5. Near-Term Risks to the Financial System
The Federal Reserve routinely engages in discussions with domestic and international policymakers, academics, community groups, and others to gauge the set of risks of greatest concern to these groups. As noted in the box "Survey of Salient Risks to Financial Stability," in recent outreach, contacts were particularly focused on the risk of persistent inflationary pressures leading to a more restrictive monetary policy stance, the potential for large losses on CRE and residential real estate, the reemergence of banking-sector stress, and risks associated with market liquidity strains and volatility. Respondents were increasingly attentive to risks posed from economic weakness in China and high levels of public debt in the U.S. and other advanced economies. Heightened geopolitical tensions continue to pose important risks to global economic activity.
The following discussion considers possible interactions of existing domestic vulnerabilities with several potential near-term risks, including international risks. The box "Transmission of Stress Abroad to the U.S. Financial System," featured in the May 2023 Financial Stability Report, discusses some transmission channels through which shocks originating abroad can transmit back to the U.S. financial system.14
A significant slowdown in economic growth could pose risks to the financial system and precipitate strains in commercial real estate
If the economy were to slow unexpectedly, profits of nonfinancial businesses would decrease, and, given the generally high level of leverage in that sector, such decreases would likely lead to financial stress and defaults at some firms. Such dynamics may lead to job losses and strains on households, potentially leading to a mild recession. Investor risk appetite and asset prices might decline, and valuations in the office building sector appear particularly vulnerable given the ongoing uncertainty surrounding post-pandemic norms regarding return to work. A correction in office property valuations accompanied by even a mild recession could result in significant losses for a range of financial institutions with sizable exposures, including some regional and community banks and insurance companies. Lenders that experience large losses may reduce their willingness to supply credit to the broader economy, which would further weigh on economic activity. While stress tests suggest the largest banks are well positioned to withstand a severe recession and contraction in CRE markets, other financial institutions with concentrated exposures could be forced to retrench.
Persistent inflation in the U.S. and other advanced economies could pose risks to the global financial system
Energy prices have increased notably in recent months, leading to renewed cost pressures that businesses might pass on to their customers. Unexpected persistence in inflation from any source could prompt upward revisions to the path of policy rates. A sharp increase in rates could lead to heightened volatility in financial markets, stresses to market liquidity, and an adjustment in asset prices. In the U.S., higher rates and lower real incomes would strain the balance sheets of some households and businesses and, in conjunction with other adverse shocks, could lead to a significant economic slowdown. Collectively, these factors could lead to pronounced losses among financial intermediaries and a consequent reduction in the supply of credit. High interest rates in foreign economies, particularly if they persist, could negatively affect the debt servicing capacity of households, businesses, and governments abroad. This stress could spill over to the U.S. through strains in dollar funding markets, rapid rebalancing of portfolios, and diminished credit provisions by foreign lenders to U.S. entities.
A further slowdown in Chinese growth could worsen financial stresses in China and strain markets worldwide
In China, a further slowdown in economic growth could increase distress among borrowers and worsen financial stresses. Many Chinese firms are struggling to service very high debt burdens, especially in the property sector, and local governments are also facing increasing fiscal strains. Stresses originating from China could spill over to other emerging market economies (EMEs), particularly those that are dependent on trade with China or on credit provided by Chinese entities. The spillovers could result in significant capital outflows from EMEs, where generally heightened debt levels may make these economies more susceptible to external shocks. Given the size of its economy and financial system, financial stresses in China also could strain global markets more broadly through disruptions to economic activity, deterioration of risk sentiment, and possibly a sharp appreciation of the dollar, potentially affecting the U.S.
A worsening of global geopolitical tensions could lead to broad adverse spillovers to global markets
The attack on Israel, in conjunction with Russia's ongoing war against Ukraine, has ratcheted up geopolitical tensions. These tensions pose important risks to global economic activity, including the possibility of sustained disruptions to regional trade in food, energy, and other commodities. Escalation of these conflicts or a worsening in other geopolitical tensions could reduce economic activity and boost inflation worldwide, particularly in the event of prolonged disruptions to supply chains and interruptions in production. The global financial system could be affected by a pullback from risk-taking, declines in asset prices, and losses for exposed businesses and investors, including those in the U.S.
Box 5.1. Survey of Salient Risks to Financial Stability
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 August 10 to October 4, the staff surveyed 25 contacts, including professionals at broker-dealers, investment funds, research and advisory firms, and academics (figure A). Several risks that featured prominently in the survey conducted in the spring remained top-of-mind, including the risk of persistent inflationary pressures leading to a more restrictive monetary policy stance, the potential for large losses on CRE and residential real estate, and the reemergence of banking-sector stress (figure B). Contacts continued to express concern over potential market liquidity strains, with some highlighting risks stemming from rising long-term interest rates. Respondents were increasingly attentive to risks posed from economic weakness in China and high levels of public debt in advanced economies. Although geopolitical tensions from both the Russia–Ukraine war and U.S.–China relations featured prominently in the May 2023 report, these risks had slipped out of the top five cited concerns for the current survey, which closed before the attack on Israel. This discussion summarizes the most cited risks from this round of outreach.
