Near-Term Risks to the Financial System
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. As noted in the box "Salient Shocks to Financial Stability Cited in Market Outreach," contacts were mostly focused on the possibility of a worsening of the pandemic and on the risk of a sudden increase in interest rates, both of which could inhibit the economic recovery or cause another downturn. The following analysis considers possible interactions of existing vulnerabilities with three broad categories of risk, some of which were also raised in these discussions: a significant reduction in the pace of the ongoing economic recovery, a sudden increase in interest rates, and risks emanating from China, other EMEs, and Europe.
Salient Shocks to Financial Stability Cited in Market Outreach
As part of its market intelligence gathering, Federal Reserve staff solicited views from a wide range of contacts on risks to U.S. financial stability. From August to mid-October, the staff surveyed 26 market contacts, including professionals at broker-dealers, investment funds, political advisory firms, and universities. Since the previous survey results published in May, concerns related to inflation, new COVID variants, and elevated risk-asset valuations have remained top of mind, while several new risks have surfaced, including possible fallout from Chinese regulatory changes, the risk of a sharply declining fiscal impulse, and the prospect of monetary policy tightening into a slowdown. Some other risks that ranked highly earlier this year declined in prominence, including fears of a disruptive rise in interest rates from heavy Treasury issuance and concerns related to increases in bank reserves. This discussion summarizes the most cited shocks in this round of outreach.
Persistent inflationary pressures
A majority of respondents cited the prospect of inflation pressures being more persistent than anticipated. A few noted that longer-lasting supply constraints in various product and labor markets could sustain inflation at elevated levels and potentially contaminate inflation expectations even as growth momentum stalls. Most contacts noted that the risk of sustained high inflation would likely be accompanied by monetary policy tightening, with potential effects on elevated risk-asset valuations. A few noted that a monetary policy response to stagflation risks would underpin a particularly sharp tightening of financial conditions.
Fallout from the Chinese regulatory tightening
Respondents also widely discussed market shocks and spillovers that could emanate from the Chinese authorities' de-risking campaign, with a focus on their efforts to reduce leverage in the property development sector. Several noted that the Chinese authorities appear willing to countenance more volatility than in the past as they pursue their deleveraging and regulatory goals, while worrying that officials could misjudge the scale of instability and contagion emanating from the campaign. Respondents focused largely on the extent to which the authorities would take measures to avert a disorderly default at Evergrande, the country's largest property developer, and attenuate broader property-sector and financial system stress.
New COVID-19 variants
Respondents remained focused on the risk of new COVID variants that could diminish the effectiveness of available vaccines and prolong pandemic effects on the global economy. A few noted risks of perpetual COVID mutations that lead to enduring behavioral changes amid recurrent outbreaks, with permanent effects on COVID-sensitive sectors.
Fading fiscal impulse
Several respondents raised concerns regarding the potential for a deeply negative fiscal impulse next year to weigh on an economy that is already showing signs of slowing momentum. A few contacts highlighted contentious debt ceiling negotiations and the prospect that legislated infrastructure spending would be lower than previously expected.
Escalation of U.S.–China tensions
As with previous surveys, a number of respondents also cited various geopolitical threats that could destabilize markets. Several contacts worried about the possible escalation of tensions between the United States and China, particularly surrounding Taiwan.
A potential worsening of the public health situation may result in a reduction in business and household confidence, negatively affecting future economic activity and financial vulnerabilities
A possible deterioration in the public health situation could slow the recent economic recovery, particularly if widespread business closures returned and supply chains were further disrupted. In that case, several vulnerabilities identified in this report could amplify the economic effects of these shocks. An economic slowdown could weaken business and household balance sheets, leading to an increase in delinquencies, bankruptcies, and other forms of financial distress. These rising losses on nonfinancial debt could put strains on banks and other lenders.
