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Regulation Amp Governance
Financial risks are rising, says watchdog
From the Financial Times of Tue, 02 Dec 2014 21:04:31 GMT

Risks to financial stability are on the rise after six years of exceptionally low interest rates, according to the US watchdog created to anticipate another crisis.

In its annual report to Congress, the Office of Financial Research said excessive risk-taking and evolution in financial markets – including less liquidity in bond markets and the growth of shadow banking – are creating new threats to stability.

The report shows how much financial markets have changed in the six years since the financial crisis, but also the limits of stability watchdogs, which struggle to turn long lists of vulnerabilities into clear-cut warnings.

“Threats to financial stability are moderate, our tools for spotting them are better, and the financial system in many ways is more resilient compared with just before the financial crisis,” said Richard Berner, director of the OFR.

“But as the financial system evolves and innovates, we must be especially watchful for important new vulnerabilities that are emerging in dynamic financial companies and markets.”

The OFR was created under the Dodd-Frank financial reform to fill gaps in financial data collection that left regulators flying blind during the 2007-09 crisis.

In a move likely to fuel the worries of big bond investors, who have expressed concerns about the health of credit markets in recent years, the OFR highlighted a number of risks currently facing the fixed-income world. Chief among these is the issue of declining liquidity, or ease of trading, in the bond market.

“The fragile nature of liquidity was especially evident during the sell-off in fixed-income markets in mid-2013 and during the market dislocations in September and October of 2014,” the OFR said in its report, referring to two episodes where a rush by investors to change positions helped spark significant turmoil in the markets.

As the financial system evolves and innovates, we must be especially watchful for important new vulnerabilities that are emerging in dynamic financial companies and markets

- Richard Berner, director of the Office of Financial Research

The OFR said it was particularly worried about certain structures – such as exchange traded funds – which invest in hard-to-trade assets but simultaneously promise investors instant liquidity with the click of a button.

For example, the OFR pointed to new exchange traded funds investing in bank loans, the managers of which might struggle to sell the underlying loans if investors wanted their money back. It is a classic example of “shadow banking”: the ETFs are taking short-term deposits and making longer-term loans.

The OFR also highlighted potential overheating in credit markets, where investors have been reaching for a number of new and exotic tools to help boost their yields following six years of ultra-low interest rates.

Such “product innovation” is a “hallmark of late-stage credit cycles,” the OFR said. “Recent issues have provided broader, cheaper access to credit such as exchange-traded, high-yield, and leveraged loan funds; total return swaps on leveraged loans; and synthetic collateralised debt obligations.”

The OFT pointed to several areas where activity is migrating to less scrutinised parts of the financial system: it flagged “captive reinsurers”, which are less-capitalised affiliates of insurers; mortgage servicers, which collect mortgage payments and could cause chaos if they failed; and securitisations of rental homes by investors.

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