The Fed Voices Concern over Rising Corporate Debt

The Federal Reserve (Fed) issued its first-ever Financial Stability Report where it praised the financial sector for being strongly capitalized while voicing concern over the historically high level of corporate debt.

In the report, the Fed analyzed four categories:

(1) elevated valuation pressures,

(2) excessive borrowing by businesses and households,

(3) excessive leverage within the financial sector, and

(4) funding risks.

The study found that the largest U.S. banks are strongly capitalized and have sufficient liquidity, creating a solid foundation for the nation’s financial sector. At the same time, corporate debt relative to U.S. gross domestic product (GDP) “is historically high, and there are signs of deteriorating credit standards.” For instance, business debt has been “growing fastest at firms with weaker earnings and higher leverage.”

According to the report, the average annual growth in U.S. nominal GDP was 4.2 percent from 1997 to 2018. During that time, total business credit increased by 5.7 percent, and leveraged business loans (this only includes leveraged loans to nonfinancial businesses) have increased by 15.1 percent.

“An analysis of detailed balance sheet information of these firms indicates that, over the past year, firms with high leverage, high interest expense ratios, and low earnings and cash holdings have been increasing their debt loads the most,” said the Fed. “High leverage has historically been linked to elevated financial distress and retrenchment by businesses in economic downturns.”

In addition to the problem of high-corporate debt levels, the Fed also argues that Brexit, international trade tensions, and internal instability that may arise in emerging markets like China could pose near-term risks to the financial system as well.