Financial Stability Report

Financial Stability Report October 2023 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM The Federal Reserve System is the central bank of the United States. It performs five key functions to promote the effective operation of the U.S. economy and, more generally, the public interest. The Federal Reserve conducts the nation’s monetary policy to promote maximum employment and stable prices in the U.S. economy; promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad; promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole; fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments; and promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and administration of consumer laws and regulations. To learn more about us, visit www.federalreserve.gov/aboutthefed.htm. i Contents Purpose and Framework .............. .. ...... .. ...... .. ...... .. ..... ....iii Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 Asset Valuations .............. .. ...... .. ...... .. ...... .. ..... .... .... 5 2 Borrowing by Businesses and Households .................. .. ...... .. .. 15 3 Leverage in the Financial Sector ................ ..... ... ....... .. ...... 25 4 Funding Risks ............... ... ..... ... ..... ... ..... ... ..... ... ..... 37 5 Near-Term Risks to the Financial System .................. .. ...... .. ... 45 Box 5.1. Survey of Salient Risks to Financial Stability .............. ... ...... .. ... 47 Box 5.2. An Approach to Assessing Climate-Related Financial Risks .............. .. . 49 Appendix: Figure Notes .............. .. ...... .. ...... .. ...... .. ..... ... 51 Note: This report generally reflects information that was available as of October 4, 2023. iii Purpose and Framework This report presents the Federal Reserve Board’s current assessment of the stability of the U.S. financial system. By publishing this report, the Board intends to promote public understand- ing by increasing transparency around, and creating accountability for, the Federal Reserve’s views on this topic. Financial stability supports the objectives assigned to the Federal Reserve, including full employment and stable prices, a safe and sound banking system, and an efficient payments system. A financial system is considered stable when banks, other lenders, and financial markets More on the Federal are able to provide households, communities, Reserve’s Monitoring Efforts and businesses with the financing they need See the Financial Stability section of the to invest, grow, and participate in a well- Federal Reserve Board’s website for more functioning economy—and can do so even information on how the Federal Reserve when hit by adverse events, or “shocks.” monitors the stability of the U.S. and world financial systems. Consistent with this view of financial stabil- The website includes: ity, the Federal Reserve Board’s monitoring • a more detailed look at our monitoring framework distinguishes between shocks to, framework for assessing risk in each and vulnerabilities of, the financial system. category; Shocks are inherently difficult to predict, • more data and research on related topics; while vulnerabilities, which are the aspects • information on how we coordinate, cooper- of the financial system that would exacerbate ate, and otherwise take action on financial system issues; and stress, can be monitored as they build up or • public education resources describing the recede over time. As a result, the framework importance of our efforts. focuses primarily on assessing vulnerabilities, with an emphasis on four broad categories and how those categories might interact to amplify stress in the financial system.1 1. Valuation pressures arise when asset prices are high relative to economic fundamentals or historical norms. These developments are often driven by an increased willingness of investors to take on risk. As such, elevated valuation pressures may increase the possibility of outsized drops in asset prices (see Section 1, Asset Valuations). 1 For a review of the research literature in this area, see Tobias Adrian, Daniel Covitz, and Nellie Liang (2015), “Finan- cial Stability Monitoring,” Annual Review of Financial Economics, vol. 7 (December), pp. 357–95. iv Financial Stability Report 2. Excessive borrowing by businesses and households exposes the borrowers to distress if their incomes decline or the assets they own fall in value. In these cases, businesses and households with high debt burdens may need to cut back spending, affecting economic activity and causing losses for investors (see Section 2, Borrowing by Businesses and Households). 3. Excessive leverage within the financial sector increases the risk that financial institutions will not have the ability to absorb losses without disruptions to their normal business operations when hit by adverse shocks. In those situations, institutions will be forced to cut back lending, sell their assets, