November 08, 2023
Financial Stability: Resilience, Challenges, and Global Connections
Governor Lisa D. Cook
At the Central Bank of Ireland, Dublin, Ireland
Thank you for the invitation to speak at the Central Bank of Ireland. I am happy to be with you today to discuss financial stability.1
My own work as an academic has frequently reinforced the importance of financial stability in the United States and abroad. Early in my career, I examined the impact of underdevelopment in the Russian banking system on growth in post-Soviet Russia and the instability that can occur in a poorly regulated financial system. Years later, as an economist on the Council of Economic Advisers, I saw how weaknesses in the financial system contributed to instability in the euro area. These formative experiences shaped my view that the Federal Reserve's work on financial stability is critical to the well-being of households, businesses, and the broader economy. This is one reason I particularly value the opportunity to serve on the Board's Committee on Financial Stability.
I will focus my remarks on my assessment of financial stability risks, based on the Federal Reserve's framework for monitoring vulnerabilities in the financial system. In my view, our financial system is substantially more resilient than it was in the mid-2000s, reflecting progress by regulators and the private sector in boosting resilience. That said, we cannot be complacent, and I see some important risks.
Achieving the Federal Reserve's dual mandate of maximum employment and stable prices depends on a stable financial system.2 We all saw how the Global Financial Crisis triggered the Great Recession and brought misery to countless millions who lost their jobs, homes, or investments.
A stable financial system provides households, communities, and businesses with the financing they need to invest, grow, and participate in a well-functioning economy—even when hit by adverse events or "shocks." Consistent with this view of financial stability, our framework for how we think about this goal—as laid out in our Financial Stability Report (FSR), which was just released in October—distinguishes between shocks to, and vulnerabilities of, the financial system.3 Importantly, and as we economists know, we cannot predict exogenous shocks, which are, by definition, the surprise events that will hit the financial system and economy. By contrast, vulnerabilities—the aspects of the financial system that would exacerbate stress—tend to build up over time and can be identified, assessed, and monitored. In the example of the Global Financial Crisis, although it was widely recognized that housing valuations were high, the magnitude of the ensuing price drop was unexpected, or a shock. That shock was amplified by vulnerabilities that had built up within the financial system over time, including weak bank capital, excessive household debt, lax lending standards, and fragile short-term wholesale funding. One hard-learned lesson of the crisis is that the Fed and other regulators must watch closely for vulnerabilities that may build up within the financial system.
Based on this experience, other historical episodes, and academic research, we focus, in the Board's FSR and other work, on assessing vulnerabilities across four broad categories related to asset valuations, borrowing by businesses and households, financial-sector leverage, and funding risks. We also consider, through contacts with market participants and experts, near-term risks that, if they were to come to pass, could interact with these vulnerabilities.
One key set of vulnerabilities stems from valuation pressures. The willingness of investors to take on risks is closely related to the economic and financial cycle. When their risk appetite drives prices higher relative to economic fundamentals, there may be a greater risk of outsized drops in prices that can be destabilizing.4 The Fed looks at a broad range of asset markets, including equities, Treasury securities, corporate bonds, loans, and real estate. This table from our FSR shows the sizes of the asset markets discussed in this section as of Q2, the most recent data available. The largest asset markets are those for residential real estate, equities, Treasury securities, and commercial real estate (CRE).5
This year, asset valuations have generally risen notably above their historical levels. In particular, prices of residential and commercial properties remain above levels historically associated with fundamentals. House prices, relative to rents, are near all-time highs. Further, prices have started increasing again in recent months after falling for more than a year. Commercial property prices also remain high relative to rental income. I am watching closely the extent to which post-pandemic supply and demand patterns normalize. Demand in the office sector has remained weak, particularly in central business districts and coastal cities, with vacancy rates increasing further and rent growth declining. Finally, average delinquency rates for commercial mortgage-backed securities have moved up recently, as office and retail loan performance has deteriorated. If delinquency rates generate selling pressure or increase notably further and result in forced sales of properties, then CRE prices could decline sharply.
