Board of Governors of the Federal Reserve System

Financial Stability

A stable financial system promotes economic welfare through many channels: It facilitates household savings to purchase a home, finance a college education, and smooth consumption in response to job loss and other adverse developments; it promotes responsible risk-taking and economic growth by channeling savings to firms to start new businesses and expand existing businesses; and it spreads risk across investors. Therefore, the Federal Reserve's responsibilities for promoting financial stability strongly complement the goals of price stability and full employment.

The Federal Reserve promotes financial stability through its supervision and regulation of financial institutions; cooperation and coordination of activities with domestic agencies directly and through the Financial Stability Oversight Council (FSOC); and engagement with the global community in monitoring, supervision, and regulation that mitigate the risks and consequences of financial instability domestically and abroad.

A central tenet of the Federal Reserve's efforts in promoting financial stability is the adoption of an approach to supervision and regulation that accounts for the stability of the financial system as a whole, in addition to a traditional, microprudential approach, which focuses on the safety and soundness of individual institutions. In particular, the first approach informs the supervision of systemically important financial institutions (SIFIs), including large bank holding companies (BHCs), the U.S. operations of certain foreign banking organizations (FBOs), and financial market utilities (FMUs). In addition, the Federal Reserve serves as a "consolidated supervisor" of nonbank financial companies designated by the FSOC as institutions whose distress or failure could pose a threat to the stability of the U.S. financial system as a whole (see "Financial Stability Oversight Council Activities" later in this section). Enhanced standards for the largest, most systemic firms promote the safety of the overall system and minimize the regulatory burden on smaller, less systemic institutions.

Furthermore, the evolving nature of risks and fluctuations in financial markets and the broader economy require timely monitoring of conditions in domestic and international financial markets, among financial institutions, and in the nonfinancial sector in order to identify the buildup and propagation of vulnerabilities that might require further study or policy action.

This section discusses key financial stability activities undertaken by the Federal Reserve over 2016, which include monitoring risks to financial stability; 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; and engaging in domestic and international cooperation and coordination. Each of these activities is informed by research into financial stability issues (see box 1 for a summary of some recent research by Federal Reserve Board staff on financial stability topics).

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 SIFIs, designated nonbank companies, and designated FMUs is discussed in section 4, "Supervision and Regulation."

Monitoring Risks to Financial Stability

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 because the nonfinancial 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.

In order to understand the interaction between the financial and nonfinancial sectors and develop appropriate policy responses, the Federal Reserve maintains a flexible, forward-looking financial stability monitoring program to help inform policymakers of the financial system's vulnerabilities to a wide range of potential adverse shocks. Such a monitoring program is a critical part of a broader program in the Federal Reserve System to assess and address vulnerabilities in the U.S. financial system.

Each quarter, Federal Reserve Board staff assess a set of vulnerabilities relevant for financial stability, including but not limited to asset valuations and risk appetite, leverage in the financial system, liquidity risks and maturity transformation by the financial system, and borrowing by the nonfinancial sector (households and nonfinancial businesses). These monitoring efforts inform internal 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, like those by the FSOC and the Financial Stability Board (FSB).

Asset Valuations and Risk Appetite

Overvalued assets constitute a source of fundamental 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 may 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. As a result, analysis typically includes a broad range of possible valuation metrics and tracks developments in areas in which asset prices are rising particularly rapidly, into which investor flows have been considerable, or where volatility has been at unusually low or high levels.

Across markets, valuation pressures were moderate most of the year but moved up somewhat near the end of the year, when pressure increased in some areas and in several indicators of investors' risk appetite. In equity markets, valuations rose, especially near year-end. The forward price-to-earnings ratio widened considerably, particularly for small firms (figure 1). At the same time, estimates of the equity risk premium--for example, the gap between the expected return on equity and the long-term Treasury yield (adjusted for inflation expectations)--declined, and such measures no longer suggest that investors are demanding an unusually high premium to bear the risk of holding equities, in contrast to the picture seen almost continuously since the financial crisis. Moreover, both realized and expected volatility in equity markets fell to low levels over the course of 2016, and the implied volatility of the S&P 500 index--the VIX--fell to the lower end of its historical range by year-end (figure 2). The low level of expected volatility in financial markets in late 2016 contrasted with some other measures of economic uncertainty late in the year, such as the Baker, Bloom, and Davis economic policy uncertainty index, which remained elevated in late 2016.¹

Throughout 2016, yields on Treasury securities as well as term premiums remained below historical averages, although both rose near year-end as market expectations about future growth shifted higher. In the corporate bond market, spreads of high-yield and investment-grade bonds relative to comparable-maturity Treasury yields, a gauge of the compensation that investors demand for exposure to the credit risk of corporate borrowers, narrowed over the year, ending near the lowest level since 2013 (figure 3).

