Near-Term Risks to the Financial System

Positive vaccine-related news, additional fiscal support, better-than-expected economic data, and accommodative monetary policy have supported favorable financial conditions and high prices of risky assets. Yet the ultimate extent and duration of the pandemic remain some of the most significant risks to the financial system. The realization of this risk continues to depend largely on the success of public health measures and the vaccination campaign, on the steps households and businesses take to resume economic activity, and on the support provided by economic policy and the remaining government lending and relief programs.

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 risk that COVID-19 variants would become resistant to currently available vaccines, thereby inhibiting the economic recovery or causing another downturn. The following analysis considers possible interactions of existing vulnerabilities with three broad categories of risk, some of which were also raised in the discussions of vulnerabilities: a downturn in U.S. economic activity or a significant reduction in the pace of the ongoing economic recovery, risks emanating from Europe, and risks from adverse developments in EMEs, including China.

Less than anticipated progress with respect to the pandemic could pose risks to the financial system

If the pandemic persists longer than anticipated—especially if new variants of the virus prove resistant to available vaccines—downward pressure on the U.S. economy could derail the ongoing recovery. If those developments occurred, a number of the vulnerabilities identified in this report could interact with the negative shock to the economy and pose additional risk to the U.S. financial system: Asset prices, which have increased in recent months, could suffer significant declines; highly leveraged nonfinancial firms could see their profits weaken, leading to financial stress and defaults; and the finances of households, especially those that are financially fragile, could deteriorate, leading to defaults and further pressure on banks and other lenders.

Although leverage is low at banks and broker-dealers, the leverage of some NBFIs, such as life insurance companies and some hedge funds, is high, exposing them to sharp drops in asset prices and funding risks. Furthermore, prime MMFs as well as bond and bank loan mutual funds are vulnerable to funding strains and sudden redemptions. Stress in the financial system could further interact with potential risks from new digital payment systems, including stablecoin arrangements. These associated risks may require additional safeguards, and regulators are monitoring these developments.30

Stresses emanating from a lingering pandemic in Europe also pose risks to the United States because of strong transmission channels

European financial institutions play an important role in global financial intermediation and have notable financial and economic linkages with the United States. Therefore, financial stress in Europe stemming from the adverse consequences of a lingering pandemic could negatively affect the United States. European economies adapted better this winter to declines in mobility and surges in the virus than last spring. Despite this resilience, the winter surge in COVID-19 cases and extended social-distancing measures weighed on the region's economy, which was still struggling to recover from the depths of the pandemic. As such, European authorities have continued to maintain supportive fiscal and monetary policies as well as bank regulatory and supervisory measures such as forbearance. Nevertheless, if efforts to contain the virus fail and real activity remains depressed, asset quality may deteriorate materially more than is already expected. If current supportive policies prematurely wear off or new ones are unable to offset the negative effects from this scenario, some systemically important European financial institutions could incur notable credit losses. Stresses in Europe could, in turn, affect the U.S. economy and financial system through a further deterioration in risk appetite, a pullback in lending from European banks to U.S. households and businesses, and losses due to large direct and indirect credit exposures.

Adverse developments in emerging market economies spurred in part by a further rise in long-term interest rates could spill over to the United States

In EMEs, difficulties in containing the virus, a possible further rise in long-term interest rates, and waning fiscal capacity pose near-term risks to financial stability. In particular, many highly indebted EME sovereigns and corporations are vulnerable to a sudden increase in debt-servicing costs from sharp rises in global interest rates. If this increase in debt-servicing costs is not accompanied by an improvement in the global economic outlook, some EMEs could again see significant capital outflows, which could be exacerbated by a drop in global risk appetite or problems in EME banking systems. Under these circumstances, authorities may find it difficult to address the negative economic and financial consequences because of limited fiscal capacity. Widespread and persistent EME stress could, in turn, have repercussions for the United States. While faced with more challenging global market conditions, U.S. financial institutions would be subject to heightened risks from both their direct exposures to stressed EME firms and sovereigns as well as their indirect exposures through U.S. businesses with strong links to EMEs.

