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OFR Analysis Of Threats To Financial Stability : Pockets of vulnerability

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Analysis Of Threats To The Financial Stability Of The United States by OFR

This chapter presents the OFR’s assessment of threats to the financial stability of the United States, discusses our framework for monitoring risk and resilience in the financial system, and highlights the tools the Office is developing and refining to achieve this core part of our mission.

The three chief threats are the: (1) impact of persistently low interest rates, (2) increasing debt and declining credit quality in U.S. corporations and emerging markets overseas, and (3) areas of weakness in the system that remain despite financial reforms and better risk management by financial companies.

Threats to Financial Stability

Threats to U.S. financial stability have edged higher since our annual report last year, but remain in the medium, or moderate, range. That assessment has not changed since we published our 2015 Financial Stability Report last month and the Federal Reserve’s subsequent incremental increase in short-term interest rates does not alter that assessment.

We continue to base our assessment on our Financial Stability Monitor, observation of the financial system, and analysis of key data and specific vulnerabilities.

Before and after the Federal Reserve raised short-term policy rates from the near-zero levels prevailing since 2008, the Fed clearly communicated its expectations: Economic conditions would evolve in a way warranting only gradual increases in the federal funds rate and short-term interest rates would probably remain below historical averages for some time. Consequently, the initial market reaction to the rate increase was orderly. We expect that such a gradual pace of future increases, as well as other factors holding down long-term rates, will keep long-term interest rates at historically low levels for some time.

Those circumstances will probably sustain incentives for investors to take more risks for higher yields on their investments. We believe that this continued “reaching for yield” behavior – combined with vulnerabilities from heavy debt loads and eroding credit quality in emerging markets and among non-financial U.S. businesses, as well as pockets of uneven resilience in the financial system – will increase the vulnerability of the U.S. financial system to shocks.

The interplay among these three themes merits further discussion:

1). Long-term impact of low interest rates – Although some interest rates have recently moved higher, given the context just described, we expect the incentives for risk-taking from historically low interest rates to endure for some time.

Persistently low rates will continue to prompt investors to take higher risks to increase their returns on investment and may encourage excessive borrowing.

The section on “Other Selected Risks” later in this chapter explores this theme in more detail.

2). Rising debt and ebbing credit quality in non-financial U.S. businesses and emerging markets – We have been warning for some time, including in our 2014 Annual Report, of growing threats to financial stability from rising debt and deteriorating credit quality in U.S. corporations and emerging markets overseas. The ratio of the debt of nonfinancial businesses in the United States to gross domestic product is historically high and companies’ leverage (the ratio of debt to earnings) continues to rise. The hunt for yield and current historically low default rates are promoting easy credit and heavy borrowing.

Today’s low default rates seem unlikely to persist. Stress in energy and commodity industries from declining prices could spread as investors reassess their risks.

Global economic risks are a broader concern. Global growth has slowed and the strong dollar is dampening U.S. exports by making U.S. goods more expensive for foreign buyers. The dollar’s rise has also pushed down the prices of dollar-denominated commodities. In many emerging markets, such as markets in China, Russia, Latin American nations, and parts of Asia and Eastern Europe, debt levels in the private sector have reached historic highs after years of heavy borrowing. These concerns are most pronounced for economies that produce energy and other commodities and economies most exposed to the slowdown in global growth.

A shock that erodes perceptions about credit quality in U.S. corporations or emerging markets could pose a threat to financial stability.

3). Pockets of vulnerability – Reforms and companies’ improvements in managing their risks after the financial crisis have strengthened key parts of the financial system. For example, these changes resulted in higher capital for banks and enhanced transparency for derivatives markets.

Despite the improvement in overall resilience, pockets of vulnerability remain:

  • New regulations and other factors have spurred the migration of some financial activities and their related risks to areas that may be less transparent and less resilient.
  • Rapid, sharp declines in market liquidity – exhibited during events from the “flash crash” of May 2010 to episodes in 2015 – have amplified market shocks. If larger shocks hit, a decline in liquidity could disrupt market functioning and could pose a threat to financial stability. (Ample market liquidity allows large volumes of assets to be traded or exchanged for cash quickly without substantially affecting price.)
  • Risks that short-term, wholesale funding could be vulnerable to the kind of runs and fire sales that marked the financial crisis continue to exist despite regulatory reforms that forced banks to reduce their reliance on this type of funding used to finance their operations and investments.
  • Interconnections among financial companies are evolving and the ramifications are not yet known. These connections can serve as channels for the propagation of shocks through the financial system.

These three themes and other risks are discussed later in this chapter.

Monitoring Tools

Monitors are tools for tracking risks in key parts of the financial system. The OFR currently produces two monitors and has several more in development.

In fiscal year (FY) 2016, the OFR will launch a monitors program to organize and plan the further development and implementation of this suite of monitors (see Chapter 3).

The two monitors in production are the Financial Stability Monitor, a graphic heat map and related material that give a snapshot of vulnerabilities in the financial system, and the Financial Markets Monitor, a periodic publication that gives the interpretation of the OFR research staff of developments in financial markets.

Other OFR monitors in development are the Money Market Fund Monitor, the Credit Default Swaps Monitor, the Hedge Fund Monitor, and the Correlation Monitor, as shown in more detail in Figure 1.

Financial Stability

Financial Stability

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