Such developments could also interact with existing vulnerabilities at financial institutions. Although banks are well-capitalized and leverage at broker-dealers remains low, the leverage of some nonbank financial institutions, such as life insurance companies and hedge funds, remains high. Furthermore, prime and tax-exempt MMFs, as well as some mutual funds holding illiquid assets, remain vulnerable to sudden redemptions, as demonstrated during the acute period of extreme market volatility at the onset of the pandemic.
A sharp rise in interest rates could slow the pace of economic recovery and lead to sharp declines in asset valuations and stresses at financial institutions, businesses, and households
A steep rise in interest rates could lead to a large correction in prices of risky assets. Valuations of many assets have benefited from low interest rates and therefore may be susceptible to a spike in yields, especially if unaccompanied by an improvement in the economic outlook. A range of financial intermediaries hold long-duration assets and could take mark-to-market losses. Such losses would reduce their ability to raise capital and retain the confidence of their counterparties, even if accounting conventions prevented the losses from appearing on financial statements.
A sharp increase in interest rates could also lower housing demand and thus reduce house prices, weakening the balance sheets of households. The resulting stresses may be especially pronounced for homeowners currently in mortgage forbearance or in the subprime and near-prime risk categories.
Additionally, the effect of a rise in interest rates on business borrowing costs would likely be amplified if spreads widened from their current low levels. This increase in business borrowing costs could have negative consequences for employment and business investment.
Stresses in China's real estate sector could strain the Chinese financial system, with possible spillovers to the United States
In China, business and local government debt remain large; the financial sector's leverage is high, especially at small and medium-sized banks; and real estate valuations are stretched. In this environment, the ongoing regulatory focus on leveraged institutions has the potential to stress some highly indebted corporations, especially in the real estate sector, as exemplified by the recent concerns around China Evergrande Group. Stresses could, in turn, propagate to the Chinese financial system through spillovers to financial firms, a sudden correction of real estate prices, or a reduction in investor risk appetite. Given the size of China's economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States.
Adverse developments in other emerging market economies spurred by a sudden and sharp tightening in financial conditions could also spill over to the United States
The uneven economic recovery and the high debt levels in EMEs also pose a risk to financial stability. A sharp tightening of financial conditions, possibly triggered by a rise in bond yields in advanced economies or a deterioration in global risk sentiment, could push up debt-servicing costs for EME sovereigns and businesses, trigger capital outflows, and stress EMEs' financial systems. Widespread and persistent EME stresses could, in turn, have repercussions for the U.S. financial system through its direct exposures to stressed EME businesses and sovereigns and through its indirect exposures via U.S. businesses with strong links to EMEs.
In Europe, a slower-than-expected recovery could trigger financial stresses and pose risks to the United States because of strong transmission channels
Despite high vaccination rates, the emergence of new variants and a resurgence of COVID-19 infections could weigh on the ongoing recovery in Europe. Slower growth could stress the European financial system by reducing asset quality and profitability of financial institutions and increasing solvency risk. A premature withdrawal of existing support measures could also materially reduce economic growth and affect financial stability, while a belated withdrawal of support measures could further stretch elevated valuations in some asset classes, including segments of the housing market, raising the risk of sudden market corrections. Stresses in Europe could, in turn, affect the U.S. economy and financial system through a deterioration in global risk appetite, a pullback in lending from European banks to U.S. businesses and households, strains in dollar funding markets, and losses due to large direct and indirect credit exposures.
The Financial Stability Oversight Council's Climate Report and the Federal Reserve's Actions
The FSOC, of which the Federal Reserve Chair is a member, was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act. It is charged with identifying risks to the financial stability of the United States, promoting market discipline, and responding to emerging threats to the stability of the U.S. financial system.
In response to President Biden's Executive Order 14030 (regarding climate-related financial risk), the FSOC published its Report on Climate-Related Financial Risk on October 21, 2021.1 The report summarizes members' efforts to identify and assess climate-related financial risks and outlines a number of recommendations encouraging members to expand their investments in the resources needed to fill climate-related data and methodological gaps, enhance climate-related financial disclosures, and assess and mitigate climate-related financial stability risks.
