Financial Stability is Questionable, Federal Reserve Gives Overview

The coronavirus (COVID-19) pandemic has caused tremendous human and economic hard-ship across the United States and around the world. The pandemic and the measures taken to contain it have effectively closed some sectors of the economy since mid-March. Economic activity in the United States has contracted at an unprecedented pace, and the unemployment rate surged to 14 .7 percent in April .

The disruptions to economic activity here and abroad have significantly affected financial conditions and have impaired the flow of credit. Policymakers in the United States and worldwide have taken extraordinary measures to strengthen the recovery once the health crisis passes. The Federal Reserve quickly lowered its policy rate to close to zero to support economic activity and took extraordinary measures to stabilize markets and bolster the flow of credit to households, businesses, and communities. In addition, the U.S. Congress and Administration rapidly enacted fiscal measures to support households and businesses. Taken together, these steps contributed to improved conditions that should boost the economic recovery when social distancing and other public health measures are able to subside.

Against this backdrop, this Financial Stability Report reviews the effect of the economic and market shocks associated with COVID-19 on U.S. financial stability to date and discusses the Federal Reserve’s response. While the financial regulatory reforms adopted since 2008 have substantially increased the resilience of the financial sector, the financial system nonetheless amplified the shock, and financial sector vulnerabilities are likely to be significant in the near term. The strains on household and business balance sheets from the economic and financial shocks since March will likely create fragilities that last for some time. Financial institutions—including the banking sector, which had large capital and liquidity buffers before the shock—may experience strains as a result.

Our view on the current level of vulnerabilities is as follows:

1. Asset valuations. Asset prices have been volatile across many markets. Since their lows in late March and early April, risky asset prices have risen and spreads have narrowed in key markets. Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse, or financial system strains reemerge.
2. Borrowing by businesses and households. Debt owed by businesses had been historically high relative to gross domestic product (GDP) through the beginning of 2020, with the most rapid increases concentrated among the riskiest firms amid weak credit standards. The general decline in revenues associated with the severe reduction in economic activity has weakened the ability of businesses to repay these (and other) obligations. Partly as a result, there has been a widespread repricing of credit risk, and the issuance of high-yield corporate bonds and the origination of leveraged loans appear to have slowed appreciably . While household debt was at a moderate level relative to income before the shock, a deterioration in the ability of some households to repay obligations may result in material losses to lenders.
3. Leverage in the financial sector. Before the pandemic, the largest U.S. banks were strongly capitalized, and leverage at broker-dealers was low; by contrast, measures of leverage at life insurance companies and hedge funds were at the higher ends of their ranges over the past decade. To date, banks have been able to meet surging demand for draws on credit lines while also building loan loss reserves to absorb higher expected defaults . Broker-dealers struggled to provide intermediation services during the acute period of financial stress. At least some hedge funds appear to have been severely affected by the large asset price declines and increased volatility in February and March, reportedly contributing to market dislocations. All told, the prospect for losses at financial institutions to create pressures over the medium term appears elevated.
4. Funding risk. In the face of the COVID-19 outbreak and associated financial market turmoil, funding markets proved less fragile than during the 2007–09 financial crisis. Nonetheless, significant strains emerged, and emergency Federal Reserve actions were required to stabilize short-term funding markets.

The outlook for the pandemic and economic activity is uncertain. In the near term, risks associated with the course of COVID-19 and its effect on the U .S . and global economies remain high . In addition, there is potential for stresses to interact with preexisting vulnera-bilities stemming from financial system or fiscal weaknesses in Europe, China, and emerging market economies (EMEs) . These risks have the potential to interact with the vulnerabilities identified in this report and pose additional risks to the U .S . financial system.