In its May 2021 Financial Stability Report, the Federal Reserve Board ("FRB") reviewed current conditions that may reflect vulnerabilities to the stability of the financial system.
The FRB found that (i) the prices of risky assets and long-term Treasury yields have increased (though the latter remain low in comparison to historical standards), (ii) banks remain well capitalized, (iii) hedge fund leverage levels are above historical averages, and (iv) funding risks at domestic banks remain low.
According to the report:
- equity prices have increased and valuations are generally high and supported by low interest rates;
- valuation pressures remain high regarding commercial real estate;
- business debt vulnerabilities remain high relative to business income;
- bank capital ratios rose above pre-pandemic levels, but elevated credit risks remain;
- leverage is at historically low levels at broker-dealers and high at life insurance companies;
- by the end of 2020, bank lending to nonbank financial institutions returned to pre-COVID-19 pandemic levels; and
- domestic banks continue to have high levels of liquid assets and stable funding.
The FRB also identified near-term risks to the U.S. financial system: (i) a stressed European financial system may transmit risk into the U.S., and (ii) a rise in long-term interest rates may add fiscal strain on emerging market economies.
In a related statement, FRB Governor Lael Brainard explained that increased vulnerabilities associated with elevated risk appetite and valuation levels, combined with "very high levels" of corporate indebtedness, could amplify the effects of a re-pricing event. Ms. Brainard highlighted the Archegos event as evidence of the need for more granular, higher-frequency disclosures from nonbank financial institutions, including hedge funds.
Primary Sources
- FRB Report: Financial Stability Report (May 2021)
- FRB Statement, Lael Brainard: Financial Stability Report
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