The Federal Reserve monitors financial system risks and engages at home and abroad to help ensure the system supports a healthy economy for U.S. households, communities, and businesses.
In pursuit of continued financial stability, the Federal Reserve monitors the potential buildup of risks to financial stability; uses such analyses to inform Federal Reserve responses, including the design of stress-test scenarios and decisions regarding other policy tools such as the countercyclical capital buffer; works with other domestic agencies directly and through the Financial Stability Oversight Council (FSOC); and engages with the global community in monitoring, supervision, and regulation that mitigate the risks and consequences of financial instability domestically and abroad.1
This section discusses key financial stability activities undertaken by the Federal Reserve over 2021, which include the following:
- monitoring vulnerabilities that affect financial stability (see figure 3.1 for a summary of key vulnerabilities)
- promoting a perspective on the supervision and regulation of large, complex financial institutions that accounts for the potential spillovers from distress at such institutions to the financial system and broader economy
- engaging in domestic and international cooperation and coordination
Some of these activities are also discussed elsewhere in this annual report. A broader set of economic and financial developments are discussed in section 2, "Monetary Policy and Economic Developments," with the discussion that follows concerning surveillance of economic and financial developments focused on financial stability. The full range of activities associated with supervision of systemically important financial institutions, designated nonbank companies, and designated financial market utilities is discussed in section 4, "Supervision and Regulation."
Monitoring Financial Stability Vulnerabilities
Financial institutions are linked together through a complex set of relationships, and their condition depends on the economic condition of the nonfinancial sector. In turn, the condition of the nonfinancial sector hinges on the strength of financial institutions' balance sheets, as the non-financial sector obtains funding through the financial sector. Monitoring risks to financial stability is aimed at better understanding these complex linkages and has been an important part of Federal Reserve efforts in pursuit of overall economic stability.
A stable financial system, when hit by adverse events, or "shocks," is able to continue meeting demands for financial services from households and businesses, such as credit provision and payment services. By contrast, in an unstable system, these same shocks are likely to have much larger effects, disrupting the flow of credit and leading to declines in employment and economic activity.
Consistent with this view of financial stability, the Federal Reserve Board's monitoring framework distinguishes between shocks to and vulnerabilities of the financial system. Shocks, such as sudden changes to financial or economic conditions, are inherently hard to predict. Vulnerabilities tend to build up over time and are the aspects of the financial system that are most expected to cause widespread problems in times of stress.
Accordingly, the Federal Reserve maintains a flexible, forward-looking financial stability monitoring program focused on assessing how the level and configuration of those vulnerabilities affect the financial system's resilience to a wide range of potential adverse shocks.
Each quarter, Federal Reserve Board staff assess a set of vulnerabilities relevant for financial stability, including but not limited to asset valuation pressures, borrowing by businesses and households, leverage in the financial sector, and funding risk. These monitoring efforts inform discussions concerning policies to promote financial stability, such as supervision and regulatory policies, as well as monetary policy. They also inform Federal Reserve interactions with broader monitoring efforts, such as those by the FSOC and the Financial Stability Board (FSB).
The Federal Reserve Board publishes its Financial Stability Report on a semiannual basis.2 The report summarizes the Board's framework for assessing the resilience of the U.S. financial system and presents the Board's current assessment of financial system vulnerabilities. It aims to promote public understanding about Federal Reserve views on this topic and thereby increase transparency and accountability. The report complements the annual report of the FSOC, which is chaired by the Secretary of the Treasury and includes the Federal Reserve Chair and other financial regulators.
Asset Valuation Pressures
Overvalued assets are a vulnerability because the unwinding of high prices can be destabilizing, especially if the assets are widely held and the values are supported by excessive leverage, maturity transformation, or risk opacity. Moreover, stretched asset valuations are likely to be an indicator of a broader buildup in risk-taking.
Nonetheless, it is very difficult to judge whether an asset price is overvalued relative to fundamentals. Accordingly, the Federal Reserve's analysis of asset valuation pressures typically includes a broad range of possible valuation metrics and tracks developments in areas in which asset prices are rising particularly rapidly, unusually high or low price volatility, and investor flows.
Fiscal and monetary policy accommodation, along with continued progress on vaccinations, continued to support a strong economic recovery during 2021 despite still-elevated levels of uncertainty about the course of the pandemic. The robust expansion and bright outlook for 2022 supported investors' risk appetite, and valuation measures during 2021 remained high relative to historical norms across most asset classes.
Prices of long-term Treasury securities, corporate bonds, and leveraged loans stood at high levels relative to their historical ranges, depressing yields. Spreads of corporate bond yields over comparable-maturity Treasury yields narrowed, particularly for speculative-grade corporate bonds, and reached very low levels relative to their historical distributions (figure 3.2). With economic growth expected to continue, equity analysts boosted their forecasts for corporate earnings. However, equity prices also rose steadily throughout the year, leaving a key indicator of equity valuations, the ratio of equity prices to expected earnings, little changed at the upper end of its historical distribution (figure 3.3). Implied stock price volatility for the S&P 500 index, captured by the VIX, rebounded after a decline in the first half of the year.
Supported by low mortgage rates and strong demand interacting with some supply constraints, house prices grew at a rapid clip during 2021, outstripping increases in rents. Since the beginning of 2020, housing inventories have declined, whereas the number of active real estate buyers has increased significantly. Despite a slowdown at the end of the year, house price growth still ended the year near recent historical highs. Indicators suggest that higher house prices were not being fueled by easier lending standards. Although the maximum debt-to-income ratio for borrowers with lower credit scores ticked up in the second half of the year, lending standards for these borrowers reportedly remained tighter than before the pandemic.
In 2021, aggregate commercial real estate (CRE) prices rose further above their pre-pandemic levels. Multifamily and industrial properties saw significant price increases, whereas retail, hotel, and office properties did not, with prices staying roughly flat. Transaction volumes recovered, approaching pre-pandemic levels toward the end of 2021. Finally, farmland prices remained elevated relative to rents.
Borrowing by Households and Businesses
Excessive borrowing by households and businesses has been an important contributor to past financial crises. When highly indebted households and nonfinancial businesses are hit by negative shocks to incomes or asset values, they may be forced to curtail spending, which could then amplify the effects of financial shocks.
In turn, financial stress among households and businesses can lead to mounting losses at financial institutions, creating an adverse feedback loop in which weaknesses among households, nonfinancial businesses, and financial institutions cause further declines in income and accelerate financial losses, potentially leading to financial instability and a sharp contraction in economic activity.
Before the onset of the pandemic, the combined total debt of nonfinancial businesses and households had been growing roughly in line with nominal gross domestic product (GDP), leaving the credit-to-GDP ratio essentially flat from 2012 to 2019 (figure 3.4). In the first half of 2020, substantial business borrowing to build cash buffers and a precipitous drop in GDP pushed the credit-to-GDP ratio to historical highs. After that surge, the ratio declined throughout the second half of 2020 and all of 2021, returning to about the same level as in 2019.
Separating the credit-to-GDP ratio into its business and household components yields some additional insights. Household debt growth picked up in 2021. Moreover, key measures of vulnerabilities arising from business debt—including debt-to-GDP, gross leverage, and interest coverage ratios—have swung widely in the past two years. As nominal GDP growth outpaced the growth of business debt, the ratio of business debt to GDP decreased throughout 2021, retracing nearly all of its early pandemic growth. The decline in this ratio was accompanied by a strong recovery in profits. The gross leverage of large businesses—the ratio of debt to assets for all publicly traded nonfinancial firms—trended down throughout 2021 and stands roughly at pre-pandemic levels.3 As earnings among large firms continued to recover and borrowing rates remained low, the ratio of earnings to interest expenses (the interest coverage ratio) moved up steadily over the year, suggesting large firms were better able to service debt. The median interest coverage ratio among these firms rose above pre-pandemic levels and near historical highs.
Business credit quality, which deteriorated after the onset of the pandemic, has continued to improve throughout 2021. For example, the rate of corporate bond downgrades remained low. While many small businesses closed or significantly scaled back their operations as a result of the pandemic, credit quality for small businesses that have continued operating or reopened stabilized during 2021, with loan delinquencies returning to pre-pandemic levels.
Although the financial position of some households remained strained, the household sector continued to recover in 2021, supported by pandemic stimulus programs, a growing economy, and rising house prices. Household debt growth picked up in the second quarter and continued the rest of the year. Debt owed by the roughly one-half of households with prime credit scores continued to account for all the growth, driven by increases in mortgage debt. However, the ratio of household debt to nominal GDP continued to decline in 2021, as GDP growth outpaced the growth in household debt.
Mortgage debt accounts for roughly two-thirds of total household debt, with new mortgage extensions skewed toward prime borrowers in recent years. The share of mortgages in forbearance declined throughout the year and is down substantially from its peak in the second quarter of 2020.4 Most of the remaining one-third of household debt is consumer credit, which consists primarily of student loans, auto loans, and credit card debt. Auto loan balances remained stable, on net, in 2021, driven primarily by borrowers with prime and near-prime credit scores. Student loan balances contracted slightly in 2021, maintaining a trend started at the onset of the pandemic. Protections originally in the Coronavirus Aid, Relief, and Economic Security Act—later extended by the Department of Education—guaranteed payment forbearance and stopped interest accrual through May 2022 for most federal student loans. Credit card balances remained well below their pre-pandemic levels.
Leverage in the Financial System
The U.S. banking system continued to weather the pandemic well in 2021 as bank capital remained above pre-pandemic levels throughout the year. The common equity Tier 1 (CET1) ratio—a regulatory risk-based measure of bank capital adequacy—increased at the start of 2021 for most banks, exceeding pre-pandemic levels (figure 3.5). CET1 ratios for most banks slightly declined through the rest of the year, as bank credit (and, thus, risk-weighted assets) expanded and shareholder payouts increased. Bank profitability remained at the upper end of its historical distribution in 2021, driven by releases of loan loss reserves associated with improvements in the economic outlook over the first half of the year.5
In June, the Federal Reserve released the results of its annual bank stress tests.6 The large banks that were tested remained well above their risk-based minimum capital requirements during a severe hypothetical recession that included, among other features, substantial stress in U.S. CRE, housing, and corporate debt markets. Restrictions on the capital distributions of banks put in place during the pandemic ended on June 30, as previously announced.7 In addition, bank regulatory capital requirements incorporated the new 2021 stress capital buffers on October 1. These stress capital buffers were computed based on the June 2021 stress-test results.
Outside the banking sector, leverage at large life insurance companies remained at post-2008 highs during the course of 2021. Based on a number of measures, leverage at hedge funds during 2021 stood above its historical average.
High-quality liquid assets increased for U.S. global systemically important banks through most of 2021, reflecting an increase in Treasury securities, agency mortgage-backed securities (MBS), and central bank reserve balances (figure 3.6). Core deposits, which traditionally are a highly stable funding source, have remained near their highest levels as a share of liabilities since 1997. However, the share of nonoperational corporate deposits and uninsured retail deposits, which tend to be less sticky and perhaps more sensitive to interest rate movements in a high-inflation environment, rose during the second half of 2021. A measure of the exposure of banks to interest rate risk—calculated as the difference between the effective time to maturity, or next contractual interest rate adjustment, for bank assets and liabilities—increased to historically high levels for all banks by the end of the year. This increase was due to a rise in holdings of long-term Treasury securities and agency MBS at banks amid large deposit inflows. However, banks' strong capital positions, high levels of liquid assets, and high levels of historically stable funding sources are mitigating factors to the potential vulnerabilities from maturity transformation.