Issuance of high-yield corporate bonds edged down in the second half of 2016, and gross issuance of leveraged loans was strong most of the year but declined in the last quarter (figure 4). As a result, growth in risky debt outstanding in the fourth quarter of the year was close to the lowest level in recent years. However, the notable decrease in speculative-grade spreads in November and December suggests that the decline in issuance likely does not reflect a tightening of financial conditions.

An area of growing valuation pressures over the past year was commercial real estate (CRE), with property prices continuing to outpace rents and with capitalization rates decreasing to historically low levels (figure 5). While CRE debt remained modest relative to the overall size of the economy and the tightening in bank lending standards for CRE loans in the second half of 2016 may result in some reduction in CRE lending, some smaller banks may be vulnerable to a sizable decline in CRE prices. In addition, residential home prices continued to rise briskly in 2016, although price increases nationally in 2016 were not outsized relative to improvements in fundamentals or earlier periods of rapid price gains. For example, house prices relative to rents--one measure of valuations--rose moderately in 2016, and they remained well within a typical range and far below the levels seen in the past decade across much of the country (figure 6).

Leverage in the Financial System

The financial strength of the banking sector continued to improve in 2016, and stronger capital positions at domestic banking organizations have contributed to the improved resilience of the U.S. financial system. Regulatory capital remained at historically high levels for most large domestic banks. The ratio of Tier 1 common equity to risk-weighted assets stayed near 12 percent, on average, for BHCs in 2016 (figure 7). Moreover, the leverage ratio, which looks at common equity relative to total assets without adjusting for risk, also remained at levels substantially above pre-crisis norms. Finally, all 33 firms participating in the Federal Reserve's supervisory stress tests for 2016 were able to maintain capital ratios above required minimums to absorb losses from a severe macroeconomic shock.²

In addition, bank equity prices increased significantly in late 2016. However, the equity prices of many of the largest foreign banks remained depressed, reflecting investors' heightened concerns about the need for those firms to raise outside equity, meet unresolved legal exposures, and adapt their business models to the post-crisis environment. On December 23, the Department of Justice (DOJ) announced settlement agreements with Deutsche Bank and Credit Suisse over the mis-selling of residential mortgage-backed securities.³ The DOJ still has pending cases with Barclays and the Royal Bank of Scotland.

Moreover, financial institutions outside the banking sector also do not appear to have taken on additional leverage in recent years. Insurance companies appear adequately capitalized relative to prudential standards. Available indicators of gross leverage at hedge funds, such as gross notional leverage, were little changed in 2016.

Liquidity Risks and Maturity Transformation by the Financial System

Vulnerabilities associated with liquidity risks and maturity transformation continued to fall in 2016. The most significant shifts over the year occurred at money market mutual funds (also referred to as money market funds, or MMFs). In October 2016, regulations from the Securities and Exchange Commission (SEC) that required prime institutional MMFs to adopt a floating net asset value (NAV), along with other changes, came into effect.⁴ Investors in such prime funds appear to have placed a high value on the funds' previous feature of maintaining the NAV at par, and the prospect of the regulatory changes led to a large decline of about $1 trillion in assets under management (AUM) at prime MMFs through October of last year, with most of the assets shifting to MMFs that invest in government-guaranteed assets. Money markets functioned smoothly ahead of the mid-October 2016 reform implementation deadline, and AUM stabilized in the last couple of months of the year (figure 8).

The new SEC regulations' floating NAV feature has likely reduced the first-mover advantage inherent in these funds, lowering their run risk. That said, the configuration of short-term funding markets is still evolving. For example, total commercial paper (CP) and certificates of deposit (CDs) held by MMFs fell more than the outstanding levels of CP and CDs, indicating that other investors now hold these assets.

Apart from developments at prime funds, the stock of private, short-term, money-like instruments--which form funding intermediation chains that are vulnerable to runs and include prime MMFs, government-only MMFs, and other short-term instruments--has continued to trend down relative to gross domestic product (GDP) and total nonfinancial debt, maintaining a tendency toward less reliance on short-term funding across the financial system. Within the banking sector, the reliance of large BHCs on short-term funding remained subdued, and their holdings of liquid assets continued to be high by historical standards. In addition, securitization, which was associated with maturity transformation as well as lax lending standards and rapid credit growth in the few years prior to the financial crisis, stayed relatively stable by historical standards and did not appear to be funding rapid credit growth in 2016.

Finally, for open-end mutual funds that hold less-liquid assets and that could face elevated redemptions, liquidity transformation continued to pose a moderate financial stability risk, as large outflows from these funds in market downturns could exacerbate volatility in financial markets.

