If You Read Only One 192-Page Report on the Financial System Today, Make It This One

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The Financial Stability Oversight Council, the Treasury-Fed-SEC-FDIC-etc.-etc. joint venture designated by Dodd-Frank to prevent another financial crisis, released its first annual report last night and can we just say that we love it?

The purpose of the report is to convery recommendations about where the regulators see systemic risk. Some are expected (bank capital and liquidity issues, derivatives clearing, high frequency trading, housing market stabilization), but there are also some things that have fallen out of headlines, like:

Rates carry trade. There's been a lot of talk about the Fed's zero-ish rates being a giveaway to banks who borrow short from the Fed, buy Treasuries, and clip the yield difference. This never made a lot of sense to us as a giveaway, but the FSOC does seem worried that the basic mechanics of it pose a systemic risk if long rates ever go up:

In light of a sustained, historically low interest rate environment, market participants should work to ensure that they have robust processes for measuring and, where necessary, mitigating their exposure to a range of interest rate scenarios. Preparedness to face unexpected rate changes or yield curve shifts will enable market participants to make a stable transition to a new rate environment, minimizing potential disruption to the system.

Credit underwriting. And not in subprime mortgages! Who knew, but the FSOC is no fan of covenant-light loans:

[T]here have been some indicators that credit underwriting standards might have overly eased in certain products, such as leveraged loans, reflecting the dynamics of competition among arranging bankers. Greater market discipline can be supported through robust due diligence practices and processes for monitoring and responding to developments in credit underwriting standards, including deal features that may allow borrowers to take on excessive risk.

Tri-party repo. The FSOC is actually pretty jazzed about the tri-party repo market that securities dealers use to fund their inventory, which makes sense as the inability to roll intraday funding was a big contributor to Lehman's demise:

Given the vital importance and size of tri-party repo financing and the broad array of financial institutions active in this market, the regulatory community should exert its supervisory authority over the industry’s reform efforts ... Chief among these priorities are enhancing dealer liquidity risk management practices, alleviating the propensity of cash investors to withdraw funding and exit the market when risk surfaces, and implementing mechanisms to manage a potential dealer default.

Money market fund stability. The FSOC is worried about runs on money market funds that might break the buck and wants, among other things, floating money market NAVs and "deterrents to redemption, paired with capital buffers, to mitigate investor runs." So, gates on money market funds?

So that's all good stuff for Congress to consider when they sort out the imaginary crisis they're working on now.

But what we really like are the next two sections of the report, "Macroeconomic Environment" and "Financial Developments," which are as good a summary as you're going to get of the last five years in our financial system - clearly written, as brief as possible, and utterly comprehensive. We expect this report to provide as much material for reflection in the days to come as say an oversharey Gary Cohn profile. Best of all are the charts, which touch on every aspect of our financial system and even come with Excel backup (see here). If you're a capital markets banking analyst and you're not revising your "economic conditions" pitchbook pages based on this thing, you're in the wrong line of work.

Here are just a couple of story lines to get you started:

1. You deserve a raise. Even accounting for the crisis, the financial sector contributes an increasing share of GDP even as it accounts for a decreasing share of payrolls (note differing timeframes/scales):

2. Banks vs. capital markets

There's a theory that a key competitive advantage of U.S.-style capitalism is that our companies get so much of their financing from public capital markets rather than banks. Here's what the FSOC has to say about that:

U.S. companies are overwhelmingly financed by capital markets and the share is growing over time:

Even our banks are increasingly financed by capital-markets-type financing (CP, repo) rather than traditional deposits:

Compared to other advanced economies, our biggest banks are relatively tiny, perhaps precisely because we rely so much on markets:

3. No one is entirely immune from crap i-bank-style graphics

Interconnectivity!

FSOC Annual Report (pdf)

Also: Watchdog Sees Financial Weak Spots [WSJ]

U.S. Systemic risk council recommendations [Reuters]

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