Near-term risks to the financial system
Developments in domestic and international markets could pose near-term risks to the U.S. financial system. The ultimate effects of shocks arising from such developments likely depend on the vulnerabilities in the financial system identified in the previous sections of this report.
Brexit and euro-area fiscal challenges pose risks for U.S. markets and institutions...
Large European economies have notable financial and economic linkages with the United States, and stresses emanating from Europe may pose risks for the U.S. financial system. Two of those risks are particularly salient now. First, the United Kingdom and the European Union (EU) have not yet ratified the terms for the U.K. March 2019 withdrawal from the EU, known as Brexit. Besides its extensive implications for trade and a host of other activities, Brexit calls for a significant reorganization of financial arrangements between U.K. and EU residents. Without a withdrawal agreement, there will be no transition period for European entities following the U.K. exit from the EU, and a wide range of economic and financial activities could be disrupted. Second, confidence in the euro area's fiscal and financial prospects remains sensitive to ongoing developments despite improvement since the 2010-12 sovereign debt crisis. Recently, Italy's new budget proposal, which includes a wider deficit projection than anticipated, is leading to concerns among market participants and EU officials that this plan would put Italy's sovereign debt on an unsustainable path. European banks are exposed to these fiscal risks as significant investors in euro-area sovereign bonds.
The potential consequences for the U.S. financial system from these European risks arise through several transmission channels. First, an intensification of sovereign debt concerns or unresolved uncertainty about the implications of Brexit could lead to market volatility and a sharp pullback of investors and financial institutions from riskier assets, as occurred following the June 2016 Brexit referendum in the United Kingdom and earlier during the European debt crisis. Second, spillover effects from U.K. and other European banks could be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through the common participation of globally active banks in a broad range of activities and markets. Moreover, because London is an important international financial center, U.S. banks and broker-dealers participate in some of the markets most likely to be affected by Brexit. Third, an economic downturn in Europe, likely accompanied by dollar appreciation, would also affect the United States through trade channels, which could harm the creditworthiness of some U.S. firms, particularly exporters.
. . . and problems in China and other emerging market economies could spill over to the United States
In China, the pace of economic growth has been slowing recently, and years of rapid credit expansion have left lenders more exposed in the event of a slowdown. Chinese nonfinancial private credit has almost doubled since 2008, to more than 200 percent of GDP. Against this backdrop, developments that significantly strain the repayment capacity of Chinese borrowers and financial intermediaries--including an escalation in international trade disputes or a collapse in Chinese real estate prices--could trigger adverse dynamics.
A number of other emerging market economies (EMEs) have also seen significant increases in either corporate or sovereign debt that could be difficult to service in the event of an economic downturn. For some borrowers, much of this debt is denominated in foreign currencies, so as monetary policy normalizes in the United States and in other advanced economies, EMEs may be vulnerable to rising global interest rates or to stronger advanced-economy currencies. Although the recent market turbulence faced by Argentina and Turkey in part reflects higher vulnerabilities in those countries, if global interest rates rose faster than currently anticipated or if other shocks hit the global economy, wider stress in EMEs could occur.
Should significant problems arise in China or in EMEs more broadly, spillovers, including dollar appreciation, declines in world trade and commodity prices, and a pullback from risk-taking by investors outside the affected markets, could be sizable. In addition, the effect of a stronger dollar and weaker foreign economies on trade could affect the creditworthiness of U.S. firms, particularly exporters and commodity producers.
Trade tensions, geopolitical uncertainty, or other developments could make investors more averse, in general, to taking risks
An escalation in trade tensions, geopolitical uncertainty, or other adverse shocks could lead to a decline in investor appetite for risks in general. The resulting drop in asset prices might be particularly large, given that valuations appear elevated relative to historical levels. In addition to generating losses for asset holders, a significant fall in asset prices would make it more costly for nonfinancial businesses to obtain funding, putting pressure on a sector where leverage is already high. Markets and institutions that may have become accustomed to the very low interest rate environment of the post-crisis period will also need to continue to adjust to monetary policy normalization by the Federal Reserve and other central banks. Even if central bank policies are fully anticipated by the public, some adjustments could occur abruptly, contributing to volatility in domestic and international financial markets and strains in institutions.
The banking sector is resilient, however, as evidenced by high levels of capital and liquidity. Moreover, stress tests conducted by the Federal Reserve on the largest banks routinely feature large declines in asset prices, suggesting that those institutions are positioned to weather asset price changes without having to significantly pull back on their lending activities. The broader financial system is also substantially more resilient, with less leverage and funding risk than leading up to the financial crisis, so these sources of vulnerability are less likely to amplify the effects of falling asset prices.