ECONOMIC REPORT OF THE PRESIDENT

U.S. financial stability, subjecting each designated company to enhanced
prudential standards and supervision by the Federal Reserve. While any
financial institution that performs maturity transformation faces run-risk, in
traditional banking the risk is mitigated through the use of deposit insurance
and the Federal Reserve’s availability as a lender of last resort. On the other
hand, many non-bank financial institutions engage in financial intermediation
and therefore maturity and liquidity transformation, without explicit
public-sector guarantees, access to liquidity from the Federal Reserve, or
regulatory oversight.
Such non-bank financial institutions gather funds from those wishing
to invest, typically by issuing commercial paper, engaging in repurchase
agreements (repo), or issuing debt instruments.10 Money market mutual
funds (MMFs) or other types of investment funds, often purchase these
debt instruments on behalf of investors. Institutions engaged in such activities
include large securities dealers, finance companies, and asset managers
who use such funds to invest in other assets that have longer maturity, less
liquidity, or both.
As discussed above, the size of the shadow-banking sector grew much
faster than the traditional banking sector in the decade leading up to the
financial crisis. Following the crisis, the sector shrank to the level seen earlier
in the 2000s and continued to decrease in the following years. Two other
important components of the shadow-banking sector, repo and commercial
paper, grew rapidly in the years prior to the crisis before falling in the years
following the crisis and ensuing recession. Figure 6-13 shows the repo market
is well below its size in the years immediately preceding the crisis. As
Figure 6-14 shows, the commercial paper market has stabilized at a level well
below its peak in recent years. By adding additional oversight of the sector,
Dodd-Frank has reduced the likelihood of shadow-banking entities being
the source of financial instability.
As part of its mandate to identify risks to financial stability, in July
2013 the FSOC designated four non-bank firms as Non-Bank Systemically
Important Financial Institutions. These firms became subject to heightened
prudential requirements and supervision by the Federal Reserve Board.
This additional regulatory scrutiny, along with pressure from investors
and analysts, has led some firms to consider actions that will reduce their
10 A repurchase agreement, or repo, is a type of short-term loan where the “borrower” sells
securities to the “lender” with an agreement to buy them back at a future date at a slightly
higher price. This is similar to a collateralized loan except ownership of the collateral passes
between the borrower and lender. The difference in the selling price and the buyback price
represents the interest on the loan and is referred to as the ‘repo rate’.
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