In the years leading up to the 2007-09 financial crisis, many parts of the U.S. financial system grew dangerously overextended. By early 2007, house prices were extremely high, and relaxed lending standards resulted in excessive mortgage debt. Financial institutions relied heavily on short-term, uninsured liabilities to fund longer-term, less-liquid investments. Money market mutual funds and other investment vehicles were highly susceptible to investor runs. Over-the-counter derivatives markets were largely opaque. And banks, especially the largest banks, had taken on significant risks without maintaining resources sufficient to absorb potential losses.
As a result of these vulnerabilities, a drop in house prices precipitated a financial panic. A broad initial retrenchment in asset prices led to sharp withdrawals of short-term funding from a wide range of institutions. These funding pressures resulted in fire sales, which contributed to additional declines in asset prices and generated further losses and even more withdrawals of funding. Some financial institutions failed, and many more pulled back on lending. As home prices continued to fall, and mortgage credit became scarce, millions of mortgages, many held in complex financial vehicles that increased investor leverage, could not be refinanced. Many mortgages ultimately went into default, creating devastating and widespread losses for homeowners.
Reforms undertaken since the financial crisis have made the U.S. financial system far more resilient than it was before the crisis. Working with other agencies, the Federal Reserve has taken steps to ensure that financial institutions and markets can support the needs of households and businesses through good times and bad. Banking institutions have built stronger capital and liquidity buffers that, together with reforms to the rules governing money market funds, strengthen the ability of institutions to withstand adverse shocks and reduce their susceptibility to destabilizing runs. Recovery and resolution plans have helped ensure that risks leading to the failure of financial intermediaries are borne by the institutions and investors taking the risks and not U.S. taxpayers. Reforms to derivatives markets have rendered them less opaque and have reduced credit exposures between derivatives counterparties.
Despite this important progress, vulnerabilities may build over time. This report examines a variety of quantitative and qualitative indicators across a range of markets and institutions to evaluate developments in the four broad areas of potential vulnerabilities described in the previous section. Our assessment of the current level of vulnerabilities is as follows:
- Valuation pressures are generally elevated, with investors appearing to exhibit a high tolerance for risk-taking, particularly with respect to assets linked to business debt.
- Borrowing by households has risen roughly in line with household incomes. However, debt owed by businesses relative to gross domestic product (GDP) is historically high, and there are signs of deteriorating credit standards.
- The nation's largest banks are strongly capitalized, and leverage of broker-dealers is substantially below pre-crisis levels. Insurance companies have also strengthened their financial position since the crisis.
- Funding risks in the financial system are low relative to the period leading up to the crisis. Banks hold more liquid assets, and money market mutual funds are less vulnerable to destabilizing runs by investors.