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 November 2022 Financial Stability Report was released, Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank failed following substantial deposit outflows prompted by concerns over poor management of interest rate risk and liquidity risk. In March, to prevent broader spillovers in the banking system, the Federal Reserve, together with the Federal Deposit Insurance Corporation (FDIC) and the Department of the Treasury, took decisive actions to protect bank depositors and support the continued flow of credit to households and businesses. Owing to these actions and the resilience of the banking and financial sector, financial markets normalized, and deposit flows have stabilized since March, although some banks that experienced large deposit outflows continued to experience stress. These developments may weigh on credit conditions going forward.

A summary of the developments in the four broad categories of vulnerabilities since the last report is as follows:

1. Asset valuations. Yields on Treasury securities declined in March amid heightened financial market volatility. Measures of equity prices relative to expected earnings were volatile over the period but remained above their historical median, while risk premiums in corporate bond markets stayed near the middle of their historical distributions. Valuations in residential real estate remained elevated despite weakening activity. Similarly, commercial real estate (CRE) valuations remained near historically high levels, even as price declines have been widespread across CRE market segments (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 since the November report and remained at moderate levels. Business debt remained elevated relative to gross domestic product (GDP), and measures of leverage remained in the upper range of their historical distributions, although there are indications that business debt growth began to slow toward the end of last year. Measures of the ability of firms to service their debt stayed high. 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 (see Section 2, Borrowing by Businesses and Households).
3. Leverage in the financial sector. Concerns over heavy reliance on uninsured deposits, declining fair values of long-duration fixed-rate assets associated with higher interest rates, and poor risk management led market participants to reassess the strength of some banks (discussed in the box "The Bank Stresses since March 2023"). Overall, the banking sector remained resilient, with substantial loss-absorbing capacity. Broker-dealer leverage remained historically low. Leverage at life insurance companies edged up but stayed below its pandemic peak. Hedge fund leverage remained elevated, especially for large hedge funds (see Section 3, Leverage in the Financial Sector).
4. Funding risks. Substantial withdrawals of uninsured deposits contributed to the failures of SVB, Signature Bank, and First Republic Bank and led to increased funding strains for some other banks, primarily those that relied heavily on uninsured deposits and had substantial interest rate risk exposure. Policy interventions by the Federal Reserve and other agencies helped mitigate these strains and limit the potential for further stress (discussed in the box "The Federal Reserve's Actions to Protect Bank Depositors and Support the Flow of Credit to Households and Businesses"). Overall, domestic banks have ample liquidity and limited reliance on short-term wholesale funding. Structural vulnerabilities remained in short-term funding markets. Prime and tax-exempt money market funds (MMFs), as well as other cash-investment vehicles and stablecoins, remained vulnerable to runs. Certain types of bond and loan funds experienced outflows and remained susceptible to large redemptions, as they hold securities that can become illiquid during periods of stress. Life insurers continued to have elevated liquidity risks, as the share of risky and illiquid assets remained high (see Section 4, Funding Risks).

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 conducted from February to April (discussed in the box "Survey of Salient Risks to Financial Stability"). Frequently cited topics in this survey included persistent inflation and tighter monetary policy, banking-sector stress, commercial and residential real estate, and geopolitical tensions. The box "Transmission of Stress Abroad to the U.S. Financial System" describes how financial stresses abroad can spill over to the U.S. financial system.

Finally, the report contains additional boxes that analyze salient topics related to financial stability: " Update on the Transition to the Secured Overnight Financing Rate," " Financial Institutions' Exposure to Commercial Real Estate Debt," and "Financial Stability Risks from Private Credit Funds Appear Limited."