Figure A. Fall 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 August to October.
Figure B. Spring 2023: Most cited potential risks over the next 12 to 18 months
Accessible Version | Return to text
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.
Persistent inflation and monetary tightening
Contacts continued to highlight the risk of persistent or reaccelerating inflationary pressures, particularly in the U.S. amid a more resilient economic outlook, that could lead to further monetary policy tightening and volatile market conditions. Some contacts worried that persistent elevated inflation might entrench expectations of higher inflation, which could lead to higher realized inflation and require an even more restrictive monetary policy stance that could either induce or exacerbate a recession.
Commercial real estate
Many contacts saw real estate as a potential trigger for systemic stress, most notably in the commercial sector, where concerns over higher interest rates, declining property prices, and structural shifts in demand for office space may prompt large realized losses. Survey respondents viewed small and regional domestic banks as particularly vulnerable due to their higher concentration of CRE exposures, which could lead to tighter bank lending conditions.
Reemergence of banking-sector stress
Although survey respondents noted the banking sector has stabilized since the period of acute stress earlier this year, many highlighted risks of renewed deposit outflows given that large portions of deposits remain uninsured. Many respondents continued to link risks of reemerging banking-sector stress to potential losses on CRE exposures, particularly among smaller and regional banks.
Market liquidity strains and volatility
Respondents expressed concern over strained liquidity conditions and intermediation capacity in sovereign bond markets during periods of market stress, which could exacerbate volatile trading conditions. Contacts noted these factors could weigh on investor sentiment and risky asset prices while also exposing vulnerabilities among highly levered NBFIs, which could be forced to liquidate assets, putting downward pressure on market prices, potentially tightening financial conditions.
Weakness in the Chinese economy and financial sector
Contacts frequently noted slowing growth in China and highlighted several risks that could emerge from continued economic weakness, including capital flight, which could contribute to a stronger U.S. dollar and put downward pressure on Chinese assets and other Asian financial markets. Respondents also cited that weak growth in China, alongside weakness in Europe, increased the likelihood of a global recession, despite economic resilience in the U.S. Increased foreign exchange market volatility and the implementation of capital controls were also cited as risks.
Fiscal debt sustainability
Respondents noted possible risks emanating from higher levels of public debt and wider fiscal deficits in advanced economies, particularly in the U.S., which could drive Treasury market volatility and strain Treasury market liquidity. Higher long-term interest rates and bond term premia were noted as possible effects of expected increases in sovereign bond issuance.
Box 5.2. An Approach to Assessing Climate-Related Financial Risks
The Federal Reserve's responsibilities with respect to climate change are narrow but important. These responsibilities are tightly linked to its role in promoting the safety and soundness of individual financial institutions as well as the stability of the financial system. Hence, the Federal Reserve, much like many financial market participants, is working to better understand the risks that climate change may pose to individual banking organizations and the financial system.
A key area of focus is identifying the appropriate data and tools needed to assess climate-related financial risks that could affect the goals mandated to the Federal Reserve by Congress. These efforts focus on the translation of physical and transition risks associated with climate change into financial risks. To do so, climate data need to be processed into a form that can be merged with financial data. In addition, exposures of financial institutions to those risks need to be assessed, which requires analyses of financial institution disclosures. To go beyond exposures of individual institutions, models or scenarios are used to evaluate the transfer of climate-related risks within the financial system and to assess the significance of climate-related risks to financial stability.
Because the effects of climate change are highly uncertain, geographically diffuse, and realized over time, it is important to scrutinize underlying assumptions, consider alternative estimation methodologies, and utilize a wide range of data. Accordingly, a focus of this work is on coordinating with domestic and international groups to develop models and to address data gaps in order to improve financial stability risk assessments.
Measurement of climate-related financial risks to individual financial institutions and to financial markets requires data and methodologies that may be new to financial institutions, market participants, and regulators. Because other regulators face similar challenges, the Federal Reserve is engaging both with Financial Stability Oversight Council members and with international groups, such as the Financial Stability Board, the Basel Committee on Banking Supervision, the Network of Central Banks and Supervisors for Greening the Financial System, and the International Monetary Fund.1
1. See, for example, Financial Stability Board (2021), FSB Roadmap for Addressing Climate-Related Financial Risks (Basel: FSB, July 7), https://www.fsb.org/wp-content/uploads/P070721-2.pdf. Return to text
References
14. See the box "Transmission of Stress Abroad to the U.S. Financial System" in Board of Governors of the Federal Reserve System (2023), Financial Stability Report (Washington: Board of Governors, May), pp. 63–65, https://www.federalreserve.gov/publications/files/financial-stability-report-20230508.pdf. Return to text