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 that the system supports a healthy economy for U.S. households, communities, and businesses.

In order to maintain a resilient financial system, 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 efforts 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 2023, 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; and
3. engaging in domestic and international cooperation and coordination.

Periodically, Federal Reserve Board staff assess potential vulnerabilities relevant for financial system stability. These monitoring efforts promote financial stability by informing broader policy discussions and stimulating additional research.

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 and designated financial market utilities is discussed in section 4, "Supervision and Regulation."

Monitoring Financial Vulnerabilities

This section describes the Federal Reserve's monitoring of vulnerabilities in the financial system during 2023.

Financial institutions are linked together through a complex set of relationships, and their resilience depends on the economic condition of households and businesses. In turn, the condition of households and businesses hinges on the strength of financial institutions' balance sheets, as the nonfinancial sector obtains funding through the financial sector. The Federal Reserve's measures to monitor risks to financial stability are designed to better understand these complex linkages and have been an important part of the Federal Reserve's efforts to achieve 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 households and businesses, 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).

Since 2018, the Federal Reserve Board has also published its Financial Stability Report, which 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.² 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 may be an indicator of a broader buildup in risk-taking. Because it is very difficult to judge whether an asset price is overvalued relative to fundamentals, the Federal Reserve's analysis of asset valuation pressures typically tracks a broad range of measures, including price volatility, underwriting standards, and investor flows.

The economy remained strong over the year, and the economic outlook centered on continued growth. Against this backdrop, valuation pressures across different sectors remained notable. Equity prices were still high relative to earnings (figure 3.2). In addition, real estate prices continued to be high relative to fundamentals. Spreads on corporate bonds and loans ended 2023 at levels below those seen over most of 2022 and 2023 and similar to the levels seen in the late 2010s (figure 3.3).

Valuation pressures in the residential real estate sector remained elevated by historical standards. Despite high borrowing costs and tightening of lending standards, various house price indexes showed increases over the year. 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 relative to fundamentals despite the continued decline in prices in most segments. Amid low transaction volumes, transaction-based prices may not fully reflect the deterioration in CRE markets, because rather than realizing losses, owners could decide not to put their properties on the market and instead choose to wait for more favorable conditions. Finally, farmland prices continued to increase, supported by high commodity prices and limited farmland inventories.

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.

A commonly used measure of the financial position of households and businesses is the ratio of the combined total debt of nonfinancial businesses and households relative to gross domestic product (GDP). Total debt declined over the year, even as nominal GDP continued to grow in 2023, leaving the credit-to-GDP ratio close to its lowest level in
20 years (figure 3.4). This development suggests that, in the aggregate, households and businesses do not appear to have borrowed excessively.

Separate examination of business and household borrowing yields some additional insights. 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. Net leverage—the ratio of debt less cash to assets—showed a similar trend. The ability of public firms to service their debt, as measured by the interest coverage ratio, 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 continued to be 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 declined slightly in 2023. The volume of downgrades exceeded the volume of upgrades, and default rates slightly increased. Nevertheless, both remained low by historical standards. Direct lending to nonfinancial businesses by private credit funds and other private investors grew rapidly. While risks associated with private credit from investor redemption and leverage appeared limited, the sector remains opaque, making it difficult to assess vulnerabilities.

In the household sector, household debt relative to GDP declined in 2023. 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 2023, credit card and auto delinquency rates increased slightly. This increase was likely due to the unwinding of pandemic support programs rather than a significant deterioration in lending standards, which remain conservative. Student loan delinquencies were held down by pandemic-related debt relief. Although the extended pandemic forbearance has ended, the new forgiveness plan of a 12-month "on ramp" to repayment and the new Saving on a Valuable Education plan could temper rising future delinquencies.

Leverage in the Financial System

The banking sector remained sound and resilient overall in 2023. Bank runs at Silicon Valley Bank (SVB) and other banks in March 2023 showed that the interaction of fair value losses on bank balance sheets and fragile funding structures could amplify a shock. The use of a systemic risk exception and the Bank Term Funding Program (BTFP) helped mitigate these vulnerabilities and stopped the contagion from bank runs at SVB in March 2023. Common equity tier 1 ratios—regulatory risk-based measures of bank capital adequacy—at the largest banks were near or above the top quartile of their range throughout the past decade (figure 3.5). Nonetheless, fair value losses on fixed-income assets remain sizable at some banks, and there is the potential for weakening loan performance associated with CRE lending to emerge at some lenders. The largest banks appear most resilient to these potential risks. Some smaller banks with less diversified portfolios may face greater challenges.