Many types of nonbank financial institutions, however, experienced funding difficulties at the onset of the pandemic. For example, prime money market funds (MMFs), particularly institutional funds, experienced runs in March 2020, with outflows reaching the same proportion of assets redeemed during the run on MMFs in 2008. Assets under management at prime MMFs steadily declined through 2021, while those at tax-exempt MMFs stayed relatively flat over the same period. Vulnerabilities associated with liquidity transformation at prime and tax-exempt MMFs contribute to the susceptibility of these funds to runs and call for structural fixes. In October 2021, the FSB published a report analyzing options to mitigate MMF vulnerabilities globally, including several potentially promising options—such as swing pricing or similar mechanisms, a minimum balance at risk, and capital buffers—many of which were considered in a report by the President's Working Group on Financial Markets that focused on U.S. MMFs in 2020.8
With regard to funding risk surrounding the payments system, there were two key developments. First, central counterparties managed risks while adapting to persistent volatility and elevated activity in some markets. Second, according to a variety of sources, the value of stablecoins outstanding grew roughly fivefold in 2021.9 Stablecoins are purported to maintain a stable value relative to a national currency or other reference asset or assets. Certain stablecoins, including the most widely held, are supposed to be redeemable at any time at a stable value in U.S. dollars but are, in part, backed by assets that may become illiquid. If the assets backing a stablecoin fall in value, the issuer may not be able to meet redemptions at the promised value. Although not typically considered a cash management vehicle, stablecoins have structural vulnerabilities similar to those of other cash-like vehicles that make them susceptible to runs. Accordingly, the potential use of stablecoins in payments and their capacity to grow can also pose risks to payment and financial systems.
Domestic and International Cooperation and Coordination
The Federal Reserve cooperated and coordinated with both domestic and international institutions in 2021 to promote financial stability.
Financial Stability Oversight Council Activities
As mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the FSOC was created in 2010. The FSOC is chaired by the Secretary of the Treasury and includes the Chair of the Board of Governors of the Federal Reserve System as a member. It established an institutional framework for identifying and responding to the sources of systemic risk. Through collaborative participation in the FSOC, U.S. financial regulators monitor not only institutions but also the financial system as a whole. The Federal Reserve, in conjunction with other participants, assists in monitoring financial risks, analyzing the implications of those risks for financial stability, and identifying steps that can be taken to mitigate those risks. In addition, when an institution is designated by the FSOC as systemically important, the Federal Reserve assumes responsibility for supervising that institution.
In 2021, the FSOC continued to serve as a central venue for member agencies to coordinate risk analysis and policy enactment in the wake of the COVID-19 pandemic. The council continued to monitor the financial stability implications of the pandemic and identified three priority areas: addressing vulnerabilities from nonbank financial intermediation (NBFI), promoting resilience in the U.S. Treasury market, and enhancing the resilience of the financial system to climate-related financial risks.
In 2021, the council convened working groups on hedge funds and open-end funds to better share data and identify risks associated with both kinds of nonbank financial institutions. In June, the council also released a statement outlining how MMFs have the potential to create or amplify stresses in short-term funding markets.10 The statement supported engagement by the Securities and Exchange Commission (SEC) to develop options to address this critical issue.
Council member agencies on the Inter-Agency Working Group on Treasury Market Surveillance (IAWG), including the Federal Reserve, in November issued a progress report reviewing policy options to strengthen the resilience of U.S. Treasury markets.11 The IAWG's staff briefed the council on the report's findings, and the 2021 FSOC Annual Report included a box on the IAWG's efforts to increase resilience in these essential markets.12
Additionally, the council released a report identifying climate change as an emerging and increasing threat to financial stability in the United States. The Board's staff collaborated with other member agencies to draft the report and accompanying recommendations, which encourage member agencies to build capacity and expertise to ensure that climate-related financial risks are identified and managed.13
The report also called for the establishment of a new FSOC standing committee, the Climate-related Financial Risk Committee. This committee will identify priority areas for climate-related council work and serve as a coordinating body to share information and facilitate the development of common approaches and standards across FSOC members and interested parties.
Financial Stability Board Activities
In light of the interconnected global financial system and the global activities of large U.S. financial institutions, the Federal Reserve participates in international bodies, such as the FSB. The FSB monitors the global financial system and promotes international financial stability by coordinating with national financial authorities and international standard-setting bodies on information exchanges and work focused on developing strong global financial-sector policies. The Federal Reserve is a member of the FSB, along with the SEC and the U.S. Treasury. In late 2021, Governor Quarles's term as the Chair of the FSB expired. Governor Brainard has been appointed as Chair of the FSB's Standing Committee on the Assessment of Vulnerabilities for a term of two years.
