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 2022, which include the following:

1. Monitoring vulnerabilities that affect financial stability (see figure 3.1 for a summary of key vulnerabilities)
2. 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
3. Engaging in domestic and international cooperation and coordination

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 systemically important financial institutions, designated nonbank companies, and designated financial market utilities is discussed in section 4, "Supervision and Regulation."

Monitoring Financial Stability Vulnerabilities

This section describes the Federal Reserve's monitoring of vulnerabilities in the financial system during 2022.

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 how the level and configuration of those vulnerabilities affect the financial system's resilience to a wide range of potential adverse shocks.

Each quarter, Federal Reserve Board staff assess 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 semiannually.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 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. Accordingly, 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, unusually high or low price volatility, and investor flows.

Amid persistently high inflation in 2022 and a very tight labor market, monetary policy tightened and the economic outlook deteriorated. Against this backdrop, yields on long-term Treasury securities rose notably, which, along with diminished risk appetite, contributed to a decline in broad equity indexes and a widening of corporate credit spreads. The valuation measures tracked for most corporate financial assets declined toward their historical averages. In contrast, valuation pressures in real estate remained high.

More specifically, prices of long-term Treasury securities and leveraged loans declined over the year, increasing yields. Spreads of corporate bond yields over comparable-maturity Treasury yields widened in the first half of 2022 but slightly narrowed toward the end of the year, consistent with signs of returning risk appetite, particularly for speculative-grade corporate bonds (figure 3.2). Amid heightened uncertainty about the economic outlook, equity prices declined and the ratio of equity prices to expected earnings, a key indicator of equity valuations, declined to near its historical median (figure 3.3). Reflecting the considerable uncertainty in the markets, implied stock price volatility for the S&P 500 index, captured by the volatility index (VIX), continued to remain elevated throughout the year.

Rising borrowing costs and tightening of lending standards have put downward pressure on home values, with various house price indexes showing small price declines since last summer. Even so, valuation pressures in the residential real estate sector remained elevated by historical standards. The price-to-rent ratio remained at the upper end of its historical distribution, supported by a tight inventory of homes for sale.

Commercial real estate (CRE) prices remained high by historical standards. However, some signs pointed to easing of valuation pressures in the CRE sector. The growth rate in CRE prices slowed markedly across all sectors because of higher vacancy rates and borrowing costs. Tighter lending standards also contributed to downward pressure on commercial property prices. Finally, farmland prices continued to increase, supported by high and rising commodity prices.

Borrowing by Households and Businesses

Excessive borrowing by households and businesses has been an important contributor to past financial crises. When highly indebted households and nonfinancial businesses are hit by negative shocks to incomes or asset values, they may be forced to curtail spending, which could then 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.

The combined total debt of nonfinancial businesses and households grew roughly in line with nominal gross domestic product (GDP) in 2022, leaving the credit-to-GDP ratio essentially flat and close to its pre-pandemic level (figure 3.4).

Separating the credit-to-GDP ratio into its business and household components yields some additional insights. Business debt relative to GDP was little changed in 2022. The gross leverage of large businesses—the ratio of debt to assets for all publicly traded nonfinancial firms—declined slightly but remained elevated by historical standards. In contrast, net leverage—the ratio of debt less cash to assets—trended up over the year as businesses started to run down their cash reserves. The ability of public firms to service their debt, as measured by the interest coverage ratio, improved, on net, over the year and remained high by historical standards, in part reflecting solid earnings. The adverse effect of rising interest rates on the ability of businesses to service their debt was muted, as corporate bonds—which account for the majority of the debt of public firms—generally have fixed interest rates. Although businesses with floating-rate obligations experienced significant increases in interest expenses, earnings were sufficiently strong for most firms to handle these higher interest payments without stress.

Business credit quality remained solid in 2022. The volume of downgrades and defaults remained low in the first half of the year. In the second half, default rates edged up and speculative-grade corporate bond downgrades exceeded upgrades, but they remain low by historical standards.

In the household sector, household debt relative to GDP changed little in 2022. Mortgage debt accounts for roughly two-thirds of total household debt, with new mortgage extensions skewed toward prime borrowers in recent years. Most of the remaining one-third of household debt is consumer credit, which consists primarily of student loans, auto loans, and credit card debt. Although the strength of households' balance sheets held up through 2022, with still-large buffers of excess savings, credit card and auto delinquency rates for near-prime and subprime borrowers increased significantly. This increase is attributed to the unwinding of pandemic support programs rather than a deterioration in lending standards, which remain conservative. Student loan delinquencies were held down by the extension of the repayment holiday.

Leverage in the Financial System

During 2022, banks' common equity tier 1 ratio—a regulatory risk-based measure of bank capital adequacy—remained within the range that has prevailed since 2010, but it edged down outside the largest banks, in part because of stronger loan growth (figure 3.5). The level of tangible common equity—a measure of bank capital that excludes intangible items such as goodwill and reflects more mark-to-market losses—declined considerably over the year, driven by unrealized losses on securities in the available-for-sale (AFS) portfolio as a result of increases in interest rates.³ Overall, bank profitability continued to be healthy in 2022, driven by rising net interest margins and new originations. Strong profitability bolsters banks' resilience, as retained earnings are the most straightforward way for banks to boost their capital position. The credit quality of bank assets has remained strong despite higher rates and economic uncertainty. Although delinquencies on nonprime consumer loans increased significantly in 2022, they compose a small share of banks' loan portfolios.