The Federal Reserve's work to identify and address climate-related financial risks is broadly aligned with the recommendations in the report.
Expanding the Federal Reserve's capacity to assess and mitigate climate-related financial risks
The Federal Reserve's November 2020 Financial Stability Report discussed how climate change may create or amplify risks to the financial system.2 Following the January 2021 announcement of the creation of the Supervision Climate Committee (SCC), in March 2021, the Federal Reserve announced the formation of the Financial Stability Climate Committee.3 This Federal Reserve System staff committee complements the microprudential focus of the SCC and is undertaking work to identify links between climate change and financial stability, including by investigating how climate change can increase financial-sector vulnerabilities and looking for climate-related amplification channels.
Filling climate-related data and methodological gaps
As the FSOC report noted, the assessment of climate-related financial risks requires both data that regulators may be unaccustomed to working with and new methods to analyze those data. To address these challenges, the Federal Reserve is identifying additional data, technology, and modeling resources, including those available through other U.S. government agencies, that are needed to support the Federal Reserve's efforts to understand the financial and economic risks associated with climate change.
Enhancing climate-related disclosures
The Federal Reserve supports the FSOC report's emphasis on the need for consistent and comparable disclosures, which are fundamental to a rigorous and thorough analysis of climate-related risks. The Federal Reserve will work with FSOC colleagues to support the development and implementation of effective approaches in this area.
Assessing and mitigating climate-related risks that could threaten financial stability
The Federal Reserve is developing a program of climate-related scenario analysis, a tool increasingly used by individual firms and regulatory agencies, to evaluate the potential economic and financial risks posed by different climate outcomes. The Federal Reserve considers an effective scenario analysis program, which is designed to be forward looking over a period of years or decades, to be separate from its existing regulatory stress-testing regime. This undertaking is complex, and the Federal Reserve is committed to developing an analytically rigorous program that supports all of its statutory responsibilities.
Climate change poses significant challenges for the global economy and the financial system. The public rightly expects the Federal Reserve to work to ensure that the financial system is resilient to climate-related financial risks.
The Federal Reserve will share its progress and looks forward to coordinating with its FSOC colleagues to meet the critical challenges outlined in the FSOC report. As the Federal Reserve advances its understanding of the financial stability risks associated with climate change and gains experience with policies to strengthen the system, it will continue to work together with domestic and international colleagues to sharpen its responses.
1. See Financial Stability Oversight Council (2021), Report on Climate-Related Financial Risk (Washington: FSOC, October), https://home.treasury.gov/system/files/261/FSOC-Climate-Report.pdf. Return to text
2. See the box "The Implications of Climate Change for Financial Stability" in Board of Governors of the Federal Reserve System (2020), Financial Stability Report (Washington: Board of Governors, November), pp. 58–59, https://www.federalreserve.gov/publications/2020-november-financial-stability-report-purpose.htm. Return to text
3. See Federal Reserve Bank of New York (2021), "Kevin Stiroh to Step Down as Head of New York Fed Supervision to Assume New System Leadership Role at Board of Governors on Climate," press release, January 25, https://www.newyorkfed.org/newsevents/news/aboutthefed/2021/20210125; and Lael Brainard (2021), "Financial Stability Implications of Climate Change," speech delivered at "Transform Tomorrow Today," Ceres 2021 Conference, Boston, March 23, https://www.federalreserve.gov/newsevents/speech/brainard20210323a.htm. Return to text
Cyber Risk and Financial Stability
Cyber risk, defined as the risk of loss from dependence on computer systems and digital technologies, has grown in the financial system. Cyber events, especially cyberattacks, are among the top risks cited in financial stability surveys in the United States and globally, presenting both microprudential and macroprudential concerns.1 While substantial attention has been paid to improving resilience to cyber risk at individual institutions, this discussion focuses on the ramifications of cyber risk for the financial system and financial stability.