Borrowing by the Nonfinancial Sector

Excessive borrowing by the private nonfinancial sector has been an important contributor to past financial crises. Highly indebted households and nonfinancial businesses may be vulnerable to negative shocks to incomes or asset values and may be forced to curtail spending, which could amplify the effects of financial shocks. In turn, losses among households and businesses can lead to mounting losses at financial institutions, creating an adverse feedback loop in which weakness among households, nonfinancial businesses, and financial institutions causes further declines in income and accelerated financial losses, potentially leading to financial instability and a sharp contraction in economic activity.

Vulnerabilities associated with nonfinancial-sector leverage remained moderate in 2016. Nominal private nonfinancial-sector credit grew about 4-1/2 percent over 2016, a shade faster than nominal GDP, leaving the private nonfinancial-sector credit-to-GDP ratio elevated but stable at approximately 150 percent, a level similar to that in the mid-2000s (figure 9). Household debt growth was modest through the fourth quarter, and the debt-to-income ratio for households continued to inch down over the past few years. Aggregate borrowing relative to income in the household sector has declined significantly from its peak, and recent borrowing remains skewed toward low-risk households.

Leverage among the riskier corporate borrowers, however, has stayed near or at multidecade highs, particularly for speculative-grade and unrated firms, although the growth of risky corporate debt has decelerated considerably over recent quarters (figure 10). Despite high leverage, interest expense ratios were low by historical standards, even among higher-risk firms, as were measures of expected default based on accounting and stock return data, especially outside the oil sector. Nonetheless, high leverage could leave some parts of the corporate sector vulnerable to difficulties should adverse shocks materialize.

Financial Stability and the Supervision and Regulation of Large, Complex Financial Institutions

Large, complex financial institutions interact with financial markets and the broader economy in a manner that may--during times of stress and in the absence of an appropriate regulatory framework and effective supervision--lead to financial instability.⁵

Key Supervisory Activities

One essential element of enhanced supervision of large banking organizations is the stress-testing process, which includes the stress tests mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) and the Comprehensive Capital Analysis and Review (CCAR). In addition to fostering the safety and soundness of the participating institutions, stress tests embed elements focused on the stability of the financial system as a whole by incorporating the following:

• examining the loss-absorbing capacity of institutions under a common macroeconomic scenario that has features similar to the strains experienced in a severe recession and which includes, as appropriate, identified salient risks
• conducting a simultaneous exercise across large institutions to understand the potential for correlated exposures
• considering the effects of counterparty distress on the largest, most interconnected firms

The results from the 2016 supervisory stress tests conducted as part of the Dodd-Frank Act stress tests (DFAST) and CCAR were released in June 2016.⁶ The DFAST and CCAR results suggest that all of the firms evaluated have sufficient capital to remain above minimum requirements through a severely adverse macroeconomic scenario. In addition, they continue to build capital. The severely adverse scenario featured a more severe downturn in the U.S. economy relative to the CCAR 2015 scenario, including short-term U.S. Treasury rates that fell below zero and a larger increase in unemployment. This increase in severity reflected the Board's scenario design framework for stress testing, which includes countercyclical elements. The international part of the scenario featured severe recessions in the euro area, the United Kingdom, and Japan and a mild recession in developing Asia.

In addition, the Federal Reserve Board completed an extensive review of its statutory stress-test and CCAR programs and made some related modifications to the rules associated with those programs for the 2017 cycle.⁷ Among other changes, the Board removed certain large, noncomplex firms from the qualitative assessment of the CCAR, reducing significant burden on these firms and focusing the qualitative review in CCAR on the largest, most complex financial institutions.⁸

Moreover, the Board, together with the other federal banking agencies, issued an advance notice of proposed rulemaking inviting public comment on a set of potential enhanced cybersecurity risk-management and resilience standards that would apply not only to depository institutions and regulated holding companies with over $50 billion in assets, but also to certain financial market infrastructure companies.⁹ The standards would be tiered, with an additional set of higher standards for systems of covered entities that provide key functionality to the financial sector.

Key Regulatory Activities

Over the course of 2016, the Federal Reserve took a number of steps to continue improving the resilience of financial institutions and the overall financial system. This section summarizes steps that bear most directly on financial stability. First, last fall, the Federal Reserve Board finalized its framework for setting the countercyclical capital buffer (CCyB) and later voted to affirm the CCyB amount at 0 percent.¹⁰ The buffer is designed to increase the resilience of the financial system by raising capital requirements on internationally active banking organizations when there is an elevated risk of above-normal losses in the future. In forming its view about the appropriate size of the U.S. CCyB, the Board intends to monitor a wide range of financial and economic indicators and consider their implications for financial system vulnerabilities, including but not limited to asset valuation pressures, risk appetite, leverage in the financial and nonfinancial sectors, and maturity and liquidity transformation in the financial sector. The decision to maintain the CCyB at 0 percent in part reflected an assessment that vulnerabilities associated with financial-sector leverage were at the lower ends of their historical ranges.

