Board of Governors of the Federal Reserve System

Overview

This report reviews conditions affecting the stability of the U.S. financial system by analyzing vulnerabilities related to valuation pressures, borrowing by businesses and households, financial-sector leverage, and funding risks. It also highlights several near-term risks that, if realized, could interact with these vulnerabilities.

Since the May 2022 Financial Stability Report was released, the economic outlook has weakened, and uncertainty about the outlook has remained elevated. Inflation remains unacceptably high in the United States and is also elevated in many other countries. Central banks around the world, including the Federal Reserve, have tightened monetary policy in response. A weaker outlook, higher interest rates, and elevated uncertainty have contributed to a substantial tightening in financial conditions. Economic, financial, and geopolitical risks also have risen across advanced and emerging market economies (EMEs), further contributing to asset price declines and periods of significant market volatility. These developments, and future shocks, have the potential to be amplified by vulnerabilities associated with asset valuations, borrowing by households and businesses, financial-sector leverage, and funding risks.

Against this backdrop, our view of the current level of vulnerabilities is as follows:

1. Asset valuations. Higher interest rates and a weaker outlook for the economy led prices of financial assets to fall amid heightened volatility, but real estate prices remained elevated. Measures of equity prices relative to expected earnings declined. Risk premiums in equity and corporate bond markets were near the middle of their historical distributions. In contrast, property markets still show elevated valuations. Although housing activity weakened and national average price increases slowed sharply year over year, home prices remained historically high relative to rents. Valuations of commercial real estate (CRE) were also elevated (see Section 1, Asset Valuations).
2. Borrowing by businesses and households. On balance, vulnerabilities arising from borrowing by nonfinancial businesses and households were little changed over the first half of 2022 and remained at moderate levels. Borrowing by businesses remained at high levels relative to gross domestic product (GDP) in the first half of 2022, but some measures of their ability to service that debt improved as the effects of rising interest rates were offset by higher business earnings. Household debt remained at modest levels relative to GDP, and most of that debt is owed by households with strong credit histories or considerable home equity. Nonetheless, borrowing costs continue to rise and inflation is reducing real incomes, a combination that may pose risks to the ability of some businesses and households to service their debts, especially in the event of further adverse shocks to income or inflation (see Section 2, Borrowing by Businesses and Households).
3. Leverage in the financial sector. Banks maintained risk-based capital ratios near their post-2010 averages, and broker-dealer leverage remained historically low. Leverage at life insurance companies declined to about the middle of its historical range. In contrast, hedge fund leverage likely remained somewhat above its historical average, though comprehensive data are available only with a lag. Bank lending to nonbank financial institutions (NBFIs), an indicator of NBFI leverage, reached new highs. More generally, monitoring some parts of the nonbank financial sector, where hidden pockets of leverage could amplify adverse shocks, could be enhanced with more comprehensive and timely data (see Section 3, Leverage in the Financial Sector).
4. Funding risks. Short-term funding markets continue to have structural vulnerabilities, as some markets and institutions remain vulnerable to large and unexpected withdrawals, especially considering the highly uncertain outlook. Funding risks at domestic banks are low, given their large holdings of liquid assets and limited reliance on short-term wholesale funding. Prime and tax-exempt money market funds (MMFs), as well as other cash-investment vehicles, remain vulnerable to runs. Many bond and bank-loan mutual funds continue to be susceptible to large redemptions, because they hold assets that can become illiquid amid stress. The market capitalization of stablecoins—which have a set of structural vulnerabilities, including weaknesses in regulatory oversight, opacity, and consumer protection issues—continued to decline after falling sharply earlier in the year. Central counterparties (CCPs) have maintained a high level of financial resources to cover potential credit exposures in case of default by one or more clearing members, and participants have continued to meet their margin calls to date (see Section 4, Funding Risks).

In addition, market liquidity—the ability to trade assets without a large effect on market prices—remained low in several key asset markets since the May report, as discussed in the box "Liquidity Conditions in Treasury and Other Core Financial Markets." Low liquidity amplifies the volatility of asset prices and may ultimately impair market functioning. It could also increase funding risks to financial intermediaries that rely on marketable securities as collateral. These potential amplification channels may interact with leverage in the financial system.

This report also discusses potential near-term risks based in part on the most frequently cited risks to U.S. financial stability as gathered from outreach to a wide range of researchers, academics, and market contacts (discussed in the box "Survey of Salient Risks to Financial Stability"). Contacts expressed increased concern about market functioning, including the possibility of disorderly markets and extreme volatility. In addition, persistently and unexpectedly high inflation, combined with further rate increases in the United States, could negatively affect domestic economic activity and financial conditions, which would affect the ability of businesses and households to service their debts and, as a result, the credit risk faced by financial intermediaries. As described in the box "International Risks and U.S. Financial Stability," consequences of Russia's invasion of Ukraine, stresses in China, the strength of the dollar, and other developments abroad could lead to adverse developments in some economies, which could affect U.S. financial stability. Moreover, shocks caused by cyber events, especially cyberattacks, could impair the U.S. financial system. If any of these near-term risks were realized, and especially should such events precipitate a marked worsening of the economic outlook, their effects could be amplified through the financial vulnerabilities identified in this report.

The report also contains additional boxes that analyze salient topics related to financial stability: " Climate Scenario Analysis: An Explainer" and "Digital Assets and Financial Stability."