Board of Governors of the Federal Reserve System

As part of its market intelligence gathering, staff from the Federal Reserve Bank of New York solicited views from a wide range of contacts on risks to U.S. financial stability. From February to early April, the staff surveyed 25 contacts, including professionals at broker-dealers, investment funds, research and advisory organizations, and universities (figure A). The potential for persistent inflationary pressures to result in more restrictive monetary policy remained a top-cited risk, as it has been since the fall 2021 survey (figure B). Following the closure of SVB on March 10, a large majority of respondents highlighted the risk of additional banks coming under renewed stress. Many noted vulnerabilities in real estate markets, with some highlighting the potential for CRE exposures to trigger further banking sector concerns. Respondents also continued to focus on geopolitical risks, especially the possibility of heightened tensions between the U.S. and China and a further escalation of Russia's war in Ukraine. This discussion summarizes the most cited risks from this round of outreach.

Figure A. Spring 2023: Most cited potential risks over the next 12 to 18 months

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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?"

Source: Federal Reserve Bank of New York survey of 25 market contacts from February to April.

Figure B. Fall 2022: Most cited potential risks over the next 12 to 18 months

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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?"

Source: Federal Reserve Bank of New York survey of 26 market contacts from August to October.

Persistent inflation and monetary tightening

Concern over persistent inflationary pressures driving a highly restrictive monetary policy stance, particularly in the U.S., remained top of mind. Several contacts highlighted that labor and economic activity data remained robust despite the rapid rise in policy rates, suggesting global central banks may need to tighten further to fight inflation, risking a sharper economic slowdown and financial market instability. Some contacts noted that central bank balance sheet reductions in the U.S. and abroad could strain market functioning, particularly in sovereign bond markets.

Stress in the banking sector and nonbank financial institutions

Market participants highlighted the risk of stress in the banking sector, noting that higher funding costs and depressed profitability may render some banks vulnerable to deposit runs. Many respondents noted heightened market scrutiny over deposit stability and declines in fair value of legacy long-duration fixed-rate assets that could trigger further contagion and market volatility. Some contacts highlighted risks stemming from NBFIs in an environment of tightening monetary policy, such as that seen in the U.K. in September 2022.

Commercial real estate

Many contacts saw real estate as a possible trigger for systemic risk, particularly in the commercial sector, where respondents highlighted concerns over higher interest rates, valuations, and shifts in end-user demand. Some market participants associated risks in real estate with the emergence of banking-sector stress, noting some bank exposures to underperforming CRE assets could prompt instability.

Geopolitical risks

Many market participants cited a broad range of geopolitical risks, largely centered on the relationship between the U.S. and China. They noted rising tensions could cause a deterioration in trade and financial flows, with negative implications for global supply chains and investor sentiment. Some also cited the risk of military or political conflict between China and Taiwan, and any subsequent potential intervention by the U.S., as a possible flash point. Elsewhere, respondents highlighted the risk of an escalation of Russia's war in Ukraine as weighing on the economic outlook in Europe and driving higher commodity prices, with some noting that further escalation could increase risks of cyberwarfare.

Debt limit

Respondents saw the potential for funding market disruptions and tighter financial conditions if the statutory debt limit is not raised in a timely manner, while noting the adverse ramifications of a technical or outright default, including a sharp rise in Treasury yields, an increase in corporate financing costs, and a deterioration in risk sentiment. Relatedly, some contacts noted the risk of higher government financing costs in an environment where monetary policy remains in restrictive territory for a protracted period.

The U.S. financial system plays a central role in the global financial system, making it susceptible to spillovers from shocks abroad.¹ This discussion describes four important transmission channels: (1) U.S. dollar funding markets, (2) asset markets, (3) financial institution interconnectedness, and (4) the U.S. real economy.

As illustrated in figure A, shocks may generate stress for foreign financial markets, internationally active financial institutions, sovereigns, and international trade and commodity markets. This stress may be transmitted to the U.S. financial system through the four channels noted earlier, resulting in two types of spillovers: (1) disruptions to financial intermediation, which can reduce credit available to U.S. households and businesses; and (2) increased risks of default and insolvency due to losses on assets held by U.S. financial institutions. The strength of these spillovers largely depends on the extent of cross-border linkages and how existing vulnerabilities in the U.S. financial system interact with the foreign stress.

Figure A. Spillovers of foreign shocks to the U.S. financial system

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U.S. dollar funding market channel

The U.S. dollar is the leading currency for global funding and investment—accounting for almost half of outstanding cross-border bank credit and international debt securities—and is widely used for trade and other international transactions.² U.S. and foreign financial intermediaries engage in dollar-denominated borrowing, lending, and investment activities within a complex and interconnected network of markets involving a broad set of financial instruments.³ Disruptions in foreign institutions' ability to borrow U.S. dollars can transmit stress to the U.S. financial system in several ways, listed below.

