagion or systemic forces. Thus, the reverse stress test is likely to require institutions
to address issues that are not normally captured in stress tests.
Same-day matching A process that occurs when parties to an OTC derivatives trade obtain legal confirmation
of the transaction on the same day the trade is executed, also known as T+0 matching
or same-day confirmation. Same-day matching continues to be an operational efficiency
goal for the post-trade processing of OTC derivatives.
Triparty repo In a triparty repo model, a custodian bank helps to administer a repo (repurchase) agreement
between two parties. An investor places its money with a custodian bank, which in turn lends
it to another institution; assets are then pledged as collateral for the loan. The triparty agent
is responsible for administration of the transaction, including collateral allocation, marking
to market, and substitution of collateral. Both the lender and borrower of cash enter into
these transactions to avoid the administrative burden of bilateral repos.
Upgrade trade For less liquid securities financed on behalf of hedge fund clients, prime brokers may enter
into upgrade trades. In such a trade, the less liquid securities are exchanged with certain
stock lenders for more liquid securities that are then monetized by the prime broker through
repurchase arrangements.
Value-at-risk A measure of expected loss over a given time interval under normal market conditions
at a specified confidence level.
*Based on publicly available and supervisory sources.
32

SSG Report 2009

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Senior Supervisors Group

Risk Management Lessons from

III. FUNDING AND LIQUIDITY RISK MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

IV. SUPERVISORY EVALUATION OF SELF-ASSESSMENTS AND CRITICAL AREAS

APPENDIX A: SELF-ASSESSMENT: FIRMS REPORTED DEGREE OF ALIGNMENT

APPENDIX B: MEMBERS OF THE SENIOR SUPERVISORS GROUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

II. SUMMARY OF KEY OBSERVATIONS AND CONCLUSIONS

III. FUNDING AND LIQUIDITY RISK MANAGEMENT

IV. SUPERVISORY EVALUATION OF SELF-ASSESSMENTS AND CRITICAL AREAS

A. Background on Self-Assessment Exercise B. Overview of Results

CANADA UNITED KINGDOM

*Based on publicly available and supervisory sources.

*Based on publicly available and supervisory sources.

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