Board of Governors of the Federal Reserve System

Financial Stability

A stable financial system promotes economic welfare through many channels: It facilitates household savings to purchase a home, finance a college education, and smooth consumption in response to job loss and other adverse developments; it promotes responsible risk-taking and economic growth by channeling savings to firms to start new businesses and expand existing businesses; and it spreads risk across investors.

A financial system is considered stable when financial institutions—banks, savings and loan associations, and other financial product and service providers—and financial markets are able to provide households, communities, and businesses with the resources, services, and products they need to invest, grow, and participate in a well-functioning economy. Disruptions to these activities of the financial system have arisen during, and contributed to, stressed macroeconomic environments. Accordingly, the Federal Reserve's objective to promote financial stability strongly complements the goals of price stability and full employment. In pursuit of continued financial stability, the Federal Reserve monitors the potential buildup of risks to financial stability; uses such analyses to inform Federal Reserve responses, including the design of stress-test scenarios and decisions regarding other policy tools such as the countercyclical capital buffer; works with other domestic agencies directly and through the Financial Stability Oversight Council (FSOC); and engages with the global community in monitoring, supervision, and regulation that mitigate the risks and consequences of financial instability domestically and abroad.

Moreover, the Federal Reserve promotes financial stability through its supervision and regulation of financial institutions. A central tenet of the Federal Reserve's efforts in promoting financial stability is the adoption of an approach to supervision and regulation that, in addition to a traditional approach focused on the safety and soundness of individual institutions, accounts for the stability of the financial system as a whole. In particular, a supervisory approach accounting for financial stability concerns informs the supervision of systemically important financial institutions (SIFIs), including large bank holding companies, the U.S. operations of certain foreign banking organizations, and financial market utilities (FMUs). In addition, the Federal Reserve serves as a "consolidated supervisor" of nonbank financial companies designated by the FSOC as institutions whose distress or failure could pose a threat to the stability of the U.S. financial system as a whole (see "Financial Stability Oversight Council Activities" later in this section). Enhanced standards for the largest, most systemic firms promote the safety of the overall system and minimize the regulatory burden on smaller, less systemic institutions.

This section discusses key financial stability activities undertaken by the Federal Reserve over 2019, which include monitoring risks to financial stability; promoting a perspective on the supervision and regulation of large, complex financial institutions that accounts for the potential spillovers from distress at such institutions to the financial system and broader economy; and engaging in domestic and international cooperation and coordination.

Some of these activities are also discussed elsewhere in this annual report. A broader set of economic and financial developments are discussed in section 2, "Monetary Policy and Economic Developments," with the discussion that follows concerning surveillance of economic and financial developments focused on financial stability. The full range of activities associated with supervision of SIFIs, designated nonbank companies, and designated FMUs is discussed in section 4, "Supervision and Regulation."

Monitoring Risks to Financial Stability

Financial institutions are linked together through a complex set of relationships, and their condition depends on the economic condition of the nonfinancial sector. In turn, the condition of the nonfinancial sector hinges on the strength of financial institutions' balance sheets, as the nonfinancial sector obtains funding through the financial sector. Monitoring risks to financial stability is aimed at better understanding these complex linkages and has been an important part of Federal Reserve efforts in pursuit of overall economic stability.

A stable financial system, when hit by adverse events, or "shocks," is able to continue meeting demands for financial services from households and businesses, such as credit provision and payment services. By contrast, in an unstable system, these same shocks are likely to have much larger effects, disrupting the flow of credit and leading to declines in employment and economic activity.

Consistent with this view of financial stability, the Federal Reserve Board's monitoring framework distinguishes between shocks to and vulnerabilities of the financial system. Shocks, such as sudden changes to financial or economic conditions, are inherently hard to predict. Vulnerabilities tend to build up over time and are the aspects of the financial system that are most expected to cause widespread problems in times of stress. Accordingly, the Federal Reserve maintains a flexible, forward-looking financial stability monitoring program focused on assessing the financial system's vulnerabilities to a wide range of potential adverse shocks.

Each quarter, Federal Reserve Board staff assess a set of vulnerabilities relevant for financial stability, including but not limited to asset valuation pressures, borrowing by businesses and households, leverage in the financial sector, and funding risk. These monitoring efforts inform discussions concerning policies to promote financial stability, such as supervision and regulatory policies as well as monetary policy. They also inform Federal Reserve interactions with broader monitoring efforts, such as those by the FSOC and the Financial Stability Board (FSB).

The Federal Reserve Board published two Financial Stability Reports in 2019.¹ The report, which is published on a semiannual basis, summarizes the Board's framework for assessing the resilience of the U.S. financial system and presents the Board's current assessment of financial system vulnerabilities. It aims to promote public understanding about Federal Reserve views on this topic and thereby increase transparency and accountability. The report complements the annual report of the FSOC, which is chaired by the Secretary of the Treasury and includes the Federal Reserve Chair and other financial regulators.

