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.

A financial system is considered stable when financial institutions--banks, savings and loans, and other financial product and service providers--and financial markets are able to provide households, communities, and businesses with the resources, services, and products they need to invest, grow, and participate in a well-functioning economy. Disruptions to these activities of the financial system have arisen during, and contributed to, stressed macroeconomic environments, and financial stability in its most basic form could be thought of as a condition in which financial institutions and markets are able to support consumers, communities, and businesses during such stressed conditions. Accordingly, the Federal Reserve's objective to promote financial stability strongly complements the goals of price stability and full employment. In pursuit of continued financial stability, the Federal Reserve monitors the potential buildup of risks to financial stability; uses such analyses to inform Federal Reserve responses, including the design of stress-test scenarios and decisions regarding other policy tools such as the countercyclical capital buffer (CCyB); works with other domestic agencies directly and through the Financial Stability Oversight Council (FSOC); and engages with the global community in monitoring, supervision, and regulation that mitigate the risks and consequences of financial instability domestically and abroad.

Moreover, the Federal Reserve promotes financial stability through its supervision and regulation of financial institutions. 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, 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.

This section discusses key financial stability activities undertaken by the Federal Reserve over 2017, 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, as 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, such as those by the FSOC and the Financial Stability Board (FSB).

Asset Valuations and Risk Appetite

Overvalued assets are a fundamental source of 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 are likely to 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 remained elevated and continued to edge up. In equity markets, the forward price-to-earnings ratio increased noticeably, in particular for large 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--declined, and such measures suggest that investors demanded a relatively low premium to bear the risk of holding equities. Moreover, both realized and expected volatility in equity markets declined over 2017 to very low levels by historical standards, although realized volatility picked up late in the year (figure 2).

Throughout 2017, yields on Treasury securities remained below historical averages; however, they were higher than in 2016. 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 corporate credit risk, narrowed over the year (figure 3). Strong demand for exposure to corporate credit risk was also apparent in the further increase in leveraged lending with limited degrees of investor protection--termed "covenant lite" loans. Such loans continue to account for a high fraction of market volume (figure 4).

An area of ongoing valuation pressures over the past year was commercial real estate (CRE), with prices increasing faster than the historical trend and, for industrial and multifamily properties, with net operating income relative to property prices (capitalization rates) continuing to decline from already low levels. Residential home prices also continued to rise in 2017, although price increases nationally in that year were not outsized relative to improvements in fundamentals. For example, house prices relative to rents--one measure of valuations--rose moderately in 2017, with an increase similar to annual changes over the previous five years.

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 overall in 2017. Nominal private nonfinancial-sector credit grew a bit less than 5 percent over 2017 and a shade faster than nominal gross domestic product (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 5).

While borrowing by the total nonfinancial private sector remained moderate, leverage among riskier corporate borrowers has stayed at or near multidecade highs, particularly for speculative-grade and unrated firms (figure 6). 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.

Gross issuance of high-yield corporate bonds was strong throughout 2017, and gross issuance of leveraged loans was the strongest over the past decade (figure 7). A sizable fraction of leveraged loan issuance, however, was used for refinancing purposes. The four-quarter percent change in net issuance of risky debt increased throughout the year.

CRE loan growth remained strong over the past year (figure 8). CRE-related loan growth at banks also continued to be strong but began to decline from its peak in 2016. This decline in bank loan growth rates was likely due to a tightening of CRE lending standards. Issuance of commercial mortgage-backed securities, however, remained robust through the fourth quarter.

Household debt growth continued to be modest over the past year, and the debt-to-income ratio for households continued to inch down. Aggregate borrowing relative to income in the household sector declined significantly from its peak, and recent borrowing remained skewed toward low-risk households.

Leverage in the Financial System

Vulnerabilities related to financial-sector leverage appear low. The financial strength of the banking sector continued to improve in 2017, and stronger capital positions at domestic banking organizations 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 2017 (figure 9). 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 34 firms participating in the Federal Reserve's supervisory stress tests for 2017 were able to maintain capital ratios above required minimums to absorb losses from a severe macroeconomic shock.¹

Overall, leverage at nonbank financial firms remains significant. While, in the aggregate, dealers continue to shrink their on-balance-sheet leverage to levels far below those seen leading up to and during the financial crisis, there are signs that nonbank financial leverage has been increasing in some areas. For example, the provision of margin credit to equity investors such as hedge funds has risen substantially. Insurance companies' capital levels are robust, and overall risk exposures are generally lower than those typical of commercial banks.

Liquidity Risks and Maturity Transformation by the Financial System

Vulnerabilities associated with liquidity risks and maturity transformation remained low in 2017, partly reflecting regulations introduced since the 2008 financial crisis. In the banking sector, the largest banks hold high levels of high-quality liquid assets (figure 10). The reliance of global systemically important banks (G-SIBs) on short-term wholesale funding is near post-crisis lows. At the same time, the share of core deposits in total liabilities for G-SIBs is historically high.

