FRB Reports on Stability of Financial System

In its April 2024 Financial Stability Report, the Federal Reserve Board ("FRB") assessed economic vulnerabilities and identified a number of potential "near-term shocks" to the stability of the financial system.

According to the report:

• Valuation pressures arise when asset prices are high relative to economic fundamentals or historical norms and are often driven by an increased willingness of investors to take on risk. Elevated valuation pressures may increase the possibility of outsized drops in asset prices.
• Excessive borrowing by businesses and households exposes the borrowers to distress if their incomes decline or the assets they own fall in value. Businesses and households with high debt burdens may need to cut back spending, affecting economic activity and causing losses for investors.
• Excessive leverage within the financial sector increases the risk that financial institutions will not have the ability to absorb losses without disruptions to their normal business operations when hit by adverse shocks. This results in institutions being forced to cut back lending, sell their assets or even shut down which can impair credit access for households and businesses, further weakening economic activity.
• Funding risks expose the financial system to the possibility that investors will rapidly withdraw their funds from a particular institution or sector, creating strains across markets or institutions. FRB observed that financial institutions raise funds from the public with a commitment to return their investors’ money on short notice, but those institutions then invest much of those funds in assets that are hard to sell quickly or have a long maturity. This liquidity and maturity transformation can create an incentive for investors to withdraw funds quickly in adverse situations. Facing such withdrawals, financial institutions may need to sell assets quickly at "fire sale" prices, thereby incurring losses and potentially becoming insolvent, as well as causing additional price declines that can create stress across markets and at other institutions.

The FRB found that, since its October 2023 report, (i) equity valuations increased, (ii) business and household vulnerability debt remained moderate, (iii) vulnerabilities associated with financial leverage reflected fair value losses on fixed-rate assets for some banks and elevated leverage at some nonbanks and (iv) vulnerabilities from funding risks reflected challenges at some banks and structural vulnerabilities in other sectors engaged in liquidity transformation.

FRB also identified near-term risks to the U.S. financial system including that:

• higher-for-longer interest rates in the U.S. and other advanced economies could create strains in the global financial system;
• a worsening of global geopolitical tensions could lead to broad adverse spillovers; and
• weakness in economic activity could compound existing strains in real estate markets, both domestically and abroad and could amplify risks to the global financial system.