Federal Reserve Financial Stability Report Warns on Worsening Liquidity Risks

The Federal Reserve released its twice–yearly report on financial hazards in its 2022 financial stability report warning the recent deterioration in liquidity has not been as extreme as in some past episodes but the risk of a sudden significant deterioration appears higher than normal. They also noted commodities have been subject to notable dysfunction.

Federal Reserve 2022 financial stability report Highlights

“According to some measures, market liquidity has declined since late 2021 in the markets for recently-issued U.S. cash Treasury securities and for equity index futures,” the U.S. central bank said in its Financial Stability Report.

“While the recent deterioration in liquidity has not been as extreme as in some past episodes, the risk of a sudden significant deterioration appears higher than normal,” the report said. “In addition, since the Russian invasion of Ukraine, liquidity has been somewhat strained at times in oil futures markets, while markets for some other affected commodities have been subject to notable dysfunction.”

In a statement accompanying the release of the report, Fed Governor Lael Brainard said the war “has sparked large price movements and margin calls in commodities market and highlighted a potential channel through which large financial institutions could be exposed to contagion.”

“From a financial stability perspective, since most participants access commodities futures markets through a large bank or broker-dealer that is a member of the relevant clearing house, these clearing members are exposed to risk when clients face unusually elevated margin calls,” Brainard said. “The Federal Reserve is working with domestic and international regulators to better understand the exposures of commodity market participants and their linkages with the core financial system.”

Overview

This report reviews conditions affecting the stability of the U.S. financial system by analyzing
vulnerabilities related to valuation pressures, borrowing by businesses and households, financial
leverage, and funding risk. It also highlights several near-term risks that, if realized, could interact
with these vulnerabilities.

Since the November 2021 Financial Stability Report, uncertainty about the economic outlook has
increased. The Russian invasion of Ukraine has caused tremendous human and economic hardship, and the implications for the U.S. and global economies are highly uncertain. In the near
term, the invasion and related events are likely to create additional upward pressure on inflation
and weigh on economic activity. After deteriorating early in the period because of the emergence
and spread of the highly contagious Omicron variant, the pandemic outlook has improved but
remains uncertain. Finally, inflation has been higher and more persistent than expected, even
before the invasion of Ukraine, and uncertainty over the inflation outlook poses risks to financial
conditions and economic activity.

Against this backdrop, financial markets experienced high volatility and some strains on market
liquidity. On net, over the period, Treasury yields increased markedly, broad equity prices declined
notably, and credit spreads widened considerably in corporate bond markets. While business and
household debt increased last year and likely has continued to do so this year, the ratio of credit
to gross domestic product (GDP) continued to fall and is approaching pre-pandemic levels. Credit
quality remained robust. Banks remained well capitalized, but some money market and bond funds
are still exposed to sizable liquidity risks. A few signs of funding pressures emerged amid the
escalation of geopolitical tensions. However, broad funding markets proved resilient, and spillovers
have been limited to date.

  1. Asset valuations. Heightened uncertainty about the economic outlook led to notable
    fluctuations in financial markets. Since the previous report, broad equity prices declined
    notably, and spreads in corporate bond markets widened considerably. Prices of risky financial
    assets remained generally high compared with corresponding expected cash flows. Since
    November, house prices rose at a rapid rate and continued to outstrip increases in rents. Asset
    prices remain vulnerable to declines in response to negative shocks (see Section 1, Asset
    Valuations).
  2. Borrowing by businesses and households. Key indicators of vulnerabilities arising from
    business and household debt—including debt-to-GDP ratios, gross leverage, and interest
    coverage ratios—continued to improve and have largely recovered from the economic stresses
    of the COVID-19 recession. Nonetheless, rising inflation, supply chain disruptions, and ongoing
    geopolitical events might pose risks to the ability of some businesses and households to
    service their debts (see Section 2, Borrowing by Businesses and Households).
  3. Leverage in the financial sector. Banks maintained risk-based capital ratios well above
    regulatory minimums. Leverage at broker-dealers stayed low, while leverage at life insurance
    companies and hedge funds remained high by historical standards. Issuance of non-agency
    asset-backed securities recovered from the low levels of the pandemic (see Section 3,
    Leverage in the Financial Sector).
  4. Funding risks. Funding risks at domestic banks remained low as a result of large holdings of
    liquid assets and a limited reliance on short-term wholesale funding. However, some types of
    money market funds (MMFs) and stablecoins remain prone to runs, and many bond and bank
    loan mutual funds continue to be vulnerable to redemption risks. Elevated market volatility
    associated with the Russian invasion of Ukraine has led to increased margin calls by central
    counterparties (CCPs), which in turn increased the demand for liquidity from a range of market
    participants (see Section 4, Funding Risks)

This report also details how near-term risks have changed since the November 2021 report 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 (discussed in the box “Survey of
Salient Risks to Financial Stability”). Stresses in Europe related to the Russian invasion of Ukraine or in emerging markets—such as those that could arise from China or be driven by inflationary
pressures—could spill over to the United States. In addition, elevated inflation and rising rates in
the United States could negatively affect domestic economic activity, asset prices, credit quality,
and financial conditions more generally. As concerns over cyber risk have increased, U.S. government agencies and their private-sector partners have been stepping up their efforts to protect the
financial system and other critical infrastructures. If any of these near-term risks were realized,
and especially should such events precipitate a marked worsening of the economic outlook, their
effects could be amplified through the financial vulnerabilities identified in this report.

Source: Federal Reserve Financial Stability Report

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