Board of Governors of the Federal Reserve System

Overview

This report reviews vulnerabilities affecting the stability of the U.S. financial system 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 October 2023 Financial Stability Report is as follows:

1. Asset valuations. Valuations rose further to levels that were high relative to fundamentals across major asset classes. Equity prices grew faster than expected earnings, pushing the forward price-to-earnings ratio to the upper end of its historical distribution. Corporate bond spreads narrowed and currently stand at levels that are low relative to their long-run averages. Residential property prices remained high relative to fundamentals and prices continued to rise in recent months. Prices of commercial real estate (CRE) declined amid weak demand for office properties (see Section 1, Asset Valuations).
2. Borrowing by businesses and households. The balance sheets of nonfinancial businesses and households remained solid, as the ratio of total private debt to gross domestic product (GDP) declined further, approaching its historical average. Although business debt remained high when measured relative to GDP (or to business assets for publicly traded corporations), business debt declined in real terms throughout last year. Firms' ability to service their debt remained robust owing to strong earnings and low borrowing costs on existing debt. 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. The banking sector remained sound and resilient overall, and most banks continued to report capital levels well above regulatory requirements. Nevertheless, fair value losses on fixed-rate assets remained sizable for some banks, and some banks with concentrated exposure to loans backed by commercial real estate properties experienced stress. Outside the banking sector, available data suggest that hedge fund leverage grew to historic highs, driven primarily by borrowing by the largest hedge funds. Leverage at life insurance companies remained around its median, while they continued to take on credit and liquidity risk. Broker-dealer leverage remained near historical lows (see Section 3, Leverage in the Financial Sector).
4. Funding risks. Liquidity at most domestic banks remained ample, with 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, declines in the fair value of assets, and elevated exposure to CRE. 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. In addition, life insurers continued to rely on a higher-than-average share of nontraditional 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 late January through the end of March (discussed in the box "Survey of Salient Risks to Financial Stability"). The risk of persistent inflationary pressures leading to a more restrictive than expected monetary policy stance remained the most frequently cited risk, mentioned by nearly three-fourths of survey participants. The share of survey participants mentioning policy uncertainty as a risk to the financial system stood at just under two-thirds, significantly higher than in the October report. Over half of all survey participants mentioned the potential effect of large realized losses on CRE and residential real estate, down from three-fourths of all participants in the previous survey. Rounding out the top five, risks associated with the reemergence of banking-sector stress and with fiscal debt sustainability in advanced economies continued to feature prominently.

In addition, the report also contains the box "The Bank Term Funding Program," which describes the role the program played in providing funding to the banking system beginning with its inception in response to the March 2023 banking-sector stresses up until it ceased extending new loans on March 11, 2024.