Near-term risks to the financial system

Developments in domestic and international markets could pose a number of near-term risks to the financial system, with the ultimate effects likely depending on the vulnerabilities of the financial system identified earlier in this report. The Federal Reserve routinely engages with domestic and international policymakers, academics, community groups, and others in part to gauge the set of risks of particular concern to these groups. The box "Salient Shocks to Financial Stability Cited in Market Outreach" presents views reported by a range of financial market participants. The following analysis considers possible interactions of existing vulnerabilities with three broad categories of potential risks identified in these conversations: risks emanating from Europe; risks originating from emerging market economies (EMEs), including China; and an unexpected and marked slowing of U.S. economic growth.

Salient Shocks to Financial Stability Cited in Market Outreach

As part of its market intelligence gathering, the Federal Reserve staff conducts outreach to a wide range of market and official-sector contacts to gather their views on risks to U.S. financial stability.1 As in the previous report, respondents cited uncertainties around trade and monetary policy as the top two sources of risk over the next 12 to 18 months (see the figure in this box). Survey respondents for this report appear more concerned about the prospect of sharp declines in market liquidity, raising this risk to be the third most cited (the subject of the box "What Has Been Happening to the Liquidity of the U.S. Treasury and Equity Futures Markets?"). The threat of geopolitical shocks was viewed as broadening; indeed, contacts cited numerous and potentially mutually reinforcing East Asian flashpoints in addition to Iran tensions and Brexit. Finally, global recession concerns remained pronounced, with respondents highlighting a number of vulnerabilities—including U.S. and Chinese indebtedness as well as untested market structures and investment strategies—that could amplify stress in a downturn.

The risks from U.S. trade and advanced-economy monetary policy are front and center

Trade frictions—centered on the U.S.–China dispute but also including possible actions against the European Union—remained the most widely cited potential near-term shock. Respondents generally expected higher tariffs on Chinese imports to persist well into next year and noted that the tariffs had started to affect U.S. economic activity. Some contacts also worried about a deterioration in broader U.S.–China relations—rooted in technology and national security issues—and the potential for regional geopolitical risks in Hong Kong, Taiwan, and North Korea to amplify bilateral tensions. Several respondents cited a new, related risk of more activist U.S. investment and currency policies, including the possible taxation of—or limits on—capital flows as well as interventions in foreign exchange markets.

The second most widely cited risk centered on the efficacy of U.S. and other advanced-economy monetary policies. Many respondents wondered whether central banks would be able to counter an economic slowdown due to already low levels of interest rates and compressed risk premiums. Relatedly, some contacts argued that select foreign central banks with negative policy rates were either close to or beyond reversal rates, which are the rates at which the negative effects of incremental easing—for example, weaker profitability of financial institutions or higher precautionary savings from retirees—might offset positive growth impulses. Amid very low global interest rates, contacts also noted a heightened willingness to assume leverage as well as credit, duration, and currency risks, rendering risk premiums and exposures vulnerable to a potential sharp upward repricing of interest rates. With regard to the Federal Reserve specifically, a few contacts highlighted the possibility that U.S. interest rates could turn negative, with potentially severe repercussions for money market funds and the municipal bond market. Moreover, several respondents cited the short-lived episode of funding market volatility in September while noting that an additional episode of upward pressure on secured and unsecured rates could weigh on risk sentiment or damage central bank credibility.

Contacts express concern that a recession could expose leveraged sectors and untested market structures

A number of contacts expressed concern that a U.S. recession would expose highly leveraged sectors of the economy. As with previous outreach, concerns related to nonfinancial corporate debt were cited most frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds. However, in this round, a few contacts also raised concerns over household balance sheets, highlighting the gradual increase in credit card delinquencies in recent years, as well as subdued growth of net worth among a large share of lower-income households that tend to have higher propensities to consume.

Additionally, several contacts highlighted that a downturn could test new market structures, investment strategies, and business models, generating hard-to-foresee spillovers. Contacts focused especially on the growth of passive investment strategies and exchange-traded funds (ETFs), highlighting that a market downturn could expose liquidity mismatches in the assets and liabilities of select ETFs. Respondents also noted other shifts in market structure—a growing concentration of dealer intermediaries in some markets and a rising presence of high-frequency traders that tend to withdraw in stress—could render market liquidity more vulnerable to shocks.

In addition, contacts pointed to untested credit models based on big data, the rapid growth of new credit originating outside of the banking sector, and the concern that dealers were largely staffed with traders that had never operated in a sustained market downturn. Finally, several respondents noted the disruptive potential of new financial technologies, including the possibility that they could weaken bank deposit stability, facilitate riskier credit extension, and disintermediate banks.

