The Results are in, the US Financial System is Stable

Intro

The Federal Reserve recently published its first financial stability report, which summarizes the Fed’s framework for assessing the state of the US financial system and presents the Fed’s current evaluation. This is important because the findings outlined in the Fed report are used in the design of future stress tests on the nation’s largest financial institutions and in setting the amount of liquid assets that banks and other financial institutions must have set aside in the event of an emergency. It is also highly informative about the current health of the US financial system and the vulnerable areas that may warrant future monitoring. The report is intended to increase public understanding of the Fed’s processes and transparency about its current view of the financial system, which informed stakeholders can use to predict and prepare for future actions taken by the Fed.

The Framework

The Fed’s framework for assessing the resilience of the financial system focuses on monitoring the vulnerabilities that can build up over time. Vulnerabilities are unstable aspects of the financial system that may lead to more widespread concerns in the event of a downturn or an adverse “shock”, such as a trade war or a debt crisis in the Eurozone. There are four broad categories of financial vulnerabilities that the Fed outlines in its report:

Elevated valuation pressures: High asset prices relative to fundamentals or historical norms, which is generally caused by high investor risk tolerance. When asset prices are elevated, there is a higher likelihood of large drops in asset prices.

Excessive borrowing by businesses and households: Too much borrowing can make businesses and households unstable. Falling incomes or asset values will then lead to deep spending cuts affecting overall economic activity and defaults on loan payments will impact financial institutions’ and investors’ performance.

Excessive leverage within the financial sector: In the event of an adverse shock, highly levered financial institutions are less capable of absorbing losses. This in turn reduces their ability to lend and may force them to sell off assets to offset losses.

Funding risks: The possibility that investors will run on the financial system by withdrawing funds. When a run occurs, financial institutions that do not hold enough liquid assets may have to sell assets quickly, forcing prices down and incurring losses.

The report notes that these vulnerabilities can interact with one another, having cascading effects across the financial system. For example, a severe drop in asset prices and income that impedes a business’ ability to pay back its debts could lead to high default rates, causing losses for investors and financial institutions that may be more difficult to absorb if the banks are highly levered. This could then lead to banks selling off assets, further exacerbating asset price declines.

The Fed’s Findings

Given the Fed’s framework and the broad categories of vulnerabilities, the high level view of the Fed’s findings are as follows:

• Asset valuations are high relative to historical standards and investors exhibit high risk tolerance.
• Household borrowing has grown in line with income, but corporate debt relative to GDP is high and there are signs that credit standards have been deteriorating.
• Financial institutions are well capitalized, leverage is below pre-crisis levels.
• Funding risks are low. Bank assets are liquid and banks rely more on higher quality capital (core deposits) to fund loans than before the crisis.

Overall, the report paints a positive picture of the US financial system’s health. While there are some vulnerabilities present, as there will be in any economy, the Fed does not deem them to pose a serious threat to the country’s financial stability. After providing a high level overview of the framework and the current assessment of the nation’s financial stability, the Fed report goes into detail on the various vulnerabilities outlined in its framework. Here, we examine some of the most interesting findings.

Asset Valuation Pressures
Not too much of what the Fed had to say about elevated valuations was very surprising or concerning. It does point out that current metrics show that corporate debt, leveraged loans (a riskier form of debt), equities, commercial real estate, farmland and residential real estate are all overvalued. However, while valuations are high relative to historical averages, they are still lower than before the crisis and seem to be somewhat in line with what can be expected during a normal business cycle. There will be a correction at some point, but this really only impacts investors in the short term. What’s more, the resilience of other aspects of the financial system reduces the likelihood that a drop in asset prices has a significant impact on the health of the financial system.

One piece of this section that was interesting, however, is the Fed’s conclusion that spreads on high yield corporate debt remain low despite signs that credit risks are increasing (though they have widened considerably in the weeks since the report’s publication). Spreads on high yield bonds reflect the compensation that investors require for the added default and liquidity risk of high yield debt versus investment grade debt. The fact that spreads remain low in the presence of rising credit risks and deteriorating lending standards may present a market inefficiency as investors are not being compensated for the excess risk they are taking.

Borrowing by Households and Investors
Household debt does not seem to pose much of a threat to US financial stability, with debt mostly growing in line with income. While the report notes that some households still struggle with debt and that student loan delinquencies are still above their long run trend (though decreasing lately), the findings seem mostly positive.