The implications of cyber events for the financial system are distinct from other financial system vulnerabilities because fire sales, liquidity freezes, and potential solvency issues may play out differently when stemming from a cyber shock. For example, if a cyber incident compromises a financial institution's data, the firm may be unable to carry out normal operations, in contrast to a traditional run. Enhancements in service offerings, such as longer operating hours of payment systems and shorter clearing and settlement windows, have left the financial system less downtime in which operations can be more easily restored after a cyber incident. More high-frequency trading means that greater volumes of transactions depend on instantaneous information flow. Uncertainty about the nature and extent of an incident may prompt runs on counterparties, competitors, or unaffected segments of the firm's operations. The 2021 ransomware attack on Colonial Pipeline, though not a financial firm, illustrates how a cyberattack can spark a run (in this case, a run on gas stations), amplifying the effects well beyond the original shock (in this case, on fuel distribution).
Cyber shocks may spread through the financial system through complex and often unrecognized interdependencies across firms, including a layer of exposures to shared technologies and third-party service providers. This layer is in addition to the connections from financial payments and exposures typically captured in measures of counterparty risk.
Another distinction of cyber risk is the possible intentional nature of events. Most cyber events experienced thus far appear to have been motivated by a desire to maximize profits rather than a desire to create havoc. However, a small group intending to cause widespread harm can target and time its attacks with the goal of impairing the financial system.
Strategies for reducing traditional financial stability vulnerabilities may be less effective for addressing cyber vulnerabilities. Capital and liquidity can reduce the likelihood of solvency runs and serve as a buffer for cyber-related losses—and thus may help contain some amplification—but they may not do much to prevent runs if customers fear a loss of access to their funds. They also may not speed up the restoration process. In addition, cyber vulnerabilities are not transparent to counterparties, and affected firms may be reluctant to disclose attacks, which could allow attacks to spread longer and to more firms.
Cyber risk in the Federal Reserve framework
The Federal Reserve's financial stability monitoring framework distinguishes between shocks to and vulnerabilities of the financial system. That framework naturally translates to considering cyber risk to financial stability (figure A).
A. Transmission of Cyber Shocks to Affect Financial Stability
|Firm Level||System Level|
|Cyber events are occurrences, malicious or not, within an information system or network.||Weaknesses in a firm's controls, defenses, and recovery ability can allow cyber events to become cyber incidents, impairing operations (for example, by causing a loss of funds or data, corrupting data, halting operations, or causing other monetary or reputational losses).||Financial system features (for example, interconnections from financial and digital exposures, data and operational dependencies, market concentration and lack of substitutes for critical services, time sensitivity, and confidence) can amplify and spread a cyber incident to disrupt the system's functioning.||Incidents that sufficiently disrupt the financial system's functioning can affect financial stability (for example, by causing a lack of availability of critical services or data, runs and asset fire sales, lack of access to funding, or disrupted payments or price discovery).|
Shocks associated with cyber risk are cyber events—occurrences, whether malicious or not, in an information system or network. Cyber events can be external or internal in origin.
For a cyber event to affect financial stability, it must first exploit firm-level vulnerabilities so that the event becomes an incident—an event that impairs the firm. Firm-level vulnerabilities are weaknesses in a firm's cybersecurity and ability to recover from a cyber event before damage is done. Potential adverse firm-level effects include a loss of funds or data, data corruption, and disrupted operations.
System-level vulnerabilities are features of the financial system that can amplify and spread a cyber incident so that the incident disrupts the system's functioning. Examples of system-level vulnerabilities include interconnectedness from financial and digital exposures, data and operational dependencies, markets with dominant firms and a lack of available substitutes for critical services, the time sensitivity of payments, and the level of confidence in financial relationships.
