Board of Governors of the Federal Reserve System

Financial Stability

The Federal Reserve monitors financial system risks and engages at home and abroad to help ensure the system supports a healthy economy for U.S. households, communities, and businesses.

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; 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.¹

This section discusses key financial stability activities undertaken by the Federal Reserve over 2020, which include the following:

• monitoring risks to financial stability
• establishing lending facilities to support the economy during the COVID-19 crisis
• 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
• engaging in domestic and international cooperation and coordination

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.

A stable financial system, when hit by adverse events, or "shocks," is able to continue meeting demands for financial services from households and businesses, such as credit provision and payment services. By contrast, in an unstable system, these same shocks are likely to have much larger effects, disrupting the flow of credit and leading to declines in employment and economic activity.

Consistent with this view of financial stability, the Federal Reserve Board's monitoring framework distinguishes between shocks to and vulnerabilities of the financial system. Shocks, such as sudden changes to financial or economic conditions, are inherently hard to predict. Vulnerabilities tend to build up over time and are the aspects of the financial system that are most expected to cause widespread problems in times of stress.

Accordingly, the Federal Reserve maintains a flexible, forward-looking financial stability monitoring program focused on assessing the financial system's vulnerabilities to a wide range of potential adverse shocks (see box 3.1 for more information on large, complex financial institutions and monitoring potential spillovers).

Each quarter, the Federal Reserve Board staff assesses a set of vulnerabilities relevant for financial stability, including but not limited to asset valuation pressures, borrowing by businesses and households, leverage in the financial sector, and funding risk. These monitoring efforts inform 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).

The Federal Reserve Board publishes its Financial Stability Report on a semiannual basis.² The report summarizes the Board's framework for assessing the resilience of the U.S. financial system and presents the Board's current assessment of financial system vulnerabilities. It aims to promote public understanding about Federal Reserve views on this topic and thereby increase transparency and accountability. The report complements the annual report of the FSOC, which is chaired by the Secretary of the Treasury and includes the Federal Reserve Chair and other financial regulators.

Asset Valuation Pressures

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, the Federal Reserve's analysis of asset valuation pressures 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.

Overall, asset valuation pressures, which were elevated before the COVID-19 outbreak in the United States, dropped at the beginning of the outbreak as asset prices plummeted. However, asset prices subsequently retraced and surpassed their pre-pandemic levels in most markets by the end of 2020. In particular, prices in equity, corporate bond, and residential real estate markets returned to or exceeded pre-pandemic levels, buoyed in part by positive vaccine-related news, additional fiscal stimulus, and better-than-expected economic data.

After rebounding in the spring of 2020 from their COVID-related declines, broad stock prices climbed over the course of 2020. Stock prices also rose considerably relative to the forecasts of corporate earnings despite significant uncertainty in the earnings outlook among market participants (figure 3.1). Measures of realized and implied stock price volatility for the S&P 500 index—the 20-day realized volatility and the VIX, respectively—decreased sharply from their very high levels at the end of the second quarter but remained moderately above their historical medians by the end of 2020.

At the onset of the pandemic, corporate bond market functioning was adversely affected as liquidity conditions deteriorated: Bid-ask spreads widened considerably, and bond mutual funds and exchange-traded funds experienced large outflows. Spreads of yields on corporate bonds over comparable-maturity Treasury yields increased significantly during the early period of the pandemic (figure 3.2).

Subsequently, liquidity conditions as well as investor risk appetite improved following the Federal Reserve's announcement in late March of a range of measures to support market functioning and the flow of credit (see box 3.2).

In the second half of 2020, the resilience of the economy, as well as the emergency approval of vaccines and optimism about further fiscal support late last year, contributed to a notable improvement in the outlook for corporate earnings and credit quality that drove declines in yields on corporate bonds. However, spreads in sectors heavily affected by the pandemic—such as the energy, airline, and leisure industries—closed the year at elevated levels.

Borrowing by Households and Businesses

Excessive borrowing by households and businesses 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, financial stress among households and businesses can lead to mounting losses at financial institutions, creating an adverse feedback loop in which weaknesses among households, nonfinancial businesses, and financial institutions cause further declines in income and accelerate financial losses, potentially leading to financial instability and a sharp contraction in economic activity.

Vulnerabilities associated with business and household debt increased over the course of 2020. Before the COVID-19 outbreak, the combined total debt owed by businesses and households expanded at a pace similar to that of nominal gross domestic product (GDP) for several years.

In the first half of 2020, credit growth accelerated and reached about 9 percent in annualized terms, mostly reflecting significant business borrowing. The precipitous drop in GDP following the outbreak and the increase in business borrowing caused a dramatic rise in the credit-to-GDP ratio to historical highs (figure 3.3). In the second half of 2020, this ratio fell markedly, as GDP partially rebounded and debt changed little. Government lending, relief programs, and low interest rates mitigated strains in the business and household sectors.

In 2020, household debt (adjusted for general price inflation) edged higher on net. Debt owed by the one-half of households with prime credit scores continued to account for almost all of the growth. By contrast, inflation-adjusted loan balances for borrowers with near-prime credit scores changed little over 2020, and balances for borrowers with subprime scores fell.

Mortgage debt accounted for roughly two-thirds of total household credit, with mortgage extensions skewed toward prime borrowers in recent years. Widespread loss-mitigation measures and low interest rates have helped damp the effect of the pandemic on mortgage delinquencies.

Most of the remaining one-third of total debt owed by households was consumer credit, consisting mainly of student loans, auto loans, and credit card debt. Credit card balances decreased in 2020, while auto loan balances expanded moderately. Many student loan borrowers benefited from payment suspensions and waived interest payments as part of the Coronavirus Aid, Relief, and Economic Security Act.

