Board of Governors of the Federal Reserve 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.

The report includes additional boxes that analyze salient topics related to financial stability, including two boxes on recent notable events in financial markets—namely, " Recent Liquidity Strains across U.S. Treasury, Equity Index Futures, and Oil Futures Markets" and "Commodity Market Stresses following Russia's Invasion of Ukraine." Additional boxes include "LIBOR Transition Update," " Central Bank Digital Currency and Financial Stability," and "Stresses in China's Real Estate Sector."