The Federal Reserve said that while inflation continues, market participants and observers believe that higher-than-expected interest rates pose the greatest threat to financial stability.
The central bank wrote in its semi-annual financial stability report released on Friday that “the risk most cited by market participants is that continued inflationary pressure may cause monetary policy positions to be more restrictive than expected.”
The report includes research on financial market contacts and the central bank's assessment of risks in four main areas, including asset valuation, corporate and household borrowing, financial sector leverage, and financing risk.
The Federal Reserve wrote in its report that since the last financial stability report was released in October, the banking industry has been performing steadily. Most banks continue to report capital levels far higher than regulatory requirements, but the Federal Reserve mentioned that current data indicates that hedge fund leverage has risen to an all-time high, mainly due to the borrowing of the largest few hedge funds.
US regulators have been sounding the alarm on leverage issues relating to hedge funds. In February, US Securities and Exchange Commission Chairman Gary Gensler said he was concerned about areas where banking and non-banking intersect.
A survey of Federal Reserve contacts at the beginning of the year showed that the threat posed by commercial real estate loan losses was lower than last year.
The Federal Reserve said in its report that the balance sheets of businesses and households remain healthy, but cautioned against households with low credit scores.
The Federal Reserve said homeowners have a solid net worth buffer, and many households continue to benefit from lower interest rates associated with refinancing or buying a home a few years ago. “However, the financial situation of some borrowers is still strained, and auto loan and credit card default rates for non-quality borrowers are rising.”
The Federal Reserve said that some smaller banks are still under pressure to lose fixed-rate assets. The Federal Reserve and other financial regulators worked last year to resolve the collapse of several regional banks, including the Bank of Silicon Valley.
The Federal Reserve emphasized some vulnerabilities in the financing market, particularly small and medium-sized banks and some money market mutual funds, and indicated that the liquidity of the US Treasury bond market is at the low end of the historical range.
According to the report, “the US Treasury bond spot market situation seems to be facing challenges and may amplify the impact.”
Policymakers have indicated that they will soon slow down the pace of downsizing, a move that will help ensure sufficient liquidity in financial markets.
Areas of risk
The report focuses on risk in four areas.
Asset valuation: The valuation rose to a level close to an all-time high, which is higher than fundamentals. Residential real estate prices also continued to rise and surpassed fundamental levels. Commercial real estate prices fell due to weak demand for office space.
Business and household borrowing: The balance sheets of businesses and households remain strong. Corporate debt declined last year but is still high. The size of household debt is moderate.
Financial sector leverage ratio: The banking system remains stable and resilient, and banks report capital levels higher than regulatory requirements. Some banks have suffered significant losses in their fixed-rate assets, and some banks with commercial real estate risk exposure are under pressure.
Financing risk: Most banks in the US are still fully liquid. Some banks believe that some short-term financing markets are still tight on capital and structurally weak. Tax-free money market funds remain vulnerable to crowding out.