Near-term risks to the financial system
The course of the pandemic and the size and duration of the resulting economic fallout remain the most significant risks to the economy and financial system. The realization of these risks depends largely on the success of public health measures and other government actions to contain the spread of COVID-19. In addition, the steps households and businesses take to resume economic activity, supported by government efforts and policy actions, may ameliorate the most adverse potential outcomes.
The Federal Reserve routinely engages in discussions with domestic and international policymakers, academics, community groups, and others to gauge the set of risks of particular concern to these groups. The following analysis considers possible interactions of existing vulnerabilities with three broad categories of risk that were also raised in these discussions: a prolonged slowdown in U.S. economic growth, risks emanating from Europe, and risks originating in China and other EMEs.
The pandemic could persist for a prolonged period or reemerge, further delaying the recovery of U.S. economic activity and leading to strains on the financial system that worsen the downturn...
Most forecasters expect a sharp contraction in economic output in the United States, for at least the first half of 2020, and a global recession. As noted in the box "Salient Shocks to Financial Stability Cited in Market Outreach," contacts are focused on the likely effects of the COVID-19 outbreak on U.S. economic activity. The expected slowdown could affect the financial system by further weakening the balance sheets of businesses and households, especially those that are already vulnerable. Furthermore, monetary and fiscal policy tools have limited ability to moderate some dimensions of what is fundamentally a public health shock.
If the outbreak persists or if there is a second wave of the pandemic, downward pressure on the U.S. economy would be sustained, as businesses would remain shuttered and workers that have been laid off would be without normal income for a longer period. A number of the vulnerabilities identified in this report could grow, making them more likely to further amplify negative shocks to the economy. Investor risk appetite and asset prices have declined, as would be expected with such an extreme shock. With a protracted pandemic, risk aversion could increase further. Disturbances from COVID-19 have substantially weakened the outlook for profits of nonfinancial businesses. Given the generally high level of leverage in the nonfinancial business sector, financial stress and defaults could become more widespread in a more sustained economic downturn. In addition, a prolonged slowdown could further deteriorate the finances of even high-credit-score households, which could lead to defaults and place financial pressure on banks and other lenders. Broader solvency issues could impair the ability of some financial institutions to lend or induce more selling of assets and redemptions of withdrawable liabilities.
Salient Shocks to Financial Stability Cited in Market Outreach
As part of its market intelligence gathering, Federal Reserve staff gather the views of a wide range of contacts on risks to U.S. financial stability. From early February to mid-April, the staff surveyed 22 contacts at banks, investment firms, academic institutions, and political consultancies. The nature of risks highlighted by respondents evolved over the course of the outreach, though concerns regarding the scope and duration of the COVID-19 pandemic—and its economic and financial effects—featured prominently throughout, as shown in the figure. Global recession concerns remained pronounced, with respondents highlighting a number of vulnerabilities—including elevated government and corporate debt levels as well as untested market structures and investment strategies—that could amplify stress in a downturn. Respondents also expressed concerns about the threat of intensifying geopolitical tensions. In contrast to the previous report, global trade tensions were not cited as one of the most salient near-term risks, partly because of the signing of a phase-one trade deal between the United States and China in December 2019.
Most Cited Potential Shocks over Next 12–18 Months
Note: Responses are to the following question: "Over the next 12–18 months, which shocks, if realized, do you think would have the greatest negative effect on the functioning of the U.S. financial system?"
Source: Federal Reserve Bank of New York phone survey of 22 market contacts from February to mid-April.
The effect of COVID-19 could generate a range of economic, market, and financial risks
Contacts were highly focused on the effect of the COVID-19 pandemic and lockdown efforts on the economy and financial system. With regard to the virus itself, respondents early in the outreach cited the potential spread of the virus from China to Europe and the United States. As the virus spread globally, the focus shifted toward the risk of a longer, deeper pandemic, with contacts highlighting the prospect that a premature easing of restrictions could prolong the outbreak and that effective vaccines or therapies might not be developed in time to attenuate possible second waves.
Respondents also highlighted a range of operational, financial, and policy risks related to the outbreak. Respondents noted that lockdowns were likely to amplify operational vulnerabilities at firms; they cited the potential for remote or home-based trading activity to weaken market functioning and for financial institutions' offshore back-office operations to be disrupted.
Many contacts expressed concern that a U.S. recession brought about by the pandemic could expose highly leveraged sectors of the economy. Contacts noted that corporate default rates were likely to increase sharply, with acute stress in the energy sector. Even before the outbreak spread to the United States, concerns related to nonfinancial corporate debt were cited frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds. More recently, surveyed respondents noted that a period of renewed outflows from credit-oriented mutual funds could lead to limits on redemptions and that stressed global insurers could become large sellers of U.S. corporate bonds.
A number of contacts also raised concerns over household balance sheets, especially in low-income segments, highlighting increases in credit card, student loan, and auto loan delinquencies as well as concerns over spillovers from nonpayments of rent and mortgages. Against the backdrop of corporate, consumer, and real estate stress, several respondents noted that bank asset quality could come under severe pressure. Smaller banks with high concentrations of lower-rated consumers, small and medium-sized businesses, and CRE were viewed as especially vulnerable.
Several policy-related risks were also identified, including the risk that funding designated to support small businesses would be either insufficient to address the scale of the need or not timely enough to avert a wave of layoffs and bankruptcies. Finally, a few contacts noted the prospect that state and local governments would face large budgetary gaps, with spillovers to the municipal bond market and local economies. In the euro area, some respondents noted that the absence of more expansive fiscal resource sharing or debt mutualization could underpin a return of redenomination risk in some of the monetary union's most indebted sovereigns.
A few respondents noted that novel investment strategies and market structures could prove vulnerable in a sustained market downturn. Specifically mentioned were the growth of short-volatility strategies, the expansion of leveraged ETFs, and the reliance in some markets on sources of liquidity that could withdraw in a shock.
Finally, geopolitical tensions were cited frequently as a medium- to long-term risk. A few contacts noted that the COVID-19 outbreak could amplify tensions and accelerate a shift away from multilateralism. Respondents also highlighted the risk of heightened trade tensions and the possibility that the virus and its fallout could accelerate global leadership changes and amplify political uncertainty.
. . . and financial institutions are at greater risk for adverse operational events in the meantime
The pandemic has had significant effects on the operations of a variety of financial firms, leading to an increase in operational risk in the financial system. Financial institutions have been operating based on their business continuity plans while often intermediating very high transaction volumes. Banks' relative success thus far demonstrates the benefits of both having those plans and actively testing them. Nonetheless, banks have been following these plans for longer than anticipated and should continue developing new longer-term plans.
Many operational challenges make it harder to operate efficiently or effectively. Absenteeism has increased because of social distancing or illness and also because of competing responsibilities such as childcare. Some large banks have selectively closed branches or opted to alternate branch operating times. Smaller banks and those that operate in rural markets may have less flexibility and could be significantly impaired if a staff member were infected. Many financial infrastructures have switched to operating completely remotely at a time when transaction volumes have often been extremely high. During periods when financial institutions operate remotely or with limited staff, the possibility of operational miscues or other mistakes may increase. For example, remote arrangements have slowed decision-making or approval channels which can result in processing delays and create backlogs due to employees who experience difficulties with internet or other infrastructure issues at home. And financial firms are also more vulnerable to security risks, as more employees work from home.
Stresses emanating from Europe pose risks to the United States because of strong transmission channels...
European banks play an important role in global financial intermediation and have notable financial and economic linkages with the United States. Over the past few months, many countries in Europe forced nationwide lockdowns to mitigate COVID-19's spread; many businesses were ordered to shut down, and residents were required to stay at home for prolonged periods, damping economic activity, which could lead to sizable loan losses in the banking system. In response to these developments, European governments have implemented fiscal policies that have resulted in increased government spending and tax relief. These fiscal policy actions will likely reduce financial stability risks, on balance, in the short run. However, further expansionary policies, possibly due to large-scale reinfections of COVID-19, could have the potential to result in a sizable increase in government debt and a further increase in sovereign risk in the long run. In Italy, for example, additional fiscal measures could have implications for the sustainability of Italian sovereign debt, which is already elevated as a share of output. If debt sustainability were to materially worsen in Italy and in other highly indebted countries, it also could stress European financial institutions and lead to political tensions within the euro area. Such a development could, in turn, affect the U.S. economy and the financial system through dollar funding markets, credit exposures, a further deterioration in risk appetite, and trade channels.
In addition to the COVID-19-related risks, a no-trade-deal Brexit still poses risks to the European and U.S. financial systems. Although the United Kingdom formally left the European Union (EU) in January, it remains under the EU's trade rules until the end of this year. The failure to reach a final trade agreement could lead to supply chain disruptions in Europe and also could result in losses for European financial institutions. Accordingly, although financial institutions will have had ample time to prepare for Brexit, an unsuccessful trade agreement could lead to strains in global financial markets, resulting in a tightening of U.S. financial conditions.
. . . and adverse developments in China and other emerging market economies with vulnerable financial systems and strained public finances could also spill over to the United States
Because of the size of the economy, prolonged or recurrent periods of markedly depressed economic activity in China due to reinfections of COVID-19 could spill over to U.S. and global markets through disruptions in supply chains, a further reduction of risk appetite, more U.S. dollar appreciation, and additional declines in commodity prices. In China, the spread of the virus has slowed significantly and, therefore, restrictions on domestic travel and economic activity have in large part been lifted. That said, a sluggish recovery of Chinese domestic demand, a deeper slump in demand from abroad, or renewed efforts to curtail another virus outbreak could put additional pressure on Chinese firms, which are already highly indebted, and could put stress on the vulnerable financial sector. This situation could further strain global financial markets and disrupt regional value chains and exports to China, which could ultimately affect the U.S. financial system.
Broader stresses in EMEs, in which health-care systems, political institutions, and financial infrastructures are more fragile, could also have repercussions for the United States. In particular, Latin American economies, which have had persistent current account deficits, have already seen significant capital outflows due to a drop in global risk appetite. If the spread of COVID-19 is not mitigated in these countries and authorities find they have limited fiscal capacity to deal with the macroeconomic shock and the health crisis, further deterioration in credit risk or risk appetite could lead to balance of payment crises. For oil exporters, these dynamics could be exacerbated if oil prices remain depressed or fall even further because of either weak demand or a resumption of disputes within OPEC (Organization of the Petroleum Exporting Countries). Further dollar appreciation due to widespread stresses in EMEs could potentially put additional strains on U.S. firms that rely on exports and supply chains for their business operations. Some U.S. financial institutions may be directly affected by their exposures to these U.S. firms, in addition to the stressed EME firms and sovereigns themselves.