Fed Releases Financial Stability Report

Earlier this month, the Federal Reserve (Fed) released its semi-annual Financial Stability Report, which provides an overview of the stability of the U.S. financial system while highlighting near-term risks that pose a threat to stability. Overall, the Fed found the financial sector to be relatively stable.

The Fed reviews four primary areas, including (1) asset valuations, (2) borrowing by businesses and households, (3) leverage in the financial sector, and (4) funding risk.

In regards to asset valuations, the Fed considers them to be slightly elevated as investors continue to invest in high-risk assets. In fact, equity prices relative to forecast earnings are higher than the median value over the past 30 years. Still, some pressures in asset valuation has eased a bit over the past six months.

The Fed also found that businesses are borrowing at historically high levels with the riskiest firms borrowing the most, suggesting that credit standards are deteriorating. This could mean that the business sector could be heavily impacted by a sudden economic downturn. Among households however, borrowing remains modest, and debt owed by subprime consumers has remained steady.

In the financial sector, the Fed finds the largest U.S. banks heavily capitalized, giving them more leeway when faced with an economic downturn. Insurance companies and hedge funds also appear to be safely leveraged.

In the last category the Fed analyzes, “funding risks in the financial system are low.” Liabilities that are vulnerable to panic are modest relative to the period before the Financial Crisis, and big banks are holding a healthy ratio of high-quality liquid assets to total assets. Again, this means that big banks should be able to accommodate a possible economic downturn.

Overall, the U.S. financial system appears to be safe and stable. The largest concern as of now is the growing debt by the riskiest U.S. firms.