In the past year, the FSB engaged in many issues related to global financial stability. Specific work included monitoring the use and effectiveness of COVID-related policy response measures; assessing challenges in cross-border payments systems; reviewing global trends and risks in NBFI; assessing new sources of vulnerabilities and risks to financial stability; monitoring and evaluating channels through which climate-related risks could affect financial stability; assessing issues regarding the rapid emergence and use of stablecoins, crypto-asset markets, and other digital assets; and transitioning away from the use of LIBOR.
1. For more information on how the Federal Reserve promotes a stable financial system, see The Fed Explained, available on the Board's website at https://www.federalreserve.gov/aboutthefed/files/the-fed-explained.pdf#page=50. Return to text
2. See Board of Governors of the Federal Reserve System (2021), Financial Stability Report (Washington: Board of Governors, May), https://www.federalreserve.gov/publications/files/financial-stability-report-20210506.pdf; and Board of Governors of the Federal Reserve System (2021), Financial Stability Report (Washington: Board of Governors, November), https://www.federalreserve.gov/publications/files/financial-stability-report-20211108.pdf. Return to text
3. This pattern is common across most firm categories, with the exception of firms in industries hard-hit by the pandemic, such as airlines, hotels, and restaurants, where leverage remains elevated. Return to text
4. Around 900,000 borrowers remain in forbearance plans, and about 60 percent of those are expected to exit forbearance by the end of February 2022. Return to text
5. Under accounting rules, banks prepare for possible loan losses before they occur. Loan loss provisions in the bank's income statement are expenses set aside for estimated credit losses and are added to the loan loss reserves. The decline in loan loss reserves during the first half of 2021 was notable for most loan categories, with the exception of CRE loans, consistent with elevated credit risk in some CRE segments. Return to text
6. See Board of Governors of the Federal Reserve System (2021), "Federal Reserve Board Releases Results of Annual Bank Stress Tests, Which Show That Large Banks Continue to Have Strong Capital Levels and Could Continue Lending to Households and Businesses during a Severe Recession," press release, June 24, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20210624a.htm. Return to text
7. See Board of Governors of the Federal Reserve System (2021), "Federal Reserve Announces Temporary and Additional Restrictions on Bank Holding Company Dividends and Share Repurchases Currently in Place Will End for Most Firms after June 30, Based on Results from Upcoming Stress Test," press release, March 25, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20210325a.htm. Return to text
8. See Financial Stability Board (2021), Policy Proposals to Enhance Money Market Fund Resilience (Basel, Switzerland: FSB, October), https://www.fsb.org/wp-content/uploads/P111021-2.pdf; and President's Working Group on Financial Markets (2020), Report of the President's Working Group on Financial Markets: Overview of Recent Events and Potential Reform Options for Money Market Funds (Washington: PWG, December), https://home.treasury.gov/system/files/136/PWG-MMF-report-final-Dec-2020.pdf. Return to text
9. The value of stablecoins outstanding stood at around $130 billion as of October 2021, based on a November 2021 report. See President's Working Group on Financial Markets, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (2021), Report on Stablecoins (Washington: PWG, FDIC, and OCC, November), https://home.treasury.gov/system/files/136/StableCoinReport_Nov1_508.pdf. Return to text
10. See Financial Stability Oversight Council (2021), "Financial Stability Oversight Council's Statement on Money Market Fund Reform," statement, June 11, https://home.treasury.gov/system/files/261/FSOC_Statement_6-11-21.pdf. Return to text
11. See Inter-Agency Working Group on Treasury Market Surveillance (2021), "Inter-Agency Working Group on Treasury Market Surveillance Releases Staff Progress Report That Reviews Potential Policies for Bolstering the Resilience of Treasury Markets," press release, November 8, https://home.treasury.gov/news/press-releases/jy0470. Return to text
12. See the box "IAWG Work on Treasury Market Resilience" in Financial Stability Oversight Council (2021), Annual Report (Washington: FSOC, December), p. 35, https://home.treasury.gov/system/files/261/FSOC2021AnnualReport.pdf. Return to text
13. See Financial Stability Oversight Council (2021), "Financial Stability Oversight Council Identifies Climate Change as an Emerging and Increasing Threat to Financial Stability," press release, October 21, https://home.treasury.gov/news/press-releases/jy0426. Return to text