Outside the banking sector, leverage at large life insurance companies in 2023 remained near the middle of its historical range and well below its pandemic peak. 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 2023 stabilized at an elevated level as the Treasury cash-futures basis trade continued to grow, suggesting a risk of sudden deleveraging if volatility in Treasury markets increases unexpectedly.

Funding Risk

Overall, banks' liquidity positions remained ample based on the risk of their funding structures. High-quality liquid assets held by banks declined mildly in 2023, driven by reductions in holdings of central bank reserves and by decreases in the market values of securities as interest rates increased. Still, the levels of high-quality liquid assets remained high by historical standards (figure 3.6). The BTFP was created to mitigate funding vulnerabilities of banks amid the stresses of mid-March 2023 and ended on March 11, 2024. A measure of the exposure of banks to interest rate risk—calculated as the difference between the timing of cash flows arising from bank assets and liabilities—declined over the year but remained well above historical levels.

Outside the banking sector, assets under management (AUM) of money market funds (MMFs) continued to increase in 2023. 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 at a historically high level. Rule changes for MMFs by the Securities and Exchange Commission that went into effect in July 2023 represent reforms to address the structural weaknesses in this sector.

After modest outflows in 2023, 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.

Finally, stablecoin assets remained sizable at around $125 billion. Given their footprint in money market instruments, runs on stablecoins could amplify strains in short-term funding markets. Stablecoins are also used as cash substitutes in crypto trading, which can amplify the risk of disruptive spillovers from the crypto ecosystem to the traditional financial system. The lack of regulatory oversight for stablecoins adds to their vulnerabilities.

Domestic and International Cooperation and Coordination

The Federal Reserve cooperated and coordinated with both domestic and international institutions in 2023 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 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 the FSOC designates an institution 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 2023, the council had four areas of priority: (1) nonbank financial intermediation, (2) Treasury market resilience, (3) climate-related financial risk, and (4) digital assets.³

The council continued to assess vulnerabilities associated with nonbank financial institutions. The Hedge Fund Working Group (HFWG) has developed an interagency risk-monitoring system to assess the financial stability risks associated with hedge funds. The Nonbank Mortgage Servicing Task Force continued monitoring the financial stability risks posed by nonbank mortgage servicers.

The council supported 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 has informed the IAWG's assessment of how funds' leverage and liquidity risk-management practices affect the U.S. Treasury market.

The council's staff-level Climate-related Financial Risk Committee (CFRC) provided a forum for FSOC members to coordinate and build capacity to identify, measure, and assess climate-related financial stability risks. In July 2023, the CFRC issued a staff progress report providing an update on efforts to advance the recommendations included in the 2021 Report on Climate-Related Financial Risk.⁴

Following the publication of its Report on Digital Asset Financial Stability Risks and Regulation in 2022, the council's Digital Assets Working Group continued to discuss and analyze developments and risks in the crypto-asset ecosystem.⁵

In 2023, the council issued a new proposed analytical framework for financial stability risks and proposed updated interpretative guidance for designating nonbank financial companies for Federal Reserve supervision and enhanced prudential standards. After releasing the two documents for public comment on April 23, 2023, the council finalized the two documents on November 3, 2023, with approval from the Federal Reserve as a member.⁶ The new framework and guidance aim to improve the council's ability to address risks to financial stability and to provide greater public transparency.

The council's 2023 annual report reviewed significant financial market developments, described potential emerging threats to U.S. financial stability, identified vulnerabilities in the financial system, and made recommendations to mitigate them.⁷ The report included boxes on the following topics: global economic conditions, household finance, the spring 2023 turmoil and policy responses, Treasury market resilience during March 2023, successful implementation of alternative reference rates, speed of financial transactions and information transmission, and quantum computing.

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 2023, the FSB engaged in many issues related to global financial stability. Specific work included addressing structural vulnerabilities from liquidity mismatch in open-end funds, assessing the financial stability implications of multifunction crypto-asset intermediaries, and enhancing the resilience of nonbank financial intermediation.

Footnotes