Federal Reserve Board Issues May 2021 Financial Stability Report

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Friday, May 07, 2021 / 12:03 PM / By Federal Reserves / Header Image Credit: Federal Reserves


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This report reviews conditions affecting the stability of the financial system by analyzing vulnerabilities related to valuation pressures, borrowing by businesses and households, financial leverage, and funding risk. It also highlights several near-term risks that, if realized, could interact with such vulnerabilities.

 

Since the November 2020 Financial Stability Report was issued, prices of risky assets generally rose further, with the outlook buoyed by positive vaccine-related news, additional fiscal stimulus, and better-than-expected economic data. Vulnerabilities from both business and household debt have declined, reflecting a slower pace of business borrowing and an improvement in earnings as well as government programs that have supported business and household incomes. Even so, many businesses and households remain under considerable strain, with job losses heavily concentrated among the most financially vulnerable, including many lower-wage workers and racial and ethnic minorities. Banks have remained well capitalized but may face heightened credit risk in the sectors most affected by the COVID-19 pandemic. Although markets for short-term funding are now functioning normally, structural vulnerabilities at some nonbank financial institutions (NBFIs) could amplify shocks to the financial system in times of stress.

 

Our current view of vulnerabilities is as follows:

 

1. Asset valuations. Prices of risky assets have generally increased since November with improving fundamentals, and, in some markets, prices are high compared with expected cash flows. Long-term Treasury yields have risen over the past few months but remain low by historical standards. High asset prices in part reflect the continued low level of Treasury yields. However, valuations for some assets are elevated relative to historical norms even when using measures that account for Treasury yields. In this setting, asset prices may be vulnerable to significant declines should risk appetite fall.

 

2. Borrowing by businesses and households. Debt owed by businesses was effectively flat in the second half of 2020, remaining at a high level relative to gross domestic product (GDP). Improving earnings, low interest rates, and ongoing government support have increased the ability of businesses to service these obligations. Debt owed by households remained at a moderate level relative to income. Delinquencies on mortgages and other consumer debt fell early in the pandemic and remain below their pre-pandemic levels, as households have received significant government support—including from forbearance and fiscal programs—and as interest rates have remained low. Even so, some businesses and households remain under considerable strain.

 

3. Leverage in the financial sector. Banks remain well capitalized, and leverage at brokerdealers is low. Measures of hedge fund leverage are somewhat above their historical averages, but the data available may not capture important risks from hedge funds or other leveraged funds. Amid elevated investor risk appetite, issuance of collateralized loan obligations (CLOs) and asset-backed securities (ABS) has been robust.

 

4. Funding risk. Funding risks at domestic banks remain low, because these banks rely only modestly on short-term wholesale funding and maintain sizable holdings of high-quality liquid assets. However, the market turmoil at the onset of the pandemic highlighted structural vulnerabilities that persist at some types of money market funds (MMFs) as well as bond and bank loan mutual funds.

 

This report also details how near-term risks have changed since the November 2020 report. Despite substantial progress with vaccinations, perceived risks associated with the course of the pandemic and its effects on the U.S. and foreign economies remain relatively high. A worsening of the global pandemic could stress the financial system in emerging markets and some European countries. Further, if global interest rates were to rise abruptly, some emerging market economies (EMEs) could experience additional fiscal strains. These risks, if realized, could interact with the vulnerabilities identified in this report and pose additional risks to the U.S. financial system

 

Download Full PDF Report Here


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