Types of Financial System Vulnerabilities and Risks
Federal Reserve staff regularly and systematically assess a standard set of vulnerabilities as part of their periodic review of financial stability. These assessments generally are provided to the Board and Federal Open Market Committee four times per year. Using a range of data sources as well as insights gained from discussions and engagement with domestic and foreign counterparts, staff regularly monitor vulnerabilities in four areas:
1. Elevated valuation pressures are signaled by asset prices that are high relative to economic fundamentals or historical norms and are often driven by an increased willingness of investors to take on risk. As such, elevated valuation pressures imply a greater possibility of outsized drops in asset prices.
2. Excessive borrowing by businesses and households leaves them vulnerable to distress if their incomes decline or the assets they own fall in value. In the event of such shocks, businesses and households with high debt burdens may need to cut back spending sharply, affecting the overall level of economic activity. Moreover, when businesses and households cannot make payments on their loans, financial institutions and investors incur losses.
3. Excessive leverage within the financial sector increases the risk that financial institutions will not have the sufficient capacity to absorb losses when hit by adverse shocks. In those situations, institutions will be forced to cut back lending, sell their assets, or, in extreme cases, shut down. Such responses can substantially impair credit access for households and businesses.
4. Elevated funding risks can occur when financial institutions raise funds from the public with a commitment to return investor money on short notice, but those institutions then invest much of the funds in illiquid assets that are hard to sell quickly or in assets that have a long maturity. This liquidity and maturity transformation can create an incentive for investors to withdraw funds quickly in adverse situations, commonly referred to as a “run.” Facing a run, financial institutions may need to sell assets quickly at “fire sale” prices, thereby incurring substantial losses and potentially even becoming insolvent.
These vulnerability assessments inform internal Federal Reserve discussions concerning both supervision and regulatory policies and monetary policy. Two times a year, the Federal Reserve publishes its Financial Stability Report summarizing its current assessment of these vulnerabilities, the salient risks to the financial system originating in the United States and abroad, and how they might interact. A shorter summary of current vulnerabilities is included in the twice-yearly Monetary Policy Report to Congress. They also inform Federal Reserve interactions with broader monitoring efforts, such as those by the Financial Stability Oversight Council and the Financial Stability Board.
Asset valuations are the prices of assets after accounting for economic fundamentals, such as future expected cash flows and interest rates. Valuations that are high relative to history or to economic fundamentals constitute a vulnerability because the unwinding of high prices can be destabilizing in the financial system and economy. Moreover, stretched asset valuations may be an indicator of a broader buildup in risk appetite leading to investors taking on higher levels of risk, or new risks that are not fully understood.
This dynamic can be more concerning when (1) the assets are widely held and the values are supported by excessive borrowing, (2) the maturity of the asset is significantly longer than the maturity of the liability financing that asset, or (3) there is a lack of publicly available information about the asset.
However, it is very difficult to judge whether an asset price is overvalued relative to fundamentals. As a result, analysis typically considers a range of possible valuation metrics, as well as developments in areas where asset prices are rising especially rapidly, the size and pace of inflows to an asset class, or the implications of unusually low or high levels of volatility in certain markets.
Excessive borrowing by businesses and households leaves them vulnerable if their incomes decline or the assets they own fall in value. In the event of such shocks, businesses and households with high debt burdens may need to cut back spending sharply, affecting the overall level of economic activity. A default can significantly limit their ability to obtain credit in the future. Moreover, when businesses and households cannot make payments on their loans, financial institutions and investors incur losses.
Highly leveraged financial system intermediaries—those with significantly more debt than equity—can amplify the effect of negative shocks in the financial system and broad economy. For example, if highly leveraged institutions collectively respond to a negative shock in the economy (e.g., a sharp decline in house prices) by tightening lending standards and shrinking their balance sheets more than called for by the shock itself, perhaps because outsized credit losses threaten their solvency, the resulting contraction in credit will aggravate the decline in economic activity resulting from the shock.
Sufficiently large losses for highly leveraged institutions, especially if those institutions have a significant share of short-term funding, can lead to “fire sales,” where assets are unloaded quickly at extremely low prices. These fire sales then reduce the value of similar assets held by other financial institutions, potentially leading to a negative feedback loop.
The Federal Reserve monitors leverage in the banking sector with the help of an extensive data collection program. This includes the data collected in support of the Dodd-Frank Act stress tests for large banking institutions, the quarterly Reports of Condition and Income for all banks, and the Consumer Credit report. Additionally, periodic surveys of nonbank providers of leverage, such as the Senior Credit Officer Opinion Survey, as well as collaboration and data sharing among all the financial regulatory agencies offer valuable insights on nonbank financial leverage.
One key benefit provided by the financial system is to aggregate short-maturity liabilities so that they can be used to fund long-maturity assets. This function has historically occurred primarily in the traditional banking system or other depository institutions, which use deposits from consumers as part of the financing to provide multiyear auto or mortgage loans. In recent decades, nonbank financial institutions have grown substantially. For example, mutual funds offer their investors the convenience of daily withdrawals even though they invest in longer-term debt instruments.
However, as seen during the 2007–09 financial crisis and the outbreak of COVID-19 in March 2020, the mismatch between long-term assets and short-term funding creates systemic vulnerabilities that can threaten the functioning of financial markets and the broader economy. This manifests when a large fraction of those investors withdraw their funding suddenly in response to an increase in risk aversion after a negative shock.
Deposit insurance provides some protection against this vulnerability within the traditional banking system. However, firms that use short-term liabilities such as repurchase agreements (or “repos”) or commercial paper, and the financial institutions that invest in them, like money market mutual funds, are also prone to run risk. Indeed, money market mutual funds came under considerable pressure during both the 2007–09 financial crisis and the pandemic in 2020. For this reason, the Federal Reserve actively monitors—as best it can, given available data and measurement—both liquidity risk and the degree of maturity transformation in the financial system.