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 than expected monetary policy stance, risks to the financial sector from increased policy uncertainty, and the potential effect of large losses on CRE and residential real estate. Risks associated with the reemergence of banking-sector stress and with fiscal debt sustainability in advanced economies also featured prominently.
The following discussion considers possible interactions of existing domestic vulnerabilities with several potential near-term risks, including international risks.
Higher-for-longer interest rates in the U.S. and other advanced economies could create strains in the global financial system
Interest rates may stay higher for longer than markets currently expect for a range of reasons. The neutral level of interest rates is uncertain. Inflation could persist for longer than expected, which could result in more restrictive monetary policy, heightened volatility in financial markets, and corrections in asset prices. In the U.S., higher-for-longer interest rates could strain the balance sheets and debt-servicing capacity of households and businesses, weakening the economic outlook. Financial intermediaries, including lenders with high exposures to CRE and consumer loans, could encounter greater losses as a result of higher interest rates, leading to a further tightening in financing conditions. In foreign economies, persistently high interest rates could challenge the debt-servicing capacity of households, businesses, and governments, including in emerging market economies (EMEs) that borrow externally. This stress could transmit to the U.S. through strains in dollar funding markets, rapid rebalancing of portfolios, and reduced credit from foreign lenders to U.S. borrowers.
A worsening of global geopolitical tensions could lead to broad adverse spillovers
Conflict in the Middle East and Russia's ongoing war against Ukraine pose risks to global economic activity, including the possibility of sustained disruptions to energy and commodity markets and global value chains. Further escalation of geopolitical tensions or policy uncertainty could reduce economic activity, boost inflation, and heighten volatility in financial markets. The global financial system could be affected by a pullback from risk-taking, declines in asset prices, and losses for exposed U.S. and foreign businesses and investors.
Weakness in economic activity could compound existing strains in real estate markets, both domestically and abroad, and could amplify risks to the global financial system
In the U.S., unexpectedly weak economic growth could lead to a reduction in investor risk appetite and additional strains in CRE, especially in the office building sector, where vulnerabilities have mounted in the post-pandemic period. A more pronounced correction in commercial property prices could result in significant losses for banks and nonbank investors with concentrated exposures to the sector. Such losses may reduce the willingness of financial intermediaries to supply credit to the economy, which would further weigh on economic activity.
Slower global growth and higher interest rates could also put pressure on real estate markets abroad. In China, residential real estate prices continue to fall, potentially putting further pressure on the highly indebted property sector. Stresses in China could spill over to other EMEs that rely on trade with China or credit from Chinese entities. Given the importance of EMEs, particularly China, to world trade and activity, such stresses could exacerbate adverse spillovers to global asset markets and economic activity, weighing on economic and financial conditions 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 late January to late March 2024, the staff surveyed 25 contacts, including professionals at broker-dealers, investment funds, research and advisory firms, and academics.
The risk of persistent inflationary pressures leading to a more restrictive than expected monetary policy stance remained the most frequently cited risk (figure A). While the share of survey participants mentioning policy uncertainty as a risk to the financial system increased notably, the share mentioning the potential for large CRE losses, the reemergence of banking-sector stress, concerns over fiscal debt sustainability, and market volatility remained high, albeit down relative to results reported in the previous survey (figure B). Other risks highlighted in the current survey include potential market liquidity strains in the U.S. Treasury market, with particular attention on the (cash-futures) basis trade, a correction in risky asset prices, and a potential cyberattack. This discussion summarizes the most cited risks from this round of outreach.
Figure A. Spring 2024: 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 January to March.
Figure B. Fall 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 August to October.
Persistent inflation and monetary tightening
Elevated inflation and the implications of tighter monetary policy remained the top-cited risk. Many of these respondents continued to note that a reacceleration of inflation could keep rates higher for longer than previously expected. However, several contacts cited the potential lagged effects of prior policy tightening as a key watchpoint and suggested that the FOMC may fall behind the curve in lowering rates or may not act quickly enough in the event of a sudden economic downturn.
Policy uncertainty
Respondents flagged policy uncertainty as a potentially significant source of shocks that could impact the financial sector. Contacts noted several areas of uncertainty including trade policy and other foreign policy issues possibly related to escalating geopolitical tensions. They also noted policy uncertainty associated with the U.S. elections in November.
Commercial real estate
Real estate market stress, particularly in CRE, was again frequently cited. Survey respondents continued to flag higher interest rates as a major headwind for the sector, with some noting that maturity walls over the next couple of years could pose refinancing risks, putting further downward pressure on prices and valuations. Respondents flagged that CRE exposures could negatively affect the banking system, with vulnerabilities particularly high for smaller and regional U.S. banks.
Banking-sector stress
Respondents continued to note the potential for banking-sector stress to reemerge. In addition to risks from CRE exposure, respondents cited the prospect that interest rates may stay higher for longer than previously expected as a catalyst for potential renewed deposit outflows. Despite being a frequently cited risk, some respondents continued to note that the U.S. banking system is well capitalized.
Fiscal debt sustainability
Concerns over fiscal debt sustainability among advanced economies were again cited as a top risk, with respondents noting particular concern regarding the U.S. Many respondents believed that deficits would remain wide and fiscal consolidation would remain unlikely.
Market liquidity strains and volatility
Respondents continued to highlight risks surrounding the potential for strained liquidity and elevated volatility across a range of financial markets. Disruptions in the Treasury market were top of mind, as well as a flight to safe-haven assets and general concerns over cyber threats.