Despite China's relatively strong economic rebound from the pandemic, it continues to have elevated corporate and local government debt, a vulnerable financial sector, and stretched real estate valuations. Although government policy is still supportive of the broader economy, Chinese authorities have introduced measures to cool down property markets. If these measures fail to limit speculation, financial vulnerabilities will continue to rise. Under such a scenario, a sudden correction in domestic property markets could put pressure on Chinese property developers and other firms and substantially stress the financial sector. 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 further strain global financial markets and negatively affect the United States.

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 early February to early April, the staff surveyed 24 market contacts, including professionals at broker-dealers, investors, political advisory firms, and academics. COVID-related risks remain the greatest concern, with respondents also focused on market and economic shocks emanating from a potential faster-than-envisaged economic recovery and significant ongoing fiscal and monetary stimulus, including a disruptive rise in real interest rates, a sharp correction in overvalued risky assets, and concern over rising inflationary pressures. These frequently cited risks differ from those highlighted in the previous round of outreach in the fall, in which respondents widely cited concerns about corporate defaults, the likelihood or efficacy of additional fiscal and monetary policy support, and U.S. political uncertainty.

Spring 2021: Most Cited Potential Shocks over Next 12 to 18 Months
Spring 2021: Most Cited Potential Shocks over Next 12 to 18 Months

Accessible Version

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?" TGA is Treasury General Account. EM is emerging market. SLR is supplementary leverage ratio. CRE is commercial real estate.

Source: Federal Reserve Bank of New York survey of 24 market contacts from early February to early April.

Fall 2020: Most Cited Potential Shocks over Next 12 to 18 Months
Fall 2020: Most Cited Potential Shocks over Next 12 to 18 Months

Accessible Version

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?" SME is small and medium‐sized enterprises. CRE is commercial real estate. CMBS is commercial mortgage‐backed security.

Source: Federal Reserve Bank of New York survey of 24 market contacts from early September to mid-October.

Vaccine challenges

Contacts were focused on the risk that COVID-19 variants would become resistant to currently available vaccines, thereby inhibiting the economic recovery or causing another downturn. For context, risks surrounding the pandemic were featured prominently in the previous round of outreach, in which respondents focused on the potential risk of a large resurgence in cases or delays in developing and deploying vaccines. In both rounds of outreach, many noted that asset prices across a range of markets reflect optimism around vaccine efficacy and economic reopening, rendering them vulnerable to any virus- or vaccine-related setbacks.

Surge in real interest rates and elevated asset price valuations

Contacts suggested that a sharp rise in real interest rates—caused by either a sooner-than-expected removal of monetary policy accommodation or larger-than-anticipated U.S. Treasury issuance—could pave the way for a correction in risky assets, including emerging market assets. Contacts observed that valuations of many assets have derived significant support from low discount rates and therefore may be susceptible to a spike in yields, especially if unaccompanied by an improvement in the economic outlook.

Effect of Treasury General Account drawdown

Several respondents noted that bank reserves were expected to continue to increase dramatically, potentially pressuring some short-term interest rates into negative territory and amplifying rate volatility. In particular, some contacts noted the unpredictable trajectory of balances in the Treasury General Account. Several respondents suggested that the outcome of the impending debt ceiling negotiations has contributed to this uncertainty, as a delay in an extension of the debt ceiling suspension could result in a rapid drawdown of the Treasury's account balances, thereby increasing reserve levels. Some worried that a surge in reserves would increase froth in markets, heightening future risks of a disruptive correction.

Escalation of U.S.–China tensions

Respondents also cited various geopolitical threats that could potentially destabilize markets. Several contacts worried about the possible escalation of tensions between the United States and China, particularly surrounding Taiwan.

References

 30. See, for instance, Lael Brainard (2020), "An Update on Digital Currencies," speech delivered at the Federal Reserve Board and Federal Reserve Bank of San Francisco's Innovation Office Hours, San Francisco (via webcast), August 13, https://www.federalreserve.gov/newsevents/speech/brainard20200813a.htm; and Randal K. Quarles (2021), "The FSB in 2021: Addressing Financial Stability Challenges in an Age of Interconnectedness, Innovation, and Change," speech delivered at the Peterson Institute for International Economics, Washington (via webcast), March 30, https://www.federalreserve.gov/newsevents/speech/quarles20210330a.htmReturn to text

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Last Update: May 13, 2021