Another notable market development has been the significant increase in longer-term bond yields since June. Decompositions between changes in expected rates and term premiums depend on the specific models and assumptions used, but I would say that an expectation of higher near-term policy rates does not appear to be causing the increase in longer-term rates.
Business and Household Borrowings
Valuation pressures are especially concerning if they are associated with excessive borrowing. If households or businesses borrow too much, they may be unable to service debt or could find themselves underwater if assets decline in value. Such stresses can propagate through the financial system, causing funding shortages that curtail credit and hamper economic activity. Of course, it's very difficult to tell in real time whether households and businesses are, in fact, borrowing "too much," so we rely on a range of benchmarks.
Currently, business debt is at historically high levels relative to such benchmarks as gross domestic product (GDP) or business assets, although those ratios are significantly lower than the record highs reached at the onset of the pandemic. However, measures of the ability of firms to service their debt remain strong overall, supported by resilient corporate profits and limited effects to date from higher interest rates. The pass-through of higher interest rates into debt-servicing costs appears to be muted by the large share of long-term, fixed-rate liabilities. However, I note that for risky borrowers or those with high-yield or unrated debt, the ability to service their debt burdens has started to show signs of weakness, as would be expected in a rising interest rate environment, and could become further strained if corporate earnings fall due to a sharper-than-expected slowdown in economic activity.
The household sector, taken as a whole, looks quite resilient. Household debt, including home mortgages, auto and student loans, and credit cards, remains at modest levels relative to GDP, and most of that debt is owed by households with strong credit histories or considerable home equity. Of course, we are seeing emerging signs of stress for households with lower credit scores, and individual borrowers may struggle with debt burdens in the face of economic hardships.
Now to financial-sector leverage. As I mentioned earlier, we pay careful attention to our financial system's ability to support the activities of businesses and households. When financial institutions are overly indebted, adverse shocks can cause them to retrench more than they otherwise would, resulting in greater declines in economic activity. In extreme circumstances, such effects can lead to credit crunches and widespread economic dislocations. Similarly, some institutions may be forced to rapidly deleverage, stressing markets and forcing other institutions to also pull back.
The United States has a large and vibrant financial system, so it is important to assess leverage across the broad array of nonbanks and banks of all sizes that provide credit to our economy. Starting with banks: The banking sector remains sound and resilient overall. Most banks continue to report solid capital levels well above regulatory requirements.
The rise in interest rates over the past two years has contributed to robust bank profitability, as banks earned higher interest income on floating-rate loans while interest expense on many deposits remained well below market rates. At the same time, higher long-term interest rates also substantially affected the fair value of banks' holdings of fixed-rate assets. As we saw earlier this year, fair value losses on bank balance sheets, when combined with poor liquidity and interest rate risk management, can leave banks exposed to additional risk. While acute stresses have abated, I continue to monitor this situation closely.
Some nonbanks can be quite leveraged. For example, available data suggest that hedge fund leverage remains elevated, especially for the largest hedge funds. It is important to better understand how their leveraged activities could impact the functioning of underlying markets.
Looking at funding, many financial institutions raise funds from the public with a commitment to return their money on short notice. But those institutions then invest much of those funds in assets that are hard to sell quickly or have a long maturity. This liquidity and maturity transformation can create strains across markets or institutions, particularly in the absence of a lender of last resort such as the Fed's discount window for commercial banks.
In the banking industry, the deposit volatility that we saw earlier this year has abated. That said, some banks have had to turn to higher-cost funding sources to make up for lost deposits and face reduced market values for investment securities.
Outside of banking, we also monitor a wide range of nonbank financial institutions (NBFIs) such as money market funds, open-end funds, insurers, central counterparties, and digital assets. Many of their activities give rise to a liquidity mismatch that could amplify market stress. They have daily or frequent redemption possibilities on the liability side, while holding less-liquid assets. I think the Securities and Exchange Commission's recent reform on money market funds and proposal for open-end funds are encouraging steps toward mitigating funding risks arising from nonbanks.