In the nonbanking sector, the amount of assets managed by money market mutual funds (also referred to as money market funds, or MMFs) increased marginally throughout 2017, with little change to portfolio composition. More than one year after the MMF reform, assets under management at prime MMFs edged up only modestly.² The weighted-average maturity of assets held by government and agency MMFs declined noticeably throughout 2017, resulting in lower maturity transformation.

Overall issuance of securitized products remained below pre-crisis levels for most asset classes, although the issuance of asset-backed securities (ABS) was strong. ABS issuance partly reflected the securitization of assets that were not typically securitized in previous years, including aircraft leases and mobile phone contracts. Currently, securitized products incorporate less maturity transformation than before the financial crisis, with volumes of asset-backed commercial paper being particularly low. Nontraditional liabilities of insurance companies, including funding-agreement-backed securities, grew significantly in 2017 even if outstanding amounts remained relatively small.

Liquidity transformation at open-end funds that hold less-liquid assets continues to pose a moderate amplification risk, because investors can typically redeem shares daily while the underlying assets may trade in less-liquid markets. Liquidity-transformation risk is also pronounced at exchange-traded funds that invest in certain asset classes, including bank loans, and that provide leveraged and inverse payoffs relative to benchmark indexes. While the limited size of these products suggests that their behavior may not have long-lasting effects on asset prices, their leverage and reliance on markets in which liquidity may be limited during stress periods entail that such products could amplify price swings across markets for short periods.

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.³

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 2017 supervisory stress tests conducted as part of the Dodd-Frank Act stress tests (DFAST) and CCAR were released in June 2017.⁴ Thirteen of the largest and most complex banks were required, for the first time, to meet the minimum supplementary leverage ratio of 3 percent as part of the quantitative assessment. 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. The severely adverse scenario featured a severe global recession that was accompanied by a period of heightened stress in corporate loan and CRE markets. The level of 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 marked growth slowdown in developing Asia.

Key Regulatory Activities

Over the course of 2017, 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.

In December 2017, the Federal Reserve Board voted to reaffirm the CCyB at the current level of 0 percent.⁵ The CCyB is a tool that the Board can use 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 evaluating the appropriate size of the U.S. CCyB, the Board monitors a wide range of financial and economic indicators and considers 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 Board also issued a final rule that improved the resolvability and resilience of systemically important U.S. banking organizations and systemically important foreign banking organizations. Covered entities would be subject to restrictions related to the terms of their noncleared qualified financial contracts.

In order to increase the transparency of its stress-testing program while maintaining its ability to test the resilience of the nation's largest and most complex banking organizations, the Board requested comments on a set of proposals that relate to the disclosure of details about supervisory stress-test models; to the Board's approach to model development, validation, and use; and to the framework for the design of the annual hypothetical economic scenarios.

The proposals on which the Board requested comments included expanding the descriptions of supervisory models and communicating the loss rates that supervisory models assign to subgroups of loans.⁶ In addition, the Board built on previous disclosures and detailed the principles and policies that underpin the development of its stress-testing models.⁷ Finally, the Board proposed to enhance the transparency of the stress-testing economic scenarios by providing a quantitative discussion of the hypothetical path of house prices and by providing notice that the Board is considering incorporating variables related to funding risks into the hypothetical scenarios.

For more information on the Board's regulatory activities, 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 2017 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 2017, the Federal Reserve worked, in conjunction with other FSOC participants, on the following major initiatives:

• Review of asset management products and activities. Following the release of a public statement on April 18, 2016, that provided an update on the FSOC's review of potential risks to U.S. financial stability that may arise from asset management products and activities, the FSOC continued its work to assess the potential for financial stability risks to arise from certain asset management products and activities.⁸ The FSOC's discussion on liquidity and redemption risks resulted in several suggestions being passed to the Securities and Exchange Commission (SEC) for consideration on the risk-management and disclosure practices of mutual funds. The council further conducted analysis on the use of leverage in investment vehicles; specifically, the analysis focused on the potential vulnerability of assets purchased with borrowed short-term funds to selling pressures in stress conditions, as well as the exposures to other market participants created by leverage.
• Nonbank designations process.On September 29, 2017, the FSOC voted to rescind its determination that material financial distress at American International Group, Inc. (AIG), 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.⁹ The FSOC made the decision that AIG's potential to pose material financial distress to U.S. financial stability was substantially reduced after the company had decreased its overall exposures to capital markets, and the FSOC reevaluated the potential for the liquidation of certain products to disrupt market functioning since its determination in June 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 2017, 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 January, the FSB released for consultation proposed guidance for central counterparty resolution and resolution planning.¹⁰

Footnotes