April 22, 2024
The Federal Reserve’s semiannual Financial Stability Report assesses the stability of the US financial system by analyzing asset valuations, borrowings by businesses and households, leverage and funding risks. The report also discussed near-term risks. What drew our attention most was the significant up move in policy uncertainty in the current report.
According to surveyed participants, persistent inflation and monetary tightening were the most cited risks to financial stability. Nearly three-quarters of respondents said these were the top risks, the same reading as in the October 2023 survey. Persistent inflationary pressures could lead to a "higher for longer" interest rate environment, putting pressure on both household and corporate balance sheets by keeping debt burden costs elevated.
The second most cited risk was policy uncertainty associated with the November US elections, escalating geopolitical tensions and trade policy. Sixty percent of those surveyed cited this as a risk in April versus just 24% in October, the biggest mover in the report.
Policy uncertainty was a key theme in our February 2024 Compass. Election-related uncertainty reduces investment, discourages foreign direct investment, prompts households to pull back and save and boosts stock market volatility. Trade policy uncertainty suppressed investment and employment gains among firms most affected by the trade wars; stock prices were also suppressed and more volatile during trade wars, which had spillover effects to the broader economy.
Commercial real estate (CRE) stress was the third most cited risk, which moved down from second in the October survey. Survey respondents noted that upcoming maturity over the next couple of years could pose refinancing risks. In turn, these exposures could affect the banking system, particularly for regional US banks, which tend to have a higher concentration of CRE investments.
The Bank Term Funding Program (BTFP) received special mention in the current report. It discusses the role the program played in providing funding to the banking system in response to the March 2023 banking-sector stresses, particularly for small banks. The BTFP provided depository institutions with an additional source of liquidity against high-quality securities to meet the needs of all their depositors. Outstanding balances of the BTFP surpassed $165 billion in late 2023 before declining in early 2024.
The significance to smaller banks to be available to access this credit facility cannot be overstated. Since its establishment, the BTFP extended advances to 1,804 depository institutions, of which 1,706, or 95 percent, were small institutions with total assets below $10 billion. The BTFP was introduced on March 12, 2023, and ceased extending new loans on March 11, 2024.
The fourth most cited risk was banking sector stress, which moved down 12 percentage points from third place in October. Although respondents flagged the potential reemergence of banking-sector stress due to CRE, others said the US banking system remains well capitalized.
In its overview of financial system vulnerabilities among four broad categories, the Federal Reserve found stability. The Fed said the banking system remained sound and resilient, with risk-based capital ratios well above regulatory requirements. Still, some banks continued to face large fair value losses on fixed-rate assets on their balance sheets.
For leverage, the business debt-to-GDP ratio remained high, but business debt continued to decline in real terms due to lower risky debt issuance. The net issuance of risky debt is defined as the difference between the issuance of speculative grade bonds, unrated bonds and leveraged loans minus repayments and retirements. Net issuance of such debt was negative in the fourth quarter of 2023 and subdued in the first quarter of 2024, the Fed reported. Additionally, the ability of corporations to service their debt remained robust. For households, the Fed said the debt-to-GDP ratio was modest and the debt was concentrated among prime-rate borrowers. That suggests a higher propensity to service the debt relative to sub-prime borrowers who have less of a financial cushion if they were incapacitated by job loss.
For asset valuations, they increased across most major asset classes. Equity prices rose faster than expected earnings, lifting the forward price-to-earnings ratio to their upper historical ranges. Corporate bond spreads narrowed and are low relative to their historical averages. Residential real estate prices remained high. A supply drought in the housing market, coupled with millennials forming households and having children, are likely to keep prices elevated. The outlook for the residential housing market was the main focus of our April 2024 Compass. CRE declined due to deteriorating fundamentals.
For funding risks, most domestic banks maintained high levels of liquidity. However, structural vulnerabilities persist at money market funds and stablecoins due to the potential for runs given their sharp run-ups. The Federal Reserve did acknowledge the combined market capitalization of all stablecoins, about $150 billion, remained small relative to the broader funding markets, and not widely used as cash-management vehicles.
Life insurers face funding risks as they hold a high share of illiquid and risky assets on their balance sheets. The share of less liquid assets held on life insurers’ balance sheets, including CRE loans, less liquid corporate debt, and alternative instruments, has increased over the past decade. At the same time, life insurers have increased their nontraditional liabilities, including funding-agreement-backed securities and cash received through repurchase agreements and securities lending transactions. With more risky and illiquid assets on their balance sheets, life insurers could potentially face more difficulty meeting a sudden rise in withdrawals and other claims.
