Federal Reserve Alert! Fed releases Financial Stability Report, their framework for assessing the resilience of the U.S. financial system and presents the Board’s current assessment.

They see as vulnerabilities: Asset valuations, Borrowing by business and households, Leverage, and Funding Risks.

Source: https://www.federalreserve.gov/publications/files/financial-stability-report-20221104.pdf

Against this backdrop, our view of the current level of vulnerabilities is as follows:

  1. Asset valuations. Higher interest rates and a weaker outlook for the economy led prices of financial assets to fall amid heightened volatility, but real estate prices remained elevated. Measures of equity prices relative to expected earnings declined. Risk premiums in equity and corporate bond markets were near the middle of their historical distributions. In contrast, property markets still show elevated valuations. Although housing activity weakened and national average price increases slowed sharply year over year, home prices remained historically high relative to rents. Valuations of commercial real estate (CRE) were also elevated
  2. Borrowing by businesses and households. On balance, vulnerabilities arising from borrowing by nonfinancial businesses and households were little changed over the first half of 2022 and remained at moderate levels. Borrowing by businesses remained at high levels relative to gross domestic product (GDP) in the first half of 2022, but some measures of their ability to service that debt improved as the effects of rising interest rates were offset by higher business earnings. Household debt remained at modest levels relative to GDP, and most of that debt is owed by households with strong credit histories or considerable home equity. Nonetheless, borrowing costs continue to rise and inflation is reducing real incomes, a combination that may pose risks to the ability of some businesses and households to service their debts, especially in the event of further adverse shocks to income or inflation.
  3. Leverage in the financial sector. Banks maintained risk-based capital ratios near their post 2010 averages, and broker-dealer leverage remained historically low. Leverage at life insurance companies declined to about the middle of its historical range. In contrast, hedge fund leverage likely remained somewhat above its historical average, though comprehensive data are available only with a lag. Bank lending to nonbank financial institutions (NBFIs), an indicator of NBFI leverage, reached new highs. More generally, monitoring some parts of the nonbank financial sector, where hidden pockets of leverage could amplify adverse shocks, could be enhanced with more comprehensive and timely data.
  4. Funding risks. Short-term funding markets continue to have structural vulnerabilities, as some markets and institutions remain vulnerable to large and unexpected withdrawals, especially considering the highly uncertain outlook. Funding risks at domestic banks are low, given their large holdings of liquid assets and limited reliance on short-term wholesale funding. Prime and tax-exempt money market funds (MMFs), as well as other cash-investment vehicles, remain vulnerable to runs. Many bond and bank-loan mutual funds continue to be susceptible to large redemptions, because they hold assets that can become illiquid amid stress. The market capitalization of stablecoins—which have a set of structural vulnerabilities, including weaknesses in regulatory oversight, opacity, and consumer protection issues—continued to decline after falling sharply earlier in the year. Central counterparties (CCPs) have maintained a high level of financial resources to cover potential credit exposures in case of default by one or more clearing members, and participants have continued to meet their margin calls to date.

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