Near-Term Risks to the Financial System
The course of the pandemic and the ultimate extent and duration of the resulting economic and financial consequences remain one of the most significant risks to the financial system. The realization of this risk continues to depend largely on the success of public health measures and other government actions to contain the spread of COVID-19, on the steps households and businesses take to resume economic activity, and on the duration of the government lending and relief programs that have, so far, ameliorated the most adverse potential economic outcomes.
The Federal Reserve routinely engages in discussions with domestic and international policymakers, academics, community groups, and others to gauge the set of risks of particular concern to these groups. As noted in the box "Salient Shocks to Financial Stability Cited in Market Outreach," contacts were mostly focused on the risks associated with the evolution of the pandemic and the policy support to contain its effects as well as on the uncertainties related to the elections in November. The following analysis considers possible interactions of existing vulnerabilities with four broad categories of risk, some of which were also raised in these discussions: a prolonged slowdown in U.S. economic growth, disruptions in dollar funding markets, risks emanating from Europe, and risks originating in China and other EMEs.
The effects of the pandemic have increased the vulnerabilities of the financial system to future shocks, including additional waves of substantial COVID-19 outbreaks
Most forecasters expect a moderate recovery in economic output in the United States and abroad following a global recession, but uncertainty surrounding this outcome is unusually high. The sharp slowdown in economic activity has disproportionately affected some businesses and households, and a further weakening in the balance sheets of those that are especially vulnerable could affect the financial system. Furthermore, monetary and fiscal policy tools have limited ability to moderate some dimensions of what is fundamentally a public health shock.
If the pandemic persists for longer than anticipated—especially if there are extended delays in the production or distribution of a successful vaccine—downward pressure on the U.S. economy could derail the nascent recovery and strain financial markets and financial institutions, particularly if many businesses are shuttered again and many workers are laid off and left without a normal income for a long period. If that were the case, a number of the vulnerabilities identified in this report could grow further, making them more likely to amplify negative shocks to the economy. Investor risk appetite and asset prices have increased in recent months but could suffer significant declines should the pandemic take an unexpected course or the economic recovery prove less sustainable. Given the generally high level of leverage in the nonfinancial business sector, prolonged weak profits could trigger financial stress and defaults. In addition, a protracted slowdown could further harm the finances of even high-credit-score households, which could lead to defaults and place financial pressure on banks and other lenders. Broader solvency issues could impair the ability of some financial institutions to lend or induce increased asset sales and redemptions of withdrawable liabilities.
Although leverage remains at modest levels at banks, broker-dealers, and other financial institutions, the leverage of some nonbank financial institutions, such as life insurance companies and hedge funds, is high, exposing them to risks stemming from sharp drops in asset prices and funding illiquidity risks. Furthermore, prime MMFs and fixed-income mutual funds remain vulnerable to funding strains and sudden redemptions, as demonstrated during the acute period of extreme market volatility and deteriorating asset prices earlier this year. While government support has lowered the risk of adverse events associated with vulnerabilities in the nonbank sector, this sector would be vulnerable to funding risk should the government support be withdrawn.
The Implications of Climate Change for Financial Stability
Climate change refers to the trend toward higher average global temperatures and accompanying environmental shifts such as rising sea levels and more severe weather events. Climate change adds a layer of economic uncertainty and risk that we have only begun to incorporate into our analysis of financial stability. Different sectors of the economy and geographic regions face different risks that will diverge from historical patterns. In this discussion, we focus on how climate change, which increases the likelihood of dislocations and disruptions in the economy, is likely to increase financial shocks and financial system vulnerabilities that could further amplify these shocks.
These climate risks are present over various horizons. The figure illustrates how these risks become financial stability risks. Acute hazards, such as storms, floods, droughts, or wildfires, can quickly alter, or reveal new information about, future economic conditions or the value of real or financial assets. Moreover, in the presence of rapid shifts in public perceptions of risk, chronic hazards (like a slow rise in sea levels) have the potential to produce similar abrupt repricing events. These repricing events and direct losses associated with climate hazards can result in an increased frequency and severity of financial shocks; the timing and repercussions of these shocks are difficult to predict in advance.
Possible Transmission from Climate-Related Risks to Financial System Vulnerabilities
Source: Federal Reserve Board staff.
Features of climate change can also increase financial system vulnerabilities, as illustrated in the figure. Opacity of exposures and heterogeneous beliefs of market participants about exposures to climate risks can lead to mispricing of assets and the risk of downward price shocks. Similarly, uncertainty about the timing and intensity of severe weather events and disasters, as well as the poorly understood relationships between these events and economic outcomes, could lead to abrupt repricing of assets. Climate risks thus create new vulnerabilities associated with nonfinancial and financial leverage. In regions affected by severe events, households and businesses could become overlevered if the value of their assets or income prospects become impaired. Levered financial institutions may be exposed to losses from disasters made more likely by climate change that are not accurately reflected in current financial models; for example, financial models may lack sufficient geographical granularity to accurately connect local physical damages to financial exposures. The financial system is also vulnerable to amplification effects of these damages if contracts are incomplete and do not capture all damages and if poorly understood financial exposures cause spillover effects or financial contagion.