Asset Valuation Pressures

Overvalued assets are a fundamental source of vulnerability because the unwinding of high prices can be destabilizing, especially if the assets are widely held and the values are supported by excessive leverage, maturity transformation, or risk opacity. Moreover, stretched asset valuations are likely to be an indicator of a broader buildup in risk-taking. Nonetheless, it is very difficult to judge whether an asset price is overvalued relative to fundamentals. As a result, the Federal Reserve's analysis of asset valuation pressures typically includes a broad range of possible valuation metrics and tracks developments in areas in which asset prices are rising particularly rapidly, into which investor flows have been considerable, or where volatility has been at unusually low or high levels.

Across markets, asset valuations were notable in the first half of 2019 and then increased to somewhat elevated levels through December 2019. These developments were supported by the continuing economic expansion and an apparent increase in investors' appetite for risk. Among several large asset categories, spreads, risk premiums, and implied volatility declined and, at the end of 2019, stood at the low ends of their historical distributions.

Equity prices increased substantially toward the end of the year, driven primarily by the decline in Treasury yields, positive trade developments, and strong labor market data. The forward price-to-earnings ratio of S&P 500 firms increased since midsummer of 2019 and stood quite high relative to its historical distribution (figure 1). Measures of realized and implied volatility of stock prices moved down since December 2018, lying at the lower ends of their historical distributions (figure 2). Investor appetite for
corporate bonds was quite strong, with spreads remaining low despite high levels of corporate leverage. Investment- and speculative-grade spreads narrowed notably and, at the end of 2019, stood in the lower range of their historical distributions (figure 3).

Valuation pressures in the commercial real estate (CRE) sector were elevated. CRE prices increased substantially over the past seven years (figure 4). That said, price-to-rent ratios are moving toward their long-run trend, and price growth decelerated toward the end of 2019. Home prices grew moderately, consistent with rents. Farmland prices continued falling from recent historical highs but stayed in the elevated region.

Borrowing by Households and Businesses

Excessive borrowing by households and businesses has been an important contributor to past financial crises. Highly indebted households and nonfinancial businesses may be vulnerable to negative shocks to incomes or asset values and may be forced to curtail spending, which could amplify the effects of financial shocks. In turn, losses among households and businesses can lead to mounting losses at financial institutions, creating an adverse feedback loop in which weaknesses among households, nonfinancial businesses, and financial institutions cause further declines in income and accelerate financial losses, potentially leading to financial instability and a sharp contraction in economic activity.

Vulnerabilities associated with household and business borrowing remained moderate overall in 2019. However, business debt and household debt, which started to diverge following the 2007–09 recession, have continued to trend in opposite directions (figure 5). Business credit continued to grow faster than nominal gross domestic product (GDP), bringing the business-sector credit-to-GDP ratio to historical highs.

Gross leverage of public firms remained at historically high levels. Leverage is especially high for public firms with positive debt balances that have a speculative-grade credit rating or are unrated. Such firms account for about one-third of nonfinancial business debt. The overall increase in investor risk appetite, associated with elevated asset valuations, did not translate into an acceleration of demand for risky debt. Net issuance of risky debt at the end of 2019 was below the high levels in previous years—albeit still solid by historical standards (figure 6). Commonly used measures of underwriting standards on leveraged loans remained weak, as shown by the high share of deals with debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratios above 6 (figure 7).

Nonetheless, the strong economy and low interest rates helped sustain a solid credit performance of leveraged loans in 2019, with the default rate on such loans near the low end of its historical range. At the same time, the favorable credit performance of the corporate sector was due at least in part to the strength of overall economic activity, and high leverage could leave some parts of the corporate sector vulnerable to difficulties should adverse shocks materialize. For instance, in an economic downturn, widespread downgrades of bonds to speculative-grade ratings could lead investors to sell the downgraded bonds rapidly, increasing market illiquidity and downward price pressures in a segment of the corporate bond market known already to exhibit relatively low liquidity.²

In contrast to the business sector, household debt growth continued to be modest over the past year. Aggregate borrowing relative to income in the household sector has declined significantly from its 2007 peak, with growth skewed mostly toward households with strong credit histories.

The composition of household debt has experienced significant changes over the past 10 years (figure 8). Credit card debt decreased significantly between 2009 and 2011, and its level in 2019 (in real terms) remains well below its 2008 peak. By contrast, student and auto loans have maintained a strong upward trend during the past 10 years.

Leverage in the Financial System

Vulnerabilities related to financial-sector leverage appear low, in part because of regulatory reforms enacted since the financial crisis. Core financial intermediaries, including large banks, insurance companies, and broker-dealers, appear well positioned to weather economic stress.

Regulatory capital remained at historically high levels for large domestic banks. In 2019, the ratio of common equity Tier 1 capital to risk-weighted assets stayed around 12 percent, on average, for the eight U.S. headquartered G-SIBs (global systemically important banks) and around 10 percent for large non–G-SIBs—that is, bank holding companies and intermediate holding companies that have total assets greater than $100 billion but are not considered G-SIBs (figure 9). Moreover, the leverage ratio, which looks at common equity relative to total assets without adjusting for risk, also remained at levels substantially above pre-crisis norms. Finally, all 18 firms participating in the Federal Reserve's supervisory stress tests for 2019 were able to maintain capital ratios above required minimums to absorb losses from a severe macroeconomic shock.³

Overall, broker-dealer leverage remained low. Leverage for bank-affiliated dealers fell slightly in the latter part of the year and stayed at the relatively low levels reached in the post-crisis period. Measures of hedge fund leverage remained elevated compared with their post-crisis levels. The increased use of leverage by hedge funds exposes their counterparties to risk and raises the possibility that adverse shocks would result in forced asset sales that could exacerbate price declines. That said, hedge funds do not play the same central role in the financial system as banks or other institutions.