Salient Near-Term Risks
Let me illustrate how these vulnerabilities factor into my views on the resilience of the financial system. I will walk through how potential near-term risks could interact with current conditions in the United States. I will cover both domestic and international risks in a way that is closely aligned with the discussion in the FSR.6 In recent outreach, as summarized in this figure from the FSR, contacts were particularly focused on the persistent inflationary pressures leading to further monetary tightening, the potential for significant losses on CRE and residential real estate, the reemergence of banking-sector stress, and market liquidity strains and volatility.
As I said earlier, the banking sector has stabilized since the period of acute stress earlier this year, and the system as a whole has ample capital and liquidity to withstand shocks. I continue to monitor the system for signs of renewed stresses. I also support seeking public comment on federal banking agencies' Basel III endgame proposal on bank capital requirements.
In addition, NBFIs have become an integral part of the financial system and are increasingly interconnected with the banking sector. It is crucial for relevant authorities to implement stronger oversight and appropriate prudential requirements for nonbanks. This is especially important amid concerns that proposed higher capital requirements for large banks could cause some bank activities to migrate to the more lightly regulated NBFIs. It would be the most effective and balanced way to enhance the stability of the entire financial system.
Internationally, inflationary pressures persist in advanced foreign economies and could pose risks to the global financial system. Energy prices have increased notably in recent months, potentially forcing businesses to pass on renewed cost pressures to customers. An unexpected increase in policy rates abroad could lead to heightened volatility in financial markets, strains in market liquidity, and an adjustment in asset prices. Higher interest rates, particularly if they persisted, could be a binding constraint on the debt-servicing capacity of foreign households, businesses, and governments. Collectively, these factors could lead to pronounced losses among global financial intermediaries and a consequent reduction in the credit supply.
In China, a further slowdown in economic growth could worsen financial stresses. Many Chinese firms, especially in the property sector, are struggling to service very high debt burdens. Local governments are also facing increasing fiscal strains. Stresses originating in China could spill over to other emerging market economies (EMEs), particularly those highly dependent on trade with China or on credit provided by Chinese entities. The spillovers could trigger significant capital outflows from EMEs, which may already be more susceptible to external shocks given generally heightened debt levels. Given the size of its economy and financial system, financial stress in China could be propagated to global markets more broadly through disruptions to economic activity, deterioration of risk sentiment, and a sharp appreciation of the dollar.
Last but not least, a worsening of global geopolitical tensions, including those involving Russia, the Middle East, and China, could lead to broad negative spillovers to global markets. Russia's ongoing war against Ukraine continues to weigh on many economies in a variety of ways, including sustained disruptions to regional trade in food, energy, and other commodities. The conflict in the Middle East could generate further risks to energy and financial markets, as well as a worsening of global humanitarian and migration challenges. More broadly, escalation of geopolitical tensions could lead to lower economic activity and increased fragmentation of global trade flows and financial intermediation, raising financing and production costs and contributing to more sustained supply chain challenges and inflationary pressures. The global financial system could be affected by a pullback from risk-taking, declines in asset prices, and losses for exposed businesses and investors.
I will conclude by saying that we must remain vigilant to potential shocks that could exacerbate vulnerabilities in the global financial system. Thank you for inviting me to speak here. I look forward to participating on the panel.
1. The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. These remarks are largely drawn from my recent speech at Duke University. See Lisa D. Cook (2023), "Financial Stability: Resilience and Challenges," speech delivered at Duke University, Durham, N.C., November 6. Return to text
2. See the Statement on Longer-Run Goals and Monetary Policy Strategy, which is available on the Board's website at https://www.federalreserve.gov/monetarypolicy/files/fomc_longerrungoals.pdf. Return to text
4. See the box "Vulnerabilities from Asset Valuations, Risk Appetite, and Low Interest Rates" in Board of Governors of the Federal Reserve System (2021), Financial Stability Report (PDF) (Washington: Board of Governors, May), pp. 15–18. Return to text
6. Based in part on the outreach survey the Federal Reserve Bank of New York conducts that informs the discussion in the FSR. See section 5 and the box "Survey of Salient Risks to Financial Stability" in Board of Governors of the Federal Reserve System (2023), Financial Stability Report (PDF) (Washington: Board of Governors, October), pp. 47–48. Return to text