Outside the banking sector, leverage at large life insurance companies decreased in 2022 to the middle of its historical distribution. However, life insurance companies continued to increase the share of assets allocated to risky instruments, which leaves their capital positions vulnerable to declines in the value of their investments. Based on a number of measures, leverage at hedge funds during 2022 stood above its historical average.

Funding Risk

High-quality liquid assets held by banks declined in 2022, as central bank reserves as well as Treasury and agency securities declined from their pandemic-era peaks as a fraction of total assets. Yet high-quality liquid assets remained high by historical standards (figure 3.6). Banks continued to maintain high levels of core deposits despite a decline in corporate operational deposits over the year. These deposit outflows resulted in only a slight increase toward the end of the year in banks' use of short-term wholesale funding, which still remained at historically low levels. A measure of the exposure of banks to interest rate risk—calculated as the difference between the effective time to maturity, or next contractual interest rate adjustment, for bank assets and liabilities—declined slightly in the second half of the year but remained near the top of its historical distribution.

Outside the banking sector, assets under management (AUM) of money market funds (MMFs) grew rapidly in 2022. Growth in prime MMFs likely reflects faster increases in their yields relative to the yields of other MMFs and deposit rates, as short-term interest rates have risen. Combined AUM in other cash-management vehicles—such as offshore prime MMFs, short-term investment funds, private liquidity funds, and ultrashort bond funds—continued to increase and remained high by historical standards. Given their susceptibility to runs and the significant role they play in short-term funding markets, MMFs and similar cash-management vehicles remain a prominent source of vulnerability.

Amid lower valuations in 2022, the total outstanding amount of corporate bonds held by mutual funds fell to its lowest level of the past decade. Bond mutual funds experienced net redemptions throughout the year, which they managed in an orderly manner. In November 2022, the Securities and Exchange Commission proposed to make swing pricing—a liquidity management tool available to bond mutual funds—mandatory.⁴ Swing pricing is intended to reduce investors' incentives to redeem from mutual funds in stress by reducing a fund's share price on days when it has outflows so that the costs arising from redemptions are imposed on redeeming investors.

Finally, stablecoins experienced significant volatility in 2022, including, in certain cases, runs. The turmoil was followed by strains throughout the digital assets ecosystem, highlighting vulnerabilities and interconnections in the space, but did not have notable effects on the traditional financial system, as interconnections remain limited. Should stablecoins grow or be widely used for payments, risks to financial and payment systems could grow.

Domestic and International Cooperation and Coordination

The Federal Reserve cooperated and coordinated with both domestic and international institutions in 2022 to promote financial stability.

Financial Stability Oversight Council Activities

As mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the FSOC was created in 2010. The FSOC is chaired by the Secretary of the Treasury and includes the Chair of the Board of Governors of the Federal Reserve System as a member. 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, analyzing the implications of those risks for financial stability, and identifying 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.

The FSOC continued to serve as a central venue for member agencies to collaborate as well as discuss and assess financial stability risks. In 2022, the council had four areas of priority: (1) nonbank financial intermediation, (2) Treasury market resilience, (3) climate-related financial risk, and (4) digital assets.

The council continued to assess vulnerabilities associated with nonbank financial institutions. In February 2022, the council issued a statement expressing support for continued efforts to monitor and address vulnerabilities stemming from nonbank financial institutions, focusing on hedge funds, open-end mutual funds, and MMFs.⁵ The Hedge Fund Working Group (HFWG) developed an interagency risk-monitoring system to assess the financial stability risks associated with hedge funds. In addition, in June 2022, the council restarted the Nonbank Mortgage Servicing Task Force meetings.

The council supports the work of the U.S. Treasury and the Inter-Agency Working Group on Treasury Market Surveillance (IAWG), of which the Federal Reserve is a member, to strengthen the resilience of U.S. Treasury markets. The work of the council's HFWG and Open-end Fund Working Group is informing the IAWG's assessment of how funds' leverage and liquidity risk-management practices affect the U.S. Treasury market.

Following the publication of its Report on Climate-Related Financial Risk in 2021, the council stood up its staff-level Climate-related Financial Risk Committee (CFRC) as well as an external advisory committee, the Climate-related Financial Risk Advisory Committee, which was established in October 2022.⁶ The CFRC provides a forum for FSOC members to coordinate and build capacity to identify, measure, and assess climate-related financial stability risks. Board staff are active participants in each of the CFRC's working groups.

In October 2022, the council released its Report on Digital Asset Financial Stability Risks and Regulation.⁷ The report identifies the financial stability risks posed by the digital assets ecosystem as well as gaps in the regulatory system that should be addressed to manage these risks. Moreover, the report encourages council members to continue to build capacity to analyze, monitor, supervise, and regulate crypto-asset activities.

The council's 2022 annual report reviews significant financial market developments, describes potential emerging threats to U.S. financial stability, identifies vulnerabilities in the financial system, and makes recommendations to mitigate them.⁸ The report includes boxes on the following topics: stress in global markets; the rapid rise of mortgage rates; the effect of interest rate risk on banks, insurance companies, and pension funds; the protection gap and insurance; recent developments in commodities markets; cyber-risk data collection; and the use of artificial intelligence in financial services.

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 international financial stability by coordinating with national financial authorities and international standard-setting bodies on information exchanges and work focused on developing strong global financial-sector policies.

In 2022, the FSB engaged in many issues related to global financial stability. Specific work included assessing liquidity mismatch in open-ended funds; evaluating financial stability risks of digital assets and decentralized finance and developing high-level policy recommendations to address them; researching the availability and use of climate vulnerabilities data; and assessing financial stability risk of—and the implications of changes in—commodities markets.

Footnotes