Borrowing by businesses, likely seeking to bridge pandemic-related interruptions to revenues, was extremely high in the first half of 2020. An indicator of the leverage of large businesses—the ratio of debt to assets for all publicly traded nonfinancial firms—reached its highest level in 20 years by mid-2020. As the growth in outstanding debt slowed later in the year, the same ratio declined but, at the end of the year, still stood above the levels leading up to the pandemic.

Credit quality deteriorated after the onset of the pandemic but stabilized in the second half of 2020, particularly among large firms. Correspondingly, the pace of corporate bond downgrades was elevated through the spring of 2020 but came down to normal levels later in the year.

Leverage in the Financial System

The U.S. banking system remained resilient throughout 2020, in part because of the regulatory reforms prompted by the 2007–09 recession, forceful interventions by the Federal Reserve, and fiscal stimulus. When the pandemic intensified in March, large capital buffers allowed banks to meet the substantially increased loan demand from businesses while providing payment relief and other types of forbearance to households. That additional lending pushed up risk-weighted assets at the same time that increased loan loss provisions eroded profitability.

As a result, the aggregate common equity Tier 1 ratio—a regulatory risk-based measure of bank capitalization—declined significantly in the first quarter (figure 3.4). However, capital ratios ended the year at new highs, not only because of the Federal Reserve Board's decision to restrict capital payouts by large banks, but also because of declines in risk-weighted assets driven by paydowns of business loans and credit card loans, reduced loan demand more generally, and tightened lending standards.³ Bank profitability also improved in the second half of 2020 because of a combination of lower-than-expected losses, a better economic outlook, and strong noninterest income.

In June 2020, the Federal Reserve released the results of the 2020 Dodd-Frank Act stress tests and the Comprehensive Capital Analysis and Review along with a sensitivity analysis to assess the resilience of large banks under three hypothetical downside scenarios related to the coronavirus event. The analysis under the more severe downside scenarios showed that most banks would have remained well capitalized, but several approached their minimum capital levels.⁴

In December, the Federal Reserve released results from the second round of bank stress tests for 2020, which showed that all banks would remain well capitalized under two updated severely adverse supervisory scenarios.

Outside the banking sector, leverage at broker-dealers changed little over 2020 and remained at historically low levels by the end of the year. While the liquidity deterioration across dealer-intermediated markets in March 2020 demonstrated potential fragility despite dealers' low leverage, this fragility was mitigated by emergency lending facilities and the supervisory actions of the Federal Reserve.

Gross leverage at hedge funds declined in the first half of 2020 to roughly the middle of its historical distribution. The COVID-19 shock exposed vulnerabilities at hedge funds. Extreme market volatility and lower liquidity in asset markets led to substantial losses at some hedge funds and sizable margin calls.⁵ While data on hedge fund leverage come from different sources with various lags, most measures increased in the second half of 2020 and are now somewhat above their historical averages, reversing the decrease in the first half of the year. Finally, leverage at life insurance companies rose to post-2008 highs during the course of 2020.

Funding Risk

At the onset of the pandemic, banks had substantial quantities of liquid assets, and their reliance on the most unstable sources of funding stood at historically low levels. Those liquidity positions improved further over the rest of 2020, as banks experienced heavy deposit inflows and their liquid asset positions increased substantially (figure 3.5).

Many types of nonbank financial institutions, however, experienced funding difficulties in the first half of 2020. For example, prime money market funds (MMFs), particularly institutional funds, experienced runs in March, with outflows reaching the same proportion of assets redeemed during the run on MMFs in 2008.

Heavy redemptions from these funds reportedly were prompted in part by investor concerns about the possibility of liquidity fees and redemption gates. As investors fled to safety, actions by the Federal Reserve were required to slow withdrawals and restore the functioning of short-term funding markets. Since the onset of the pandemic, assets under management at prime MMFs have declined steadily.

Domestic and International Cooperation and Coordination

The Federal Reserve cooperated and coordinated with both domestic and international institutions in 2020 to promote financial stability.

Financial Stability Oversight Council Activities

As mandated by the Dodd-Frank Act, the FSOC was created in 2010 and, as noted earlier, is chaired by the Treasury Secretary and includes the Federal Reserve Chair as a member (see box 3.3). It established an institutional framework for identifying and responding to the sources of systemic risk.

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 2020, the FSOC continued to serve as a central venue for member agencies to coordinate risk analysis and policy enactment—a function that took on particular significance around the COVID-19 event. The council increased the frequency of staff-level meetings, providing member agencies with timely analysis and a venue to exchange views and coordinate responses.

Financial Stability Board Activities

In light of the interconnected global financial system and the global activities of large U.S. financial institutions, the Federal Reserve participates in international bodies, such as the FSB. The FSB monitors the global financial system and promotes financial stability through the development of sound policies that can be implemented across countries. The Federal Reserve is a member of the FSB, along with the Securities and Exchange Commission and the U.S. Treasury.

In the past year, the FSB has examined several issues, including monitoring of nonbank financial intermediation, the use and effectiveness of COVID-related policy response measures, evaluating the effects of too-big-to-fail reforms, challenges in cross-border payments systems, monitoring and evaluation of channels through which climate-related risks could affect financial stability, challenges in correspondent banking, the regulatory issues regarding the emergence and use of so-called global stablecoins, transitioning away from the use of LIBOR (London interbank offered rate), asset management, fintech (emerging financial technologies), and development of effective resolution regimes for large financial institutions.

In addition, the FSB formed a high-level steering group on nonbank financial intermediation that developed a detailed work plan to analyze and address vulnerabilities. This steering group agreed to develop policy options to strengthen resilience in MMFs, which will be published in 2021.

Footnotes