Among businesses, however, the Fed report highlights some troubling credit trends. Business sector debt as a percentage of GDP is high relative to historical trends. There are signs that credit standards are deteriorating for many business loans, with a high level of new loans issued to high leverage firms. In fact, the report notes that the leverage of some firms is near its highest level in 20 years and that firms with high leverage, low earnings and low cash holdings have increased their debt burden the most. However, this is contrasted by the fact that default rates remain at the low end of their historical range. In general, the deteriorating credit standards are a sign that the economy is strong and lenders believe low default rates will persist for the foreseeable future. Of course, lenders have been wrong before and in the event of a slowdown this could present more cause for concern.

Another interesting development highlighted by the Fed report is in the distribution of investment grade debt. The share of investment grade bonds near junk status (otherwise known as high yield) has reached near-record levels. This is important because in the event of a downturn, deteriorating business fundamentals could cause this outsized share of business debt to be downgraded to junk status. Many investment funds have mandates that prohibit them from holding junk bonds, so broad downgrades to junk status would force funds to sell off this risky debt, putting further downward pressure on bond prices.

Of all of the vulnerabilities highlighted in the Fed’s report, those affecting business credit seem to warrant the most continued monitoring.

Leverage in the Financial Sector
Financial institutions were largely vilified for their role in the 2008 financial crisis. They were highly levered and held insufficient assets, both in terms of amount and quality, to cover their liabilities when the downturn in the housing market first hit. Since then, reforms by US government agencies, including the Fed and the SEC, have significantly improved the health of the nation’s financial institutions. The report notes that leverage is generally low. The results of the Fed’s most recent stress tests show that banks would be able to continue their normal lending activity even in the most severe scenarios, which include a steep drop in asset prices, a deep recession and general deterioration of business credit quality.

However, there was one slightly concerning finding. Issuance of collateralized loan obligations(CLOs), a security comprised of a basket of loans, hit $71 billion in the first half of 2018. CLOs are largely backed by a form of risky debt known as a leveraged loan, the quality of which has been deteriorating according to the Fed. So, you have high levels of issuance at the same time that credit standards and credit quality are weakening. If economic conditions worsen, leading to increased default rates, the value of CLOs could fall dramatically. Likely for this reason, the Fed points out that CLOs are a vulnerability it will continue to monitor moving forward.

Funding Risks
There was really nothing to see here in the Fed’s report. Funding risks are low. Banks are relying less on capital that has proved susceptible to runs and more on stable sources of funding such as core deposits. Core deposits are those deposits held by the bank that typically come from local customers that are believed to have low risk of being withdrawn, making them a stable funding source.  Banks also hold a larger number of liquid assets to act as a buffer in accordance with regulatory reforms since the crisis.

Near Term Risks to the Financial Sector
After going in-depth on the various vulnerabilities to the financial system, the Fed report points out some of the notable international developments that could pose a threat in the form of adverse shocks. The main threats pointed out in the report are Brexit, a looming debt crisis in the EU (particularly Italy), problems in China and other emerging economies, trade tensions and geopolitical uncertainty. The importance of China in global economic activity warrants it some extra attention. Growth has been slowing and non financial private debt is now 200% of GDP. The Fed report points out that anything that may impede the ability of Chinese households and businesses to repay their debt could “trigger adverse dynamics.” A downturn that reduces income could increase default rates, further reducing growth and leading to economic and political turmoil in the region. The resulting spillover could reduce global growth and strain the US economy, though the impact would not be nearly as severe in the US as in other regions due to the overall resilience of our financial system as highlighted in the Fed report.

Conclusion

The Federal Reserve’s Financial Stability report shows vast improvements across the US financial system since the 2008 financial crisis. Yes, there are some vulnerabilities within the financial system that could undermine its resilience if left unchecked. Yes, there are some external threats that could affect the broader US economy, such as uncertainty around Brexit, currency crises in emerging markets and global trade tensions. However, the fact that the Federal Reserve is not only aware of these vulnerabilities and threats but has publicly released its findings is an extremely positive sign. The Fed will continue to monitor these vulnerabilities and threats, as will investors, financial institutions and other government agencies, and will be able to take mitigating actions before they can pose a serious risk to the economy. Subsequent financial stability reports, which are expected to be published twice a year, will further inform the status of these vulnerabilities and whether or not any future developments warrant monitoring.

Pat Daly is a regular contributor to no gradient, both as a guest on the podcast and now as a writer.