Second, the Board also took several further regulatory steps as part of its effort to improve the resilience of financial institutions and overall financial stability. For example, the Board finalized a rule that would impose total loss-absorbing capacity and long-term debt requirements on U.S. global systemically important bank holding companies (G-SIBs) and on the U.S. operations of certain foreign G-SIBs.¹¹ The final rule would require each covered firm to maintain a minimum amount of unsecured long-term debt that could be converted into equity in a possible resolution of the firm, thereby both recapitalizing the firm without putting public money at risk and diminishing the threat that its failure would pose to financial stability. The rule is an important step in addressing the perception that certain institutions are "too big to fail." Under the final rule, U.S. G-SIBs would need to raise an additional $70 billion by January 2019.

Third, the Board and the Federal Deposit Insurance Corporation (FDIC) continued to actively engage in the resolution-planning process with the largest banks. As part of that process, the Board and the FDIC announced that Bank of America, BNY Mellon, JPMorgan Chase, and State Street adequately remediated deficiencies in their 2015 resolution plans. The two agencies also announced that Wells Fargo did not adequately remedy all of its deficiencies and will be subject to restrictions on certain activities until the deficiencies are remedied.¹²

The enhanced prudential standards, together with stress testing and other regulatory safeguards, help ensure that large U.S. BHCs and FBOs operating in the United States have robust levels of capital and liquidity as well as strong risk management. Together, these efforts not only help make certain that these firms are financially sound individually, but also limit the risk that financial distress at these firms could cause negative spillovers to the financial sector and the broader economy. Improvements in resolvability will mitigate adverse effects from perceptions of "too big to fail" and contribute to more orderly conditions in the financial system if institutions face strains. For more information on recovery and resolution-planning activity, see section 4, "Supervision and Regulation."

Domestic and International Cooperation and Coordination

The Federal Reserve cooperated and coordinated with both domestic and international institutions in 2016 to promote financial stability.

Financial Stability Oversight Council Activities

As mandated by the Dodd-Frank Act, the FSOC was created in 2010 and is chaired by the Treasury Secretary (box 2). It establishes an institutional framework for identifying and responding to sources of systemic risk. The Federal Reserve Chairman is a member of the FSOC. 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, analyzes the implications of those risks for financial stability, and identifies 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 2016, the Federal Reserve worked, in conjunction with other FSOC participants, on the following major initiatives:

• Review of asset management products and activities. After reviewing comment letters in response to its request for public comments on asset management industry risks, the FSOC released a public statement on April 18, 2016, providing an update on its review of potential risks to U.S. financial stability that may arise from asset management products and activities.¹³ The statement detailed the FSOC's views regarding potential financial stability risks and next steps to respond to these potential risks. The evaluation of risks focused on the following areas: (1) liquidity and redemption, (2) leverage, (3) operational functions, (4) securities lending, and (5) resolvability and transition planning.
• Creation of a hedge fund working group. The April statement's review of the use of leverage in the hedge fund industry suggested a need for further analysis of hedge fund activities, and, as a result, the FSOC established a working group to gather and analyze regulatory and supervisory data on hedge funds. As a working group member, the Federal Reserve has continued to participate in the ongoing analysis of potential risks to the financial system posed by the hedge fund industry.
• Nonbank designations process. On June 29, 2016, the FSOC voted to rescind its determination that material financial distress at GE Capital Global Holdings could pose a threat to U.S. financial stability, and that the company should be subject to supervision by the Federal Reserve and enhanced prudential standards.¹⁴ The FSOC made the decision that GE Capital's potential to pose material financial distress to U.S. financial stability was substantially reduced after the company had executed significant divestitures, transformed its funding model, and implemented a corporate reorganization since the FSOC's determination in July 2013.

Financial Stability Board Activities

The Federal Reserve participates in international bodies, such as the FSB, given the interconnected global financial system and the global activities of large U.S. financial institutions. The FSB is an international body that monitors the global financial system and promotes financial stability through the adoption of sound policies across countries. The Federal Reserve participates in the FSB, along with the SEC and the U.S. Treasury.

In 2016, the Federal Reserve continued its active participation in the FSB. The FSB is engaged in several issues, including monitoring of shadow banking activities, coordination of regulatory standards for global systemically important financial institutions, asset management, fintech (emerging financial technologies), evaluating the effects of reforms, and development of effective resolution regimes for large financial institutions. In June, the FSB released for consultation a set of proposed policy recommendations to address vulnerabilities from asset management activities.

Footnotes