Leverage among property and casualty insurance companies is low, while leverage among life insurance companies is moderate.

Funding Risk

Vulnerabilities associated with funding risk continued to be modest in 2019, in part because of the post-crisis implementation of liquidity regulations for banks and the 2016 money market reforms.⁴ The stress that emerged in short-term funding markets in mid-September highlighted the potential for shocks that can adversely affect the smooth functioning of these large and systemically important markets. These developments led to a higher assessment of vulnerabilities stemming from liquidity and maturity transformation toward the end of the year, raising the level of vulnerability from low to moderate.

Banks, securities dealers, money market mutual funds (also referred to as money market funds, or MMFs), and other financial market participants lend to and borrow from each other for short periods, typically ranging from overnight to two weeks, against high-quality collateral. These short-term secured loans are known as repurchase agreements (repos). The repo market allows securities dealers to finance their own inventories of Treasury securities or to finance purchases of Treasury securities by levered investors, such as hedge funds. Interest rates on these and other short-term loans among financial institutions spiked in mid-September, and some rates remained relatively elevated through early October. The pressures in repo markets in this particular episode appeared to be driven by short-lived changes to demand and supply that occurred against a backdrop of increasing Treasury securities outstanding and declining reserves in the banking system. The Federal Reserve conducted a number of operations to keep the federal funds rate within the target range, relieving pressures in short-term funding markets.⁵ That said, these developments underscored frictions in the intermediation of credit in short-term money markets, warranting further careful monitoring of vulnerabilities in this segment going forward.

At the same time, many vulnerabilities related to maturity and liquidity transformation remain subdued. In total, liquid assets in the banking system have increased substantially since the financial crisis. Large banks and G-SIBs, in particular, hold substantial amounts of liquid assets, far exceeding pre-crisis levels and well above regulatory requirements (figure 10). Large bank reliance on short-term wholesale funding is low. From this perspective, bank funding was less susceptible to runs at the end of 2019 than in the period leading up to the financial crisis—further reducing vulnerabilities from liquidity transformation.

Assets in "prime" MMFs and some alternative short-term investment vehicles remain low. The same observation holds true for aggregate measures of runnable liabilities. MMF reforms implemented in 2016 have reduced run risk in the financial system. The reforms required prime MMFs, which have proved vulnerable to runs in the past, to use floating net asset values that adjust with the market prices of the assets they hold, which resulted in a shift by investors into government MMFs. A shift in investments toward short-term vehicles that provide alternatives to MMFs and could also be vulnerable to runs or run-like dynamics would increase risk, but assets in these alternatives have increased only modestly compared with the drop in prime MMF assets.

Domestic and International Cooperation and Coordination

The Federal Reserve cooperated and coordinated with both domestic and international institutions in 2019 to promote financial stability.

Financial Stability Oversight Council Activities

As mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the FSOC was created in 2010 and, as noted earlier, is chaired by the Treasury Secretary and includes the Federal Reserve Chair as a member (see box 1). It established an institutional framework for identifying and responding to the sources of systemic risk. Through collaborative participation in the FSOC, U.S. financial regulators monitor not only institutions, but also the financial system as a whole. The Federal Reserve, in conjunction with other participants, assists in monitoring financial risks, analyzes the implications of those risks for financial stability, and identifies steps that can be taken to mitigate those risks. In addition, when an institution is designated by the FSOC as
systemically important, the Federal Reserve assumes responsibility for supervising that institution.

In 2019, the Federal Reserve worked, in conjunction with other FSOC participants, on the following major initiative:

Nonbank designations guidance. On December 4, 2019, members of the FSOC voted to approve the final interpretive guidance on nonbank financial company determinations.⁶ The guidance describes the approach that the council intends to take in using an activities-based strategy. The key focus of the guidance is on the council working with relevant financial regulators to identify products, activities, or practices that could raise potential risks to financial stability and to address those risks, leveraging the expertise of primary financial regulatory agencies.

Financial Stability Board Activities

In light of the interconnected global financial system and the global activities of large U.S. financial institutions, the Federal Reserve participates in international bodies, such as the FSB. The FSB monitors the global financial system and promotes financial stability through the development of sound policies that can be implemented across countries. The Federal Reserve is a member of the FSB, along with the Securities and Exchange Commission and the U.S. Treasury.

In the past year, the FSB has examined several issues, including monitoring of nonbank financial intermediation, challenges in correspondent banking, the emergence of so-called global stablecoins, transitioning away from the use of LIBOR (London interbank offered rate), asset management, fintech (emerging financial technologies), evaluating the effects of reforms, and development of effective resolution regimes for large financial institutions.

Footnotes