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.

A summary of the developments in the four broad categories of vulnerabilities since the May 2023 Financial Stability Report is as follows:

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

1. Asset valuations. Equity prices grew faster than expected earnings, pushing the forward price-to-earnings ratio into the upper ranges of its historical distribution. Risk premiums in corporate bond markets narrowed somewhat and remained near the middle of their historical distributions. Prices of residential and commercial properties remained high relative to fundamentals (see Section 1, Asset Valuations).
2. Borrowing by businesses and households. Balance sheets of many nonfinancial businesses and households remained solid. Growth of business debt continued to decline through the first half of the year, although business debt remained high when measured relative to gross domestic product (GDP) or business assets. Measures of the ability of firms to service their debt remained strong. Household debt remained at modest levels relative to GDP, with most of that debt 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. The banking sector remains sound and resilient overall, and most banks continued to report capital levels well above regulatory requirements. That said, the increase in interest rates over the past two years has contributed to declines in the fair value of longer-maturity, fixed-rate assets that, for some banks, were sizable. Outside the banking sector, available data suggest that hedge fund leverage remained somewhat elevated, especially for the largest hedge funds. Leverage at life insurance companies remained near the middle of its historical range, while broker-dealer leverage remained historically low (see Section 3, Leverage in the Financial Sector).
4. Funding risks. Most domestic banks have ample liquidity and limited reliance on short-term wholesale funding; nevertheless, some banks continued to face funding strains, likely owing to vulnerabilities associated with high levels of uninsured deposits and declines in the fair value of assets. The Bank Term Funding Program (BTFP) helped mitigate these strains. Structural vulnerabilities remained in other 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. Bond and loan funds that hold assets that can become illiquid during periods of stress remained susceptible to large redemptions. Life insurers continued to rely on a higher-than-average share of runnable liabilities (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 August through early October (discussed in the box "Survey of Salient Risks to Financial Stability"). The two most frequently cited topics in this survey—the risk of persistent inflationary pressures leading to a more restrictive monetary policy stance and the potential for large losses on commercial real estate (CRE) and residential real estate—were mentioned by three-fourths of all survey participants, up from one-half of all participants in the previous survey. Risks associated with the reemergence of banking-sector stress and risks associated with market liquidity strains and volatility continued to feature prominently. Additionally, in the most recent survey, respondents were increasingly attentive to risks posed from economic weakness in China as well as from fiscal debt sustainability in advanced economies. Note that data and survey results for this report closed on October 4, 2023 and do not reflect the escalation of geopolitical tensions following the attack on Israel.

In addition, the Federal Reserve is working to understand the risks that climate change may pose to individual banking organizations and the financial system. The box "An Approach to Assessing Climate-Related Financial Risks" contains information on some steps the Federal Reserve has taken to collect data to better understand climate-related risks to financial institutions and financial markets.