Potential Shocks Cited in Market Outreach
Potential Shocks Cited in Market Outreach
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Reflects outreach to 24 contacts (banks, investment firms, and official-sector institutions) in 2019:Q3. Responses were to the following question: "Over the next 12–18 months, which shocks, if realized, do you think would have the greatest negative impact on the functioning of the U.S. financial system (can impair the system and harm the economy)?" Each respondent provided at least three shocks.

Source: FRBNY phone survey of market and official-sector contacts from mid-august to end-September.

1. Contacts included analysts and strategists at banks, investment firms, and political risk consultants as well as financial stability experts from central banks, universities, and multilateral agencies. The outreach was conducted from mid-August to the end of September. Return to text

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Stresses emanating from Europe pose risks for U.S. markets and financial institutions...

European economies have notable financial and economic linkages with the United States, and a sharp economic downturn in Europe would likely spill over to the U.S. financial system. Adverse economic and financial developments in Europe could heighten uncertainty and lead to a sharp pullback of investors from riskier assets, amplifying market volatility and declines in asset prices. Stresses in European banks could also 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, including dollar funding markets. Moreover, the consequent dollar appreciation and lower global demand in the event of a sharp downturn in Europe would weaken the U.S. economy through trade channels, impairing the creditworthiness of U.S. exporting firms.

The United Kingdom and the European Union have agreed to a Brexit extension until January 31, 2020, but the risk of a no-deal Brexit in 2020, while diminished, still persists. A no-deal Brexit could trigger market and economic disruptions in Europe that might spill over to global markets, leading to a tightening of U.S. financial conditions. Should a no-deal Brexit cause distress in systemically important financial institutions in Europe, it would amplify the transmission of economic disturbances to U.S. and global financial systems.

. . . and adverse developments in China and other EMEs also could spill over to the United States

Because of the size of the Chinese economy, significant distress in China could spill over to U.S. and global markets through a retrenchment of risk appetite, U.S. dollar appreciation, and declines in trade and commodity prices. A prolonged period of rapid credit expansion in China has rendered its nonfinancial corporate sector highly vulnerable to a sharp downturn. In addition, poor asset quality and notable interconnections between banks and the large and weakly regulated shadow banking sector leave the Chinese financial sector vulnerable. In this context, near-term risks such as an escalation in the trade conflict with the United States, a rapid adjustment in property prices, or a high-profile corporate default may trigger financial instability that could be transmitted globally.

Broader stresses in EMEs, possibly due to geopolitical conflicts, could spill over to the U.S. financial system. Currently, there are a few areas where strains are acute. The social and political unrest in Hong Kong could threaten the near-term outlook in the region and may pose financial-sector risks given Hong Kong's status as a global financial hub. Argentina and Turkey also face an array of financial and economic problems. So far, these developments appear idiosyncratic and U.S. exposure is limited, but these cases point to fragilities should broader strains emerge.

A marked slowdown in economic growth could pose risks to the financial system

Although most forecasters expect continued expansion in the United States, many of the shocks highlighted in the box "Salient Shocks to Financial Stability Cited in Market Outreach" could lead to a marked slowdown in the U.S. economy. As noted in the box, such a slowdown could affect the financial system by weakening the balance sheets of businesses and households and through a decline in asset prices.

If the economy were to slow unexpectedly, profits of nonfinancial businesses would decrease, and, given the generally high level of leverage in that sector, such decreases would likely lead to financial stress and defaults at some firms. Investor risk appetite and asset prices may decline significantly in such a scenario, especially in markets such as high-yield bonds and CRE, where valuations are elevated. In addition to generating losses for the holders of the assets, a decline in asset prices could affect the financial system more generally either by impairing the ability of some financial institutions to lend or by inducing a wave of selling and redemptions of withdrawable liabilities.

While indicators point to financial fragility among some households, these shocks are less likely to propagate to the financial system through the household sector because household borrowing overall is moderate relative to income, and the majority of debt is owed by households with higher credit scores. Moreover, U.S. banks generally remain well capitalized and hold ample liquidity. The most recent stress tests conducted by the Federal Reserve indicate that the largest banks are sufficiently resilient to continue to serve creditworthy borrowers even under a severely adverse scenario.14 The broader financial system also has less leverage and funding risk by historical standards, so the effects of a decline in asset prices are less likely to be amplified through these vulnerabilities.

 

References

 14. See Board of Governors of the Federal Reserve System (2019), Comprehensive Capital Analysis and Review 2019: Assessment Framework and Results (Washington: Board of Governors, June), https://www.federalreserve.gov/publications/files/2019-ccar-assessment-framework-results-20190627.pdf  Return to text

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Last Update: November 21, 2019