Cyber incidents that sufficiently disrupt the financial system's functioning can affect financial stability. Consequences could include a lack of availability or accessibility of critical services, data, or funding; a loss of confidence, resulting in runs and asset fire sales; or disruptions to payment flows or price discovery. Less significant cyber incidents could also affect financial stability by interacting with and amplifying other financial system vulnerabilities. This prospect is made more likely by the possible intentional nature of cyber events.
Examples through the lens of the framework
While no cyber incident has yet significantly impaired the financial system, four examples illustrate the application of the framework and the ways in which a more significant incident may do so. The first example is a cyberattack directed at a bank holding company that impairs the firm's data. For instance, in 2019, the data of more than 100 million Capital One customers were accessed after an attacker exploited a vulnerability in the firewall configuration of the bank's cloud-based infrastructure. A cyberattack that affects data at multiple large financial institutions could lead to a broad loss of confidence in the security of the financial sector. If the institutions' data are corrupted during the attack, the recovery process could be extensive.
The second example is a cyberattack on a financial market exchange that disrupts trading. In 2020, distributed denial-of-service attacks overwhelmed the website of New Zealand's Exchange (NZX). The exchange had to halt trading in cash, debt, and derivatives for most of four days, which disrupted access to price information for assets traded only on its exchange. NZX was vulnerable because it lacked adequate defenses and a response playbook. An attack that shuts down trading at a large and interconnected financial market exchange could disrupt price information more widely, as well as clearing and settlement, and trigger a loss of confidence.
An attack on a third-party vendor represents the third example. In 2020, a nation-state actor inserted malware into a routine update of network management software sold by SolarWinds, a third-party vendor. SolarWinds customers, which included large financial institutions, were infected by the malware when they installed the software update. The attack opened a backdoor through which the attackers could have exploited the customers' computer systems. While financial institutions do not appear to have been the intended targets, if they had been, the outcome for financial stability could have been much worse, as the attackers reportedly had access to the computer systems for some time.2
Finally, a study by Federal Reserve Bank of New York staff simulated the extent of a hypothetical cyberattack that prevents one of the five most active banks from sending payments for one day.3 Using data from 2018, the study found that, on average across trading days that year, 31 percent of banking-sector assets (excluding the directly affected bank) would face compromised liquidity. The majority of forgone payments in a disruption support other financial market activity, so the original disruption could have broad ramifications.
While there is extensive ongoing supervisory attention to firm-level cyber resilience, data gaps remain, particularly for monitoring system-level vulnerabilities. At the firm level, consistent data on cyber incidents are needed. At the system level, measures of digital interdependencies and the speed with which backup systems and providers can be quickly enabled would be beneficial. Federal Reserve staff are working to help close these data gaps and improve understanding of amplification through tabletop exercises and premortem and postmortem studies of cyber events.
1. See the Depository Trust and Clearing Corporation's 2021 Systemic Risk Barometer Survey (https://www.dtcc.com/-/media/Files/Downloads/Thought-Leadership/26362-Systemic-Risk-2020.pdf), the Bank of England's Systemic Risk Survey for the second half of 2021 (https://www.bankofengland.co.uk/systemic-risk-survey/2021/2021-h2), and the Bank of Canada's spring 2021 Financial System Survey (https://www.bankofcanada.ca/2021/05/financial-system-survey-highlights-spring-2021/). Return to text
2. See the joint statement by the Federal Bureau of Investigation, Cybersecurity and Infrastructure Security Agency, Office of the Director of National Intelligence, and National Security Agency (https://www.cisa.gov/news/2021/01/05/joint-statement-federal-bureau-investigation-fbi-cybersecurity-and-infrastructure). Return to text
3. See Thomas M. Eisenbach, Anna Kovner, and Michael Junho Lee (forthcoming), "Cyber Risk and the U.S. Financial System: A Pre-mortem Analysis," Journal of Financial Economics. Return to text