Financial Stability Risk

October 24, 2023

The Federal Reserve’s semiannual Financial Stability Report assesses the stability of the U.S. financial system by analyzing asset valuations, borrowings by businesses and households, leverage and funding risks. In its latest report, for lack of a more precise term, the Federal Reserve painted a picture of stability. For example, corporate bond spreads narrowed and remain near the middle of their historical range; balance sheets for both households and businesses remain solid; and the banking sector remains sound and resilient. Household balance sheets remain strong as many households purchased homes when interest rates were low.

However, what drew our interest are the potential tail risks that include higher interest rates, systemic stress from commercial real estate, slowing revenue growth amongst companies, declining interest coverage ratios and rising geopolitical concerns. Those shifts are one reason the Fed may be reluctant to raise rates again, even though the economy remains remarkably resilient; it does not want to add additional uncertainty and risk to what could be a situation that could shift and add downside risk to the outlook in 2024. The economy has remained remarkably resilient this year, despite the most aggressive monetary tightening we have seen in decades. That is not something that the Fed takes for granted; it is welcome news, even if it means that rates need to stay even higher for longer.

In a survey of near-term risks to financial stability, nearly three-quarters of respondents said the top two risks are persistent inflation leading to higher interest rates and commercial real estate (CRE), up from roughly one-half of participants in the May survey. Other key concerns in the October survey, cited by about 50% of participants, included banking-sector stress, market liquidity strains, fiscal debt sustainability and weakness in the Chinese economy and the financial sector. Worries about China’s economy rose the most; only 12% of survey respondents cited it as a concern in May.

The Fed noted the current survey does not reflect geopolitical tensions following the attack on Israel because the survey closed on October 4, 2023. Survey respondents included market participants, researchers and academia. The shifts due to tensions in the Middle East will not be revealed in that survey until the data on the fourth quarter is released in early 2024.

Many contacts expressed concern that a reacceleration in inflationary pressures could result in additional tightening in monetary policy which could induce a recession. If that were to occur, profits and revenues for businesses would decline, leading to financial distress for some due to falling interest coverage ratios. In the latest report, the Fed said risky borrowers’ ability to service their debt burdens has started to show signs of weakness. This situation would become worse if economic activity contracted. Bankruptcies have begun to rise albeit off of low levels. Those shifts could further crimp lending standards if they continue their upward pace.

Another source of balance sheet pressure could come from potential downgrades. More than half of investment-grade bonds outstanding are rated in the lowest category of investment-grade at BBB, according to the Fed. Should a large share of companies be downgraded in a deteriorating economic environment, higher rollover costs for new debt would weaken firms’ balance sheets.

For CRE, the commercial sector was seen as a potential source of systemic stress due to falling property prices amid structural changes in demand for office space. The Fed said the largest banks are well positioned to withstand a severe recession and contraction in CRE. However, small and regional banks are seen as vulnerable due to their higher CRE exposures.

For the banking sector, while the Fed acknowledged that most banks continue to report above-regulatory capital levels, rising interest rates have continued to depress the fair value of longer-dated, fixed-rate assets for some banks. Overall banking sector profits remain profitable and banks’ vulnerability to future credit losses was said to be moderate.

For non-banks, leverage remains high for the largest hedge funds. The average on-balance-sheet leverage of the top 15 hedge funds by gross asset value was about 17-to-1 in the first quarter of 2023. That compares to leverage of about 7-to-1 for hedge funds in the 16-50th size range. Many hedge funds obtained short-term financing by utilizing Treasury collateral. Market liquidity strains remain a concern. In extreme cases, for example when everyone heads for the exits, the resulting lack of liquidity could imperil market functioning. The Fed also noted that life insurance companies are holding a historically high share of illiquid assets that include CRE loans, less liquid corporate debt and alternative investments, which poses a funding risk in deteriorating market conditions.

For the riskiest loans, the Fed said the credit quality of outstanding and newly issued leveraged loans remained solid through the first half of 2023 but continued to show some signs of deterioration. The Fed noted that corresponding data shows limited tolerance for riskier loans.