FACTBOX-U.S. systemic risk council recommendations

WASHINGTON, July 26 (Reuters) - The council of U.S. regulators charged with combating threats to the financial system on Tuesday recommended more steps to bolster bank capital and strengthen key short-term financing and money markets.

The steps were released as part of the Financial Stability Oversight Council's first annual report. The panel led by the U.S. Treasury is required by the Dodd-Frank financial reform law to make annual suggestions to enhance market stability.

Following are highlights of their recommendations.

TRI-PARTY REPO MARKET

The council said most intraday credit exposure should be eliminated in this vast short-term funding market, which often requires a third-party clearing bank to temporarily put up cash to complete a transaction between another lender and borrower.

The $2.8 trillion tri-party repo market broke down during the financial crisis in 2008, acting as an "accelerant" to the market meltdown when investors frantically pulled liquidity out, according to Treasury officials. Although private sector market participants have been working on efforts to improve transparency and speed settlements, it remains vulnerable to future stress.

The FSOC report said that eliminating the intraday credit exposures and improving dealer liquidity risk management practices would help to reduce the propensity of cash investors to run for the exits when risk surfaces.

MONEY MARKET MUTUAL FUNDS

The Treasury intervened to halt a run on money market funds in 2008 with a now-expired guarantee program. Some concerns have resurfaced regarding funds' exposure to European banks that hold distressed government bonds. The FSOC report endorsed some Securities and Exchange Commission efforts to bolster confidence in money market mutual funds, and said it would examine other measures, including requiring funds to maintain a mandatory floating net asset value, capital buffers to absorb losses and maintain stable values, as well as deterrents to redemptions.

MORTGAGE SERVICING

The report recommended instituting national standards for mortgage servicers, which collect monthly mortgage payments and funnel the money to investors who own the loans or mortgage-backed securities. These standards should provide the same service quality regardless of whether the loans are being held on the originator's books, have been sold or have been securitized, it said. This would provide clarity that would help reestablish investor confidence in the mortgage housing finance market, which is now almost entirely supported by government guarantees.

The council also said the compensation structure for mortgage servicers, now based on flat fees, was flawed. It called on Department of Housing and Urban Development and the regulator for housing finance giants Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB) to study alternatives that give servicers better incentives to invest the time and effort to work with borrowers to avoid default or foreclosure.

HOUSING FINANCE

The FSOC recommended that regulators and Congress press on with the massive task of reforming the U.S. housing finance system to bring private capital back to the system. It made no specific recommendation on the central question of the U.S. housing finance debate -- what should be done with Fannie Mae and Freddie Mac, the two government-controlled entities that now provide more than 90 percent of mortgage funding.

"The reform efforts should not further destabilize the fragile housing market," the report said.

BANK CAPITAL, LIQUIDITY AND RESOLUTION

The council recommended that member regulators work with financial institutions to ensure robust planning processes for capital, liquidity, and their own demise should they fail -- central themes of the Dodd-Frank legislation. The largest financial institutions must make plans for how they would be wound down without any government assistance. "In addition the largest banks should plan further improvement in their capital levels and liquidity risk profiles to support funding models without any assumption of government assistance and their continued smooth transition to new global standards," the council said.

It also called on regulators and banks to maintain discipline in credit underwriting standards and properly price risk. Given the historically low interest rate environment, it also called on banks to bolster ability to measure their interest rate risk exposure and ensure that they can respond to changing interest rates.

EMERGING FINANCIAL PRODUCTS

The council recommended that market participants make sure they have adequate understanding of the risks of new financial products, including their potential impacts under strained market conditions. It mentioned exchange traded funds, which have taken over a larger share of the mutual fund sector, and structured notes as products to examine.

The FSOC also issued a warning to innovators who may seek to develop new products to avoid regulation: "Council agencies are highly attentive to the emergence and growth of financial products, particularly those that may be designed to arbitrage new capital and accounting standards by moving financial activities outside the regulated core.

TECHNOLOGICAL CHANGE

The council urged market participants and regulators to keep pace with the rapid technological change in markets, such as the rise of computer-driven trading that led to the so-called "flash crash" in May 2010. (Reporting by David Lawder; Editing by Andrew Hay)