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 April 2024 Financial Stability Report is as follows:

1. Asset valuations. Valuation pressures remained elevated. The ratio of equity prices to earnings moved up toward the high end of its historical range, and an estimate of the equity premium—the compensation for risk in equity markets—remained well below average. Spreads between yields on corporate bonds and those on comparable-maturity Treasury securities were low compared to their history. Liquidity across many financial markets remained low, contributing to volatility during periods of high uncertainty. In U.S. property markets, home prices rose further, and the ratio of house prices to rents was near the highest levels on record. Transaction-based price indexes (adjusted for inflation) for commercial real estate (CRE) properties were little changed, while rent growth slowed and vacancy rates rose (see Section 1, Asset Valuations).
2. Borrowing by businesses and households. Vulnerabilities from business and household debt remained moderate. Total debt of households and businesses as a fraction of gross domestic product (GDP) continued to trend down to a level that is very low relative to the past two decades. Household debt relative to GDP is especially subdued relative to recent history, and most household debt is owed by prime-rated borrowers who are well positioned to meet their payment obligations. That said, delinquency rates on credit cards and auto loans among borrowers with nonprime credit ratings are above pre-pandemic levels. Indicators of business leverage remained elevated relative to historical levels, and private credit arrangements have been growing rapidly. Nonetheless, measures of the ability of businesses to service their debt have been stable within typical ranges, in part reflecting robust corporate earnings (see Section 2, Borrowing by Businesses and Households).
3. Leverage in the financial sector. Vulnerabilities associated with financial leverage remained notable. The banking sector remained sound and resilient overall, and most banks continued to report capital levels well above regulatory requirements. Fair value losses on fixed-rate assets were still sizable for some banks and remained sensitive to changes in interest rates. Further, some banks, insurers, and securitization vehicles continued to have concentrated exposures to CRE. Indicators suggest that hedge fund leverage was at or near the highest level in the past decade. Broker-dealer leverage stayed near historical lows (see Section 3, Leverage in the Financial Sector).
4. Funding risks. Funding risks have decreased some but overall remained notable. Liquidity at most domestic banks remained sound. Many banks have significantly reduced the fraction of assets funded with uninsured deposits, but use of short-term wholesale funding and brokered and reciprocal deposits has increased. The U.S. Securities and Exchange Commission (SEC) implemented reforms that reduced structural vulnerabilities among institutional prime and tax-exempt funds. However, other types of money funds and alternatives to money funds with similar vulnerabilities have grown and 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 August through late October (discussed in the box "Survey of Salient Risks to Financial Stability"). In the fall survey, there were declines relative to spring in the share of respondents citing persistent inflation pressures and monetary tightening or generalized policy uncertainty as among the most notable risks to financial stability. At the same time, there were sizable increases in the share of respondents who noted among their top risks to financial stability fiscal debt sustainability, Middle East tensions, or a U.S. recession.