One example of how climate change is likely to increase financial stability risks is through real estate exposures. Some residential and commercial properties will be subject to acute hazards such as storm surges associated with rising sea levels and more intense and frequent hurricanes. Continued productive use of these properties would require investment and adaptation. As inundations or storm surges become more frequent, the expected value of exposed real estate may decrease, which may in turn pose risks to real estate loans, mortgage-backed securities, the holders of these loans and securities, and the profitability of nonfinancial firms using such properties.
With perfect information, the price of real-estate-linked assets and the valuations of claims linked to such assets—held by banks, insurers, investment funds, and nonfinancial firms—would already reflect these climate-related risks. However, given the uncertain timing and severity of future climate-related flooding and the associated opacity of asset exposures, investors in real-estate-linked assets may react abruptly to new information about a region's exposure to climate-related financial risks. A sharp repricing, in turn, could create incentives to fire sale such assets by leveraged financial and nonfinancial firms. These asset valuation changes would be amplified by financial and nonfinancial leverage, funding risks, and interconnections across holders of the collateral-based assets, thereby creating risks to financial stability.
Several policies or other factors could moderate climate-related financial vulnerabilities or the likelihood of large shocks. Within the financial system, increased transparency through improved measurement and disclosure could improve the pricing of climate risks, such as an increase in the frequency and severity of extreme weather events, thereby reducing the probability of sudden changes in asset prices. Continued research into the interconnections between the climate, the economy, and the financial sector could strengthen knowledge of transmission, clarify linkages and exposures, and facilitate more efficient pricing of risk. Outside the financial system, efforts to mitigate or adapt to the physical effects of climate change through technological advances and policy changes could also reduce climate risks in the long run.
Staff members throughout the Federal Reserve System continue to research the relationships among climate risks and economic and financial risks and, ultimately, to better identify the transmission channels through which climate risks could affect the financial sector. This work is conducted in close consultation with other U.S. agencies and international groups in an effort to strengthen the knowledge and understanding of this growing economic and financial stability issue.
The Federal Reserve is evaluating and investing in ways to deepen its understanding of the full scope of implications of climate change for markets, financial exposures, and interconnections between markets and financial institutions. It will monitor and assess the financial system for vulnerabilities related to climate change through its financial stability framework. Moreover, Federal Reserve supervisors expect banks to have systems in place that appropriately identify, measure, control, and monitor all of their material risks, which for many banks are likely to extend to climate risks.
Disruptions in global dollar funding markets remain an important source of risk
As was highlighted by the period of acute financial stress in March, disruptions in global dollar funding markets are also an important risk to the U.S. financial system. In many advanced foreign economies and EMEs, the reliance of banks and nonbank financial institutions on short-term dollar funding markets, including through off-balance-sheet instruments such as FX swaps, remains a vulnerability.16 Disruptions in offshore dollar funding markets can adversely affect these foreign financial institutions, which may reduce lending to U.S. residents and liquidate holdings of U.S. assets in order to obtain dollars, harming U.S. households and businesses. These risks are mitigated, however, by the Federal Reserve dollar swap lines with other central banks and the FIMA Repo Facility.17
Stresses emanating from Europe also pose risks to the United States because of strong transmission channels...
European financial institutions and businesses play an important role in global financial intermediation and have notable financial and economic linkages with the United States. Faced with the largest decline in economic activity in postwar history due to the COVID-19 pandemic, European authorities have used fiscal support, accommodative monetary policy, and bank regulatory and supervisory measures to mitigate the effect of the pandemic on households and businesses. However, if a material worsening of the pandemic suppresses economic activity more than expected, continued regulatory forbearance and further expansionary policies may lead to concerns about debt sustainability in some countries. If debt sustainability were to markedly deteriorate in some of the highly indebted European sovereigns and corporates, stresses could materialize in debt markets and credit losses could be realized in certain European financial institutions. Stresses in Europe could, in turn, affect the U.S. economy and the financial system through a further deterioration in risk appetite and losses due to direct and indirect credit exposures.
In addition to the risks related to COVID-19, the possibility of a no-trade-deal Brexit continues to pose risks to the European and U.S. financial systems. Although the United Kingdom formally left the European Union (EU) in January, it remains under the EU's trade rules and financial regulations until the end of this year. The failure to reach a final trade agreement could lead to supply chain disruptions in Europe, aggravate negative effects of COVID-19 to the real economy, and increase losses at U.K. financial institutions. Accordingly, a no-trade-deal Brexit could lead to strains in global financial markets, resulting in a tightening of U.S. financial conditions.
