Financial Stability Report December 2015 by OFR
In our first Financial Stability Report, the Office of Financial Research (OFR) highlights key potential threats to U.S. financial stability, evaluates policy steps taken or aimed at reducing those threats, describes actions to be taken to improve U.S. financial data, and reports on key findings from our research.
The OFR has a mandate under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to assess and monitor threats to financial stability by assessing vulnerabilities in the financial system and weighing them against its resilience. Chapter 2 places current threats to U.S. financial stability in the medium range, focusing on elevated and rising credit risks in the U.S. nonfinancial business sector, investors’ reach for yield in a climate of persistently low interest rates, and the uneven resilience of the financial system.
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The Office is charged with evaluating the effectiveness of tools designed to promote U.S. financial stability. Chapter 3 assesses progress in the development of these tools and potential unintended consequences of financial regulation and financial stability policies.
The Office also is mandated to improve the scope, quality, and accessibility of financial data for the benefit of the Financial Stability Oversight Council (FSOC) and the public. Chapter 4 discusses ways regulators can collectively better use financial data while minimizing burden on firms through up-front coordination on use of data standards, collaboration on data collections, and broader sharing of data with appropriate safeguards. The chapter also assesses the progress in improving financial data since the crisis, paying particular attention to data about securities financing transactions, derivatives, mortgage markets, insurance, and asset management activities.
In addition, the Office conducts research to improve our ability to monitor potential vulnerabilities in the financial system, assess causes and consequences of financial crises, and evaluate financial stability policy and risk management practices. Chapter 5 highlights key findings and ongoing research questions from several important OFR research initiatives or studies.
In the coming years, the Office will organize our efforts in data, financial research, and policy evaluation around core areas of concentration to promote coherence and coordination in such initiatives. Chapter 6 describes that organizational framework and the initiatives we will pursue in 2016.
Assessing and Monitoring Threats to Financial Stability
Overall threats to U.S. financial stability remain moderate — that is, in a medium range — similar to our assessment of six months and a year ago. But some have edged higher over the past year, as we discuss in Chapter 2. We discuss three major themes.
First and most important, credit risks are elevated and rising for U.S. nonfinancial businesses and many emerging markets. OFR’s past annual reports highlighted the rising credit risks in both U.S. corporates and emerging markets. In 2015, U.S. nonfinancial business debt continued to grow rapidly, fueled by highly accommodative credit and underwriting standards. The ratio of that debt to gross domestic product has moved above pre-crisis highs, and corporate leverage continues to rise. So far, distress in U.S. credit markets has been largely limited to the lowest-rated debt issuers and the energy and commodity industries. However, that distress may spread, because investors now appear to be reassessing the credit and liquidity risks in these markets. U.S. corporate bond spreads have risen from their narrow 2014 levels toward long-term averages, better compensating investors for some, but by no means all, of the increased credit risk.
The interplay of credit with other risks, such as macroeconomic risks, is also important. The combination of higher corporate leverage, slower global growth and inflation, a stronger dollar, and the plunge in commodity prices is pressuring corporate earnings and weakening the debt-service capacity of many U.S. and emerging market borrowers. A shock that significantly further impairs U.S. corporate or emerging market credit quality could potentially threaten U.S. financial stability.
Second, the low interest rate environment may persist for some time, with associated excesses that could pose financial stability risks. Although the Federal Reserve is widely expected to begin raising interest rates imminently, both Federal Reserve policymakers and market participants expect the pace of tightening to be very gradual, and long-term interest rates may remain suppressed for some time. The persistence of low rates contributes to excesses that could pose financial stability risks, including investor reach-for-yield behavior, tight risk premiums in U.S. bond markets, and, as noted, the high level and rapid growth of U.S. nonfinancial business debt.
Third, although the resilience of the financial system has improved significantly in the past five years, it is uneven. Since the financial crisis, regulatory reforms and changes in risk management practices have strengthened key institutions and markets critical to financial stability. Yet, existing vulnerabilities persist and some new ones have emerged. Financial activity and risks continue to migrate, challenging existing regulations and reporting requirements. Market liquidity appears to be episodically fragile in major U.S. financial markets, diminishing sharply under stress. Run and fire-sale risks persist in securities financing markets. Interconnections among financial firms are evolving in ways not fully understood, for example, in the growing use of central clearing.
Financial stability is now a widely shared policy objective. Policymakers have made significant progress on each of the critical elements of a proper monitoring system: the analytic framework and tools, systemwide data, qualitative information and intelligence, and reporting and governance.
The OFR and other U.S. and international agencies have developed monitoring and assessment frameworks with new tools, including the OFR’s Financial Stability Monitor. Qualitative intelligence gathering and information-sharing have been expanded through interagency and international forums, such as the FSOC and the international Financial Stability Board, as well as outreach to the financial industry and research communities.
However, substantial challenges to financial stability monitoring remain. The financial system is highly complex, dynamic, and interrelated, making it exceedingly challenging to monitor developments in every corner of the system and adequately assess the probability and magnitude of all important risks.