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 (BHCs), 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 2018, 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. In 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 typically surprises and 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. As a result, 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).

In November 2018, the Federal Reserve Board published its first Financial Stability Report.¹ The report, which will be 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 remained elevated through most of 2018, supported by the solid economic expansion and an apparent increase in investors' appetite for risk. However, valuation pressures in equity and corporate bond markets moderated in the fourth quarter of 2018 amid a step-up in market volatility.

In equity markets, price fluctuations toward the end of 2018 brought down the forward price-to-earnings ratio of S&P 500 firms, a metric of valuations in equity markets, to a level near the median of its historical distribution (figure 1). At the same time, both realized and option-implied market volatility, which had remained low since mid-2016, jumped back to levels slightly above historical averages (figure 2). In debt markets, corporate bond spreads to comparable-maturity Treasury securities widened slightly through 2018, though spreads on investment- and speculative-grade bonds remained near the lower end of their historical range (figure 3).

Property prices continued to be an area of ongoing valuation pressures over the past year. Commercial real estate prices, which had risen substantially over the previous seven years, were about flat last year, although at historical highs (figure 4). Similar patterns were also observed in farmland prices, where price-to-rent ratios also remained at historical highs, and in home prices, with price-to-rent ratios above long-run historical trends but below the extraordinary levels seen before the financial crisis.

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 2018. 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), leaving the business-sector credit-to-GDP ratio close to historical highs.

Risky debt issuance picked up in 2017 and 2018 (figure 6). Moreover, highly leveraged corporations, measured by debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratios above 6, increased their share of large loan issuance to historically high levels, above the previous peak levels observed in 2007 and 2014 (figure 7). Nonetheless, the strong economy and low interest rates helped sustain a solid credit performance of leveraged loans in 2018, 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 recently was likely due 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.

Furthermore, the share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) reached near-record levels. As of December 2018, around 42 percent of corporate bonds outstanding were at the lowest end of the investment-grade segment, amounting to about $3 trillion.

In contrast to the business sector, household debt growth continued to be modest over the past year and remained mostly in line with income growth. 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, however, experienced significant changes over the past 10 years (figure 8). Credit card debt decreased significantly between 2009 and 2011, and its recent level (in real terms) remains well below its 2008 peak. In 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. The ratio of tier 1 common equity to risk-weighted assets remained around 12 percent, on average, for BHCs in 2018 (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 34 firms participating in the Federal Reserve's supervisory stress tests for 2018 were able to maintain capital ratios above required minimums to absorb losses from a severe macroeconomic shock.²

Leverage of broker-dealers has been trending down and, as of 2018, was substantially below pre-crisis levels. At property and casualty insurance firms, leverage has also been falling, while it has been roughly constant over the past decade for life insurance companies. However, hedge fund leverage appears to have been increasing over the past two years. 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.

Funding Risk

Vulnerabilities associated with funding risk continued to be low in 2018, in part because of the post-crisis implementation of liquidity regulations for banks and the 2016 money market reforms.³

In total, liquid assets in the banking system have increased more than $3 trillion since the financial crisis. Large banks, in particular, hold substantial amounts of liquid assets, far exceeding pre-crisis levels and well above regulatory requirements (figure 10). Bank funding is less susceptible to runs now than in the period leading up to the financial crisis—further reducing vulnerabilities from liquidity transformation. Core deposits, which include checking accounts, small-denomination time deposits, and other retail deposits that are typically insured, are near historical highs as a share of banks' total liabilities. Core deposits have traditionally been a relatively stable source of funds for banks, in the sense that they have been less prone to runs. In contrast, short-term wholesale funding, a source of funds that proved unreliable during the crisis, is near historical lows as a share of banks' total liabilities.

Money market fund (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 2018 to promote financial stability.

Financial Stability Oversight Council Activities

As mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank 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 2018, the Federal Reserve worked, in conjunction with other FSOC participants, on the following major initiatives:

Application under section 117 of the Dodd-Frank Act. On September 12, 2018, the council announced its decision to grant the appeal of ZB, N.A. (Zions), under section 117 of the Dodd-Frank Act.⁴ The action removed the firm's treatment as a nonbank financial company following its merger with Zions Bancorporation. The FSOC found that Zions's potential to pose material financial distress to U.S. financial stability was greatly reduced, as the firm engages in limited capital markets activities, presents minimal fire sale risks, and is subject to extensive regulation and supervision.

Nonbank designations process.On October 17, 2018, the council announced it had voted to rescind its determination that material financial distress at Prudential Financial, Inc. (Prudential), could pose a threat to U.S. financial stability, and that the company should be subject to supervision by the Federal Reserve and enhanced prudential standards.⁵ The FSOC made the decision that Prudential's potential to pose material financial distress to U.S. financial stability was substantially reduced following changes to simplify the company's corporate structure and enhanced capital and liquidity management policies. Further, Prudential is subject to a new regulatory regime under New Jersey state law that allows for groupwide supervision.

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 adoption of sound policies across countries. The Federal Reserve participates in 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 shadow banking activities, coordination of regulatory standards for global systemically important financial institutions, asset management, fintech (emerging financial technologies), evaluating the effects of reforms, and development of effective resolution regimes for large financial institutions. In November, the FSB published its report on incentives to centrally clear over-the-counter derivatives.⁶ Also in November, Randal K. Quarles, the Federal Reserve's Vice Chair for Supervision, was appointed chair of the FSB.

Footnotes