FRB Identifies Prominent Risks to Financial Stability
Commentary by Steven Lofchie
In its November 2022 Financial Stability Report, the Federal Reserve Board ("FRB") identified primary risks to financial stability in the banking industry, including "unexpectedly and persistently high inflation," cyberattacks, and climate-related and digital asset-related financial risk.
On rising inflation and high interest rates, the FRB said that these developments could cause losses at financial institutions, negatively impact liquidity, cause declines in asset values, reduce the availability of credit and lead to increases in bankruptcies and other financial distress.
On cyber incidents, the FRB cautioned about potential contagion due to high levels of interconnectedness among firms, but noted that many regulators have taken steps to develop better controls. The FRB also warned that a lack of substitutes for critical cyber services leaves many firms susceptible to significant disruption in the event of a cyberattack.
On climate risk, the FRB said that it will continue to develop methods to monitor climate-related risks and recommended that institutions utilize climate analysis scenarios that consider output, prices and employment, among other metrics to "explore a wide range of implications in the financial sector for individual assets, companies or industries, as well as for the overall macroeconomy." The FRB also said that it will continue to work with market participants and other regulators to explore different options for climate-related supervisory exercises.
On digital asset risk, the FRB observed that recent market activity revealed that digital asset ecosystems can be subject to similar risks to traditional finance, with the difference being that cryptocurrency prices are predominantly driven by speculation, hype and risk appetite. The FRB said that many cryptocurrencies, including stablecoins, experienced waves of significant volatility leading to crashes across the digital asset market. The FRB said that while this extreme volatility did not impact traditional markets, comprehensive regulation is necessary to pave the way for future innovation.
Commentary
With digital assets having already lost two-thirds of their value without a whimper from the larger financial system, it is hard to make the case that - after a crash that did not make much of a broader bang - they pose an unreasonable risk to financial stability.
As to climate risk, the FRB would be more accurate if it simply said it has no clue, and is trying to develop some basis for climate risk-related predictions. Nothing in the report suggests that the FRB has any "material" (using the word to mean substantive, rather than substantial) negative information as to climate risk. In short, the FRB's concerns are speculative, which is okay because the FRB should be trying to figure out the unknown unknowns. That said, it is notable that the FRB was so completely wrong on inflation and interest rates. Are its models bad? Was there undue political consideration? The FRB might want to do a self-assessment.