Foreign institutions account for a significant share of borrowing in U.S. short-term wholesale funding markets, making up around half of all borrowing done through repos, and issue more than two-thirds of U.S. dollar-denominated commercial paper and negotiable certificates of deposit.⁴ Concerns about the solvency or liquidity of foreign borrowers can induce sudden outflows from U.S.-based wholesale lenders, such as prime MMFs, that may then be forced to cut short-term funding provided to a broader set of borrowers that would have been otherwise unaffected by the foreign stress.⁵ This could, in turn, reduce credit available for U.S. households and businesses.

Stress in U.S. dollar funding markets can also limit the ability of foreign banks to provide U.S. dollar-denominated credit to U.S. and foreign borrowers. Foreign banks supply around one-third of total bank credit to U.S. residents, especially to C&I borrowers, and most of the U.S. dollar-denominated lending to non-U.S. residents (figure B). U.S. branches and agencies of foreign banks tend to rely on short-term U.S. dollar wholesale funding, making their U.S. lending particularly sensitive to funding market disruptions.

Figure B. U.S. dollar-denominated bank claims on U.S. and non-U.S. residents as of 2022:Q3

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Note: The data exclude intragroup claims.

Source: Bank for International Settlements, consolidated and locational banking statistics; Federal Reserve Board staff estimates.

Foreign banks are also important counterparties in U.S. dollar-denominated FX swaps, which many foreign NBFIs rely on as a source of U.S. dollars. If foreign banks are unable to borrow U.S. dollars in FX swap markets, other foreign financial institutions that use FX swaps will have limited ability to invest in U.S. markets and to lend to U.S. households and businesses and could be forced to liquidate U.S. assets. U.S. dollar liquidity swap line arrangements between the Federal Reserve and foreign central banks have played a critical role in alleviating U.S. dollar funding stresses when liquidity in private markets, such as the FX swap market, has dried up.⁶

Asset market channel

Stress abroad can cause rapid declines in the prices of both foreign and U.S. assets. When losses on equities and on other risk assets are severe and broad based, investors may respond by rebalancing their portfolios to low-risk assets such as U.S. Treasury securities, potentially triggering a cycle of deteriorating prices for higher-risk assets, heightened volatility and reduced market liquidity, margin calls, and forced asset sales. Spillovers to U.S. institutions may be amplified if substantial leverage is supporting stretched asset valuations.

U.S. Treasury securities are a unique type of asset critical to the functioning of the global financial system. Foreign holdings of U.S. Treasury securities totaled about $7 trillion as of December 31, 2022, or about 30 percent of outstanding marketable U.S. Treasury securities, with holdings split nearly equally between the foreign official—mostly central banks and sovereign wealth funds—and foreign private sectors. At the onset of the COVID-19 pandemic, foreign investors sought to sell U.S. Treasury securities because of an unprecedented surge in the demand for cash—in sharp contrast to typical market dynamics in previous periods of severe global financial stress—amplifying pressures on U.S. Treasury markets that resulted in significant dislocations and strained market functioning.⁷ The FIMA (Foreign and International Monetary Authorities) Repo Facility broadens the reach of the Federal Reserve's provision of U.S. dollar liquidity overseas beyond its dollar swap lines. By reducing the incentive of foreign official investors to sell U.S. Treasury securities into stressed markets, the facility contributed to the stabilization of the U.S. Treasury market in the spring of 2020.⁸

Financial institution interconnectedness channel

Many U.S. financial institutions have client and counterparty relationships with foreign financial institutions, exposing them to losses from defaults and credit impairments on the one hand, and to loss of access to credit and important financial services on the other hand.⁹ Moreover, a loss of confidence in a group of large foreign financial institutions could spread to large U.S. financial institutions, resulting in higher funding costs and the risk of broad-based pullbacks by depositors and other funding providers. This type of "contagion" is most likely to spread to U.S. institutions that have exposures to distressed foreign institutions or are considered to have similar business models. Regulatory changes following the 2007–09 financial crisis have markedly increased U.S. banks' capital and liquidity positions, providing additional resilience to various types of losses and reducing the likelihood of contagion.

U.S. real economy channel

Global economic shocks can trigger recessions abroad as well as commodity and trade market disruptions, which tend to transmit quickly through the asset market channel, as discussed earlier.¹⁰ However, any effects on U.S. real economic activity—such as higher goods prices, unemployment, and reduced consumer demand and business investment—generally take longer to materialize and are unlikely to cause U.S. borrowers to default at a rate that would generate significant losses across the U.S. financial system.