. . . and adverse developments in emerging market economies with vulnerable financial systems could spill over to the United States
China entered the pandemic with elevated corporate and local government debt, high financial-sector leverage, and stretched real estate prices. After an acute downturn, real activity in China has rebounded more sharply than in other countries in part because China was able to contain the spread of the virus more quickly. Although policy continues to support the broader economy, authorities have continued to introduce measures to tamp down on speculation in real estate markets. A sudden price correction in domestic property markets, along with weakened global demand from abroad due to a resurgence of COVID-19, could put pressure on certain firms, particularly Chinese property developers, which are already highly indebted. This development, in turn, could substantially stress the vulnerable financial sector and local governments. This situation, along with heightened trade tensions, could further strain global financial markets and disrupt regional supply chains and exports to and from China. Moreover, a reduction in risk appetite, aggravated by other geopolitical risks, could negatively affect the United States, given the size of China's economy and financial system, and its extensive trade linkages with the rest of the world.
Widespread stresses in EMEs have abated somewhat, in no small part because of an improvement in global financial conditions, but faltering economic growth, both within EMEs and elsewhere, could lead to a reemergence of financial strains in EMEs, with nontrivial repercussions for the United States. In particular, EMEs with vulnerable financial systems could see another wave of capital outflows because of a drop in global risk appetite or an escalation of problems in their banking systems. Under these circumstances, authorities may find it difficult to curb the possible amplification of financial stresses because of limited fiscal capacity. For oil exporters, these dynamics could be exacerbated if oil prices fall precipitously because of weak demand or a marked increase in the supply of oil. Further dollar appreciation due to widespread stresses in EMEs could potentially put additional strains both on EME firms with currency mismatches and on U.S. firms that rely on exports and supply chains for their business operations. Some U.S. financial institutions may be directly affected by their exposures to these U.S. firms, in addition to the stressed EME firms and sovereigns themselves.
Salient Shocks to Financial Stability Cited in Market Outreach
As part of its market intelligence gathering for this report, the Federal Reserve staff solicited views from a wide range of contacts on risks to U.S. financial stability. From early September to mid-October, the staff surveyed 24 contacts at banks, investment firms, academic institutions, and political consultancies. As shown in the figure, respondents frequently cited concerns about U.S. political uncertainty as well as the risk of a COVID-19 resurgence generating renewed restrictions. Relatedly, a large share of respondents highlighted uncertainty surrounding the likelihood and efficacy of a policy response to economic weakness as well as concerns over the potential for increased insolvencies among nonfinancial corporates and small businesses.
U.S. political uncertainty
A significant share of respondents pointed to U.S. political uncertainty as a major source of risk. Many contacts highlighted the prospect that a contested presidential election or delayed election result could amplify investor uncertainty, and some pointed to increased market-implied volatilities covering the election as signaling a relatively high degree of uncertainty over the path of asset prices.
COVID-19 resurgence
Contacts were also focused on the risk that a large COVID-19 wave in the fall and winter could lead to new lockdown measures, inhibiting the recovery or causing another downturn. Several highlighted related concerns regarding the risk of delays, or failures, in developing and deploying a vaccine, and a few noted that market prices reflected excessive optimism in the timing of a vaccine and the ability to avoid new restrictions.
Policy fatigue or limits
A related concern was that recurring outbreaks would fail to galvanize a fiscal and monetary response as forceful or effective as during the initial outbreak. A number of contacts worried that a deepening political divide could delay timing or reduce the size of additional fiscal stimulus. Moreover, with policy rates near zero, several respondents identified risks surrounding the limits and efficacy of monetary policy stimulus in the event that the recovery stalls or reverses.
Increases in business defaults
Market participants noted the risk of sharply rising default rates among nonfinancial corporates and small businesses, especially if the pandemic is prolonged or containment measures are reinstated. Contacts referenced the elevated levels of leverage in the corporate sector and expressed concern regarding the long-run effects of the virus on business models and consumer behavior. Several respondents noted that rising defaults could weaken bank asset quality and underpin a sharp retrenchment in credit to businesses.
Most Cited Potential Shocks over Next 12–18 Months
Note: Responses are to the following question: "Over the next 12–18 months, which shocks, if realized, do you think would have the greatest negative effect on the functioning of the U.S. financial system?" SME is small and medium-sized enterprises. CRE is commercial real estate. CMBS is commercial mortgage-backed security. LIBOR is London interbank offered rate.
Source: Federal Reserve Bank of New York survey of 24 market contacts from early September to mid-October.
References
16. FX swaps are widely used by market participants to borrow dollars for fixed periods of time—for instance, to fund purchases of U.S. securities. In such a transaction, a participant exchanges foreign currency for U.S. dollars at the current exchange rate while contracting at the same time to reverse the transaction at a future date at an agreed-upon exchange rate (the "forward" rate). In effect, such an FX swap is a dollar loan collateralized with foreign currency. Return to text
17. For more information, see the box "Federal Reserve Tools to Lessen Strains in Global Dollar Funding Markets" in Board of Governors of the Federal Reserve System (2020), Financial Stability Report (Washington: Board of Governors, May), pp. 16–18, https://www.federalreserve.gov/publications/files/financial-stability-report-20200515.pdf. Return to text