Overview
This report reviews conditions affecting the stability of the financial system by analyzing vulnerabilities related to valuation pressures, borrowing by businesses and households, financial leverage, and funding risk. It also highlights several near-term risks that, if realized, could interact with such vulnerabilities.
Since the May 2020 Financial Stability Report was issued, asset prices have continued to move up, on balance, amid periods of volatility. Business and household earnings have fallen and business borrowing has risen, which leave households and firms more vulnerable to future shocks. Banks absorbed large losses related to the pandemic but remained well capitalized throughout; moreover, capital ratios have since generally recovered to pre-pandemic levels. However, the COVID-19 shock highlighted how vulnerabilities related to leverage and funding risk at nonbank financial institutions could amplify shocks in the financial system in times of stress.
Our view of the current level of vulnerabilities is as follows:
- Asset valuations. Asset prices have generally increased since May of this year. The elevated levels of asset prices in various markets likely reflect the low level of Treasury yields, and measures of the compensation for risk appear roughly aligned with historical norms. Given the high level of uncertainty associated with the pandemic, assessing valuation pressures is particularly challenging, and asset prices remain vulnerable to significant declines should investor risk sentiment fall or the economic recovery weaken.
- Borrowing by businesses and households. Debt owed by businesses, which was already historically high relative to gross domestic product (GDP) before the pandemic, has risen sharply as businesses increased borrowing to weather the period of weak earnings. The general decline in revenues associated with the severe reduction in economic activity has weakened the ability of businesses to service these obligations. Household debt was at a moderate level relative to income before the public health shock, but many households have lost jobs and seen their earnings fall. As many households continue to struggle, loan defaults may rise, leading to material losses. So far, strains in the business and household sectors have been mitigated by significant government lending and relief programs and by low interest rates. That said, some households and businesses have been substantially more affected to date than others, suggesting that the sources of vulnerability in these sectors are unevenly distributed.
- Leverage in the financial sector. The pandemic stressed the resilience of banks, but they remain well capitalized. Leverage at broker-dealers also remains low. In contrast, measures of leverage at life insurance companies are at post-2008 highs and remain elevated at hedge funds relative to the past five years. Some nonbank financial institutions felt significant strains amid the acute period of extreme market volatility, declining asset prices, and worsening market liquidity earlier this year. Pressures eased as a result of policy actions, including Federal Reserve asset purchases and repurchase agreement (repo) operations, regulatory relief for dealers affiliated with BHCs, and support from the emergency lending facilities.
- Funding risk. Bank funding risk remains low, as they rely only modestly on short-term wholesale funding and maintain large amounts of high-quality liquid assets, which has helped banks manage heightened liquidity pressures. Banks also benefited from a surge in deposit inflows through the second quarter of 2020. In contrast, the large redemptions from money funds and fixed-income mutual funds, as well as the need for extraordinary support from emergency lending facilities, highlighted vulnerabilities in these sectors. While in place, those facilities substantially mitigate these vulnerabilities.
The report also details how near-term risks have changed since the May 2020 report. The outlook for the pandemic and economic activity is uncertain. In the near term, risks associated with the course of COVID-19 and its effects on the U.S. and global economies remain high. In addition, there is potential for stresses to interact with preexisting vulnerabilities in dollar funding markets or those stemming from financial systems or fiscal weaknesses in Europe, China, and emerging market economies (EMEs). These risks have the potential to interact with the vulnerabilities identified in this report and pose additional risks to the U.S. financial system.
Federal Reserve Actions and Facilities to Support Households, Businesses, and Municipalities during the COVID-19 Crisis
Since the beginning of the pandemic, the Federal Reserve has taken forceful actions to support the continued flow of credit to households, businesses, and state and local governments. At the onset of the pandemic, it became clear that businesses and families would face an extended period during which many forms of economic activity were curtailed for public health reasons. During this period, revenues and incomes would be sharply lower. Employers faced the prospect of being unable to pay wages and other obligations, which could force them to shut down permanently and, in turn, restrain the economy's recovery. At the same time, the availability of credit sharply worsened, with many lending markets commonly tapped by employers effectively shut.
Supported by funds provided by the CARES Act, the Federal Reserve created, with the authorization of the U.S. Treasury Department, a number of emergency lending facilities.1 Collectively, the facilities support the flow of credit throughout the economy both by providing backstop measures that give investors confidence that lending support is available should conditions deteriorate substantially and by supplying funding that is more directly used to meet credit demand.2
Backstops for larger firms and municipalities
The Primary Market Corporate Credit Facility (PMCCF), Secondary Market Corporate Credit Facility (SMCCF), and Municipal Liquidity Facility (MLF) were established to improve the flow of credit through bond markets, where large firms and municipalities obtain most of their long-term funding.3 The PMCCF stands ready to purchase new bonds and loans issued by investment-grade U.S. corporations so that they can maintain business operations and employment during the pandemic. The SMCCF supports trading in the bonds that corporations previously issued. The MLF helps state and local governments as well as certain multistate or revenue bond issuers manage their cash flow needs, which may be particularly acute given the potential mismatch between delayed or diminished tax receipts and higher-than-normal spending for unemployment insurance and other essential services.
The announcements of the PMCCF, SMCCF, and MLF in late March and early April led to rapid improvements in corporate and municipal bond markets well ahead of the facilities' actual opening. Spreads across a variety of debt markets quickly narrowed, permitting businesses and municipalities to borrow at sharply lower costs (figures A, B, and C). SMCCF purchases to date amount to about $13 billion—just more than 0.2 percent of the $5.5 trillion of outstanding nonfinancial corporate bonds. The MLF has, to date, purchased two issues totaling just more than $1.6 billion. However, since the announcement of the backstop facilities and funding market stabilization measures, more than $1 trillion in new nonfinancial corporate bonds and more than $250 billion in municipal debt have been issued, purchased almost entirely by the private sector (figures D and E).
A. Corporate Bond Spreads to 10-Year Treasury
Note: The shaded area with a top cap represents an expanded window focusing on the period from February 17 onward. The triple-B reflects the effective yield of the ICE Bank of America Merrill Lynch triple-B U.S. Corporate Index (C0A4), and the high yield reflects the effective yield of the ICE BofAML U.S. High Yield Index (H0A0). Treasury yields from smoothed yield curve are estimated from off-the-run securities. Spreads over 10-year Treasury yield. PMCCF is the Primary Market Corporate Credit Facility, and SMCCF is the Secondary Market Corporate Credit Facility.
Source: ICE Data Indices, LLC, used with permission.
B. Municipal Bond Yields, by rating
Source: ICE Data Indices, LLC.
C. Municipal Bond Spreads, by Rating
Note: Spreads on municipal bonds are relative to comparable-maturity Treasury yields.
Source: ICE Data Indices, LLC.
D. Cumulative Corporate Credit Issuance
Source: S&P Global, Leveraged Commentary & Data.
E. 2020 Weekly Municipal Bond Issuance, by Rating
Note: Key identifies bars in order from bottom to top.
Source: Bloomberg.
The Term Asset-Backed Securities Loan Facility (TALF) provides additional support for consumers and businesses. The TALF supports the issuance of asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, loans backed by the Small Business Administration (SBA), and certain other assets. A key market that benefits from the TALF is commercial real estate (CRE), as legacy commercial mortgage-backed securities (CMBS) and SBA securitizations collateralized by CRE mortgages are eligible for the TALF and have represented the bulk of the assets pledged as collateral for TALF loans. Similar to the other backstop facilities, while outstanding balances in the TALF have remained modest, spreads in ABS markets have narrowed considerably, and private market issuance has resumed (figure F).
F. Consumer ABS Spreads (3-Year Triple-A)
Note: TALF is the Term Asset-Backed Securities Loan Facility. Spreads are to the swap rate for credit card and auto asset-backed securities (ABS) and to 3-month LIBOR (London interbank offered rate) for student loans. FFELP is Federal Family Education Loan Program.
Source: JPMorgan Chase & Co.
Funding for small and medium-sized businesses
The Federal Reserve has taken actions to support lending by banks and nonbanks that specialize in small business loans. The Paycheck Protection Program Liquidity Facility (PPPLF) was established to extend credit to lenders that participate in the SBA's Paycheck Protection Program (PPP), which provides payroll support for small businesses. The PPP provides forgivable loans to small businesses in order for them to keep workers on their payrolls. The Main Street Lending Program (Main Street) targets firms that are often too small to issue corporate bonds or access capital markets.
Through September 30, the Federal Reserve had made more than 11,000 PPPLF advances to nearly 800 banking institutions, totaling around $70 billion. Small community banks account for 50 percent of the advances and 90 percent of active borrowers. Moreover, 80 community development financial institutions and minority development institutions, which serve communities in distress and minority communities, have received PPPLF advances supporting nearly $17 billion in loans. The average PPP loan size that the advances support was just more than $100,000, suggesting that the PPPLF funds were mostly directed to lenders that helped support small business employment. The $669 billion advanced under the PPP earlier this year may have restrained small business demand for bank loans, with many borrowers reportedly using the funds to pay down lines of credit.
Main Street established five types of loans: three for for-profit businesses and two for nonprofit organizations. Banks originate the loans, and the Federal Reserve, in turn, purchases 95 percent participation in them. Eligibility requirements and terms differ across loan types, but borrowers must have fewer than 15,000 employees or 2019 revenues of less than $5 billion. Main Street loans are designed specifically to help borrowers weather a period of sharply reduced revenues, featuring interest and principal payments that are deferred over the first two years, underwriting criteria that generally look back to borrowers' pre-pandemic financial circumstances and post-pandemic prospects, and other elements. As of October 5, Main Street had purchased 303 loan participations, totaling nearly $3 billion.
To date, Main Street loans appear to be flowing to borrowers from the hardest-hit areas of the country. For example, more loans are going to firms in states that experienced larger unemployment rate increases during the height of the pandemic. Loans have also covered a wide range of industries. Importantly, small and medium-sized banks, which tend to supply credit to small and medium-sized businesses, make up the majority of the loan participants. Community banks (defined as institutions with less than $10 billion in assets) have originated roughly 61 percent of the dollar value of extended loans. Main Street provides an important backstop should the recovery falter and a larger number of businesses need more access to credit.
1. The CARES Act (Coronavirus Aid, Relief, and Economic Security Act) authorized the Treasury's equity contribution to many of the facilities, which collectively can support up to $2.6 trillion of credit to firms of all sizes and to state and local governments. Return to text
2. In addition, backstop facilities may also implicitly affect the prices at which credit is intermediated. For additional information on facilities' price effects, see Sam Schulhofer-Wohl (2020), "The Influence and Limits of Central Bank Backstops," Federal Reserve Bank of Chicago, Chicago Fed Insights (blog), August 17, https://www.chicagofed.org/publications/blogs/chicago-fed-insights/2020/the-influence-and-limits-of-central-bank-backstops.
Though borrowers must meet eligibility standards and funds are not unlimited, these programs are designed to be broad based; taken together, they facilitate credit provision for sectors that account for more than 97 percent of all U.S. employment. See Ryan Decker, Robert Kurtzman, Byron Lutz, and Chris Nekarda (forthcoming), "Across the Universe: Policy Support for Employment and Revenue in the Pandemic Recession," Finance and Economics Discussion Series (Washington: Board of Governors of the Federal Reserve System). Return to text
3. For more details on the facilities, see the box "The Federal Reserve's Monetary Policy Actions and Facilities to Support the Economy since the COVID-19 Outbreak" in Board of Governors of the Federal Reserve System (2020), Financial Stability Report (Washington: Board of Governors, May), pp. 9–15, https://www.federalreserve.gov/publications/files/financial-stability-report-20200515.pdf. Return to text
Federal Reserve Actions to Stabilize Short-Term Funding Markets during the COVID-19 Crisis
At the onset of the pandemic in late March 2020, investors rapidly moved into cash and the most liquid financial instruments, causing acute stresses in some short-term funding markets. Dislocations in markets for U.S. Treasury securities occurred, and market functioning was unusually strained (see figure A and the box "A Retrospective on the March 2020 Turmoil in Treasury and Mortgage-Backed Securities Markets"). Investors shortened the horizon over which they would lend to companies in the commercial paper (CP) market. In addition, some prime money market funds (MMFs) experienced historically large redemptions. These stresses had the potential to amplify the shock of the pandemic, because a breakdown in short-term funding markets could leave companies unable to meet near-term obligations and households and businesses unable to access accounts they routinely use to make payments.
A. Indicative U.S. Treasury Bid-Ask Spreads
Note: Indicative bid-ask spreads for 10-year Treasury note. The bid-ask spread for a security is the difference between the bid price and the ask price, where the "bid" is the price to buy a security and the "ask" is the price to sell it. On March 15, the Federal Open Market Committee announced an increase of its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion. On March 23, the Federal Reserve announced it would continue to purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions. UST is U.S. Treasury securities.
Source: Federal Reserve Bank of New York.
The Federal Reserve, with the support of the Department of the Treasury, quickly responded and announced the Commercial Paper Funding Facility (CPFF), the Money Market Mutual Fund Liquidity Facility (MMLF), and the Primary Dealer Credit Facility (PDCF) to stabilize funding markets, backstop against further stress, and improve the flow of credit to households and businesses. The facilities gave investors confidence that they could access their cash when needed and that companies would be able to roll over CP when needed, relieving selling pressures. Consequently, redemptions among prime MMFs fell dramatically, spreads on corporate CP narrowed, and term CP volumes of five days and greater stabilized (figure B). Although balances in the PDCF, CPFF, and MMLF have fallen from their initial highs to very low levels, the facilities continue to serve as important backstops against further market stress and support the flow of credit as the pandemic persists (figure C).
B. 1-Month Funding Market Spreads for Investment-Grade Nonfinancial Corporations
Note: All spreads are to overnight index swaps of the same tenor. CP is commercial paper and CPFF is the Commercial Paper Funding Facility. MMLF is the Money Market Mutual Fund Liquidity Facility. MMLF operations began on March 23. On the same day, the Federal Reserve announced that the MMLF would be expanded to include negotiable certificates of deposit and variable-rate demand notes. CPFF operations began on April 14. Neither DTCC Solutions LLC nor any of its affiliates shall be responsible for any errors or omissions in any DTCC data included in this publication, regardless of the cause, and in no event shall DTCC or any of its affiliates be liable for any direct, indirect, special, or consequential damages, costs, expenses, legal fees, or losses (including lost income or lost profit, trading losses, and opportunity costs) in connection with this publication.
Source: Board of Governors of the Federal Reserve System; DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation.
C. Outstanding Balances of Emergency Lending Facilities
Note: PDCF is Primary Dealer Credit Facility. MMLF is the Money Market Mutual Fund Liquidity Facility. CPFF is the Commercial Paper Funding Facility.
Source: Federal Reserve Board, Statistical Release H.4.1, "Factors Affecting Reserve Balances."