Summary: OFR 2020 Annual Report to Congress
With this report, the Office of Financial Research (OFR) presents its assessment of the state of the U.S. financial system, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). The 2020 Annual Report to Congress fulfills OFR’s requirement to submit a report to Congress within 120 days of the close of the fiscal year (FY). All data cited in this report are as of Sept. 30, 2020, unless otherwise noted.
This report also reflects the OFR’s duty to inform policymakers, regulators, market participants, and the American public about its work to monitor, investigate, and report on changes in systemwide financial stability risk levels and patterns. The OFR’s efforts support sound risk management for the entire financial system. For FY 2020, the report is organized into four main parts:
Assessing Financial Risks in a Turbulent Year
It has been a decade since the OFR was established and this report is presented during a time of financial and economic uncertainty that is a first for the Office. The OFR’s data, research, and monitoring expertise was well-utilized this year and played an important role in identifying and understanding how stresses within the U.S. financial system during March 2020 interacted with vulnerabilities identified in previous years. Government financial system interventions developed during the 2007-09 financial crisis proved instrumental in moderating the effects of this year’s financial turbulence.
The cause of this year’s financial instability is novel. Within months of the new year, it became clear that the COVID-19 pandemic would be global and trigger devastating health, economic, and financial effects. During March, the medical crisis prompted U.S. state and local government decisions to declare stay-at-home orders and order the shutdown of many businesses. The pandemic and efforts to contain the health threat drastically curtailed economic activity and severely stressed financial markets. On March 9, 12, and 16, the Dow Jones Industrial Average, for example, experienced some of the worst price downturns in its history.
The economy, and even more financial markets, quickly made substantial recoveries with the help of massive government support. The Federal Reserve’s balance sheet ballooned to $7 trillion, by far an all-time high and almost double its size from a year earlier, while federal debt held by the public rose to 95 percent of gross domestic product in FY 2020 from 79 percent in FY 2019.
As this report goes to press, America’s economy has climbed rapidly back from the short but steep COVID-19 recession. And while our economy retraces its way back to trends that characterized the pre-pandemic economy, it will contend with heightened uncertainty and heterogeneous effects across sectors and firms within sectors. Extraordinary government and monetary policy support has gone far to moderate damage to our economy. But while that support helped bridge a period of heightened economic turbulence, it could also risk distortions to competitive markets if maintained too long.
Assessing Financial Risks and Key Findings
The OFR’s financial stability assessment, combined with key findings from its financial system surveillance, evaluations of system vulnerabilities, data analysis, and research, supports its view that potential risks persist and remain elevated in most of the categories OFR monitors. These areas of risk include macroeconomic, credit, market, liquidity and funding, leverage, insolvency and potential contagion, cybersecurity, and additional risks not included in the other categories. The COVID-19 pandemic increased most, if not all, of these risks.
Despite government actions to stabilize the economy, as well as the finances of firms and households, macroeconomic and credit risks remain high. The pandemic’s course remains uncertain, and thus, so must the economic recovery. Leverage is high among nonfinancial firms, with the potential for severe defaults within the commercial real estate, energy, and high-touch service sectors.
Liquidity and funding risks moderated quickly after the Federal Reserve’s mid-March intervention announcements, while a midyear return to elevated risky-asset valuations heightened market risk. Leverage within the financial sector rose modestly while remaining constrained since the 2007-09 crisis. Insolvency and contagion risks for financial firms appear to be contained while these firms maintain high capital and liquidity buffers.
Cyber risks have continued to grow in volume and sophistication. New vulnerabilities could emerge from increased reliance on remote work, as well as automated systems that strain financial firms’ telecommunications capacity or that operate outside these firms’ control. Natural disasters, the United Kingdom’s exit from the European Union, and the transition from LIBOR to alternative reference rates for financial instruments, also remain potential sources of risk to financial stability.
Exploration of Information Markets
Traditional approaches to managing systemic risks rely to a considerable extent on regulation, capital requirements, and oversight. People who are charged with enacting these strategies, however, can face political forces that favor distributional preferences over more general opportunity. In addition, they may work at a considerable distance from local knowledge that can help gauge reliance of financiers on each other for funding, the concentration of asset holdings across financiers, and the likelihood that adverse news about one financier’s solvency can encourage runs on another’s liabilities. Top-down approaches to managing systemic risk may thus face tight and hard-to-move constraints against efficiently reducing the possibility, and mitigating the severity, of threats to financial stability.
A market for information about prospects for realizing systemic risks could weaken the incentive for creditors to run on financial organizations. Information markets might also be structured to better evaluate whether proposed or enacted policies and regulations can reduce systemic risks in a cost-effective manner. Finally, this latter type of market could increase transparency about winners and losers from such policies and regulations, and thus help more productive regulations overcome distributional inefficiencies.
The OFR’s Performance
OFR promotes financial stability by delivering high-quality financial data, standards, and analysis principally to support the Financial Stability Oversight Council (FSOC) and its members. This year the OFR published its FY2020-2024 Strategic Plan, which consists of two goals: 1) Support the Financial Stability Work of the FSOC and 2) Further Organizational Excellence. The plan is designed to accommodate the changing needs of the OFR’s stakeholders as they address financial vulnerabilities, stress, and even crises, as well as evolving financial business models.
Our performance measures and indicators provided a solid picture of OFR’s progress toward objectives, goals, and mission achievement this year. Highlights include international leadership in cross-border financial data standards and the innovation of several essential data products and initiatives. In 2020, the Legal Entity Identifier (LEI) reached its goal of global preeminence as a high-quality identifier for financial firms. The OFR served on the LEI’s Regulatory Oversight Committee (ROC), which continued to focus on the quality of data that underlies the LEI. This past year, the ROC took on the role of governance for a trio of new financial data standards: the Unique Transaction Identifier (UTI), the Unique Product Identifier (UPI), and the Critical Data Elements for over-the-counter derivatives reporting (CDE).
The OFR’s ability to equip the FSOC and its members with germane data collections, financial stability monitoring services, research insights, and analysis helped address the turbulence of 2020. Among the Office’s online public monitors, the Financial Stress Index (FSI) provided, and continues to produce, daily indicators of financial system stress.
The Office also expanded its monitor offerings in 2020. The U.S. Repo Markets Data Release and the Short-term Funding Monitor were launched during the fourth quarter. Together, they provide new insights into short-term funding, the core of liquidity and maturity transformation in financial markets. Also this year, the Bank Systemic Risk Monitor (BSRM) was upgraded and the Financial Instrument Reference Database (FIRD) entered its initial phase of development.
Years of migrating our Office’s information technology to the cloud, and furthering significant system advances, proved prescient in preparation for the pandemic. Throughout this period, employee engagement and productivity were exceptional, as our Office continued to advance operational excellence and superior teamwork.
The OFR obligated $62.69 million in FY 2020 42 percent for labor and 58 percent for other expenses. A large portion of the nonlabor figure was due to significant OFR expenses, particularly in the Technology Center ($23.4 million), which support the OFR’s unique mandates. Office staff totaled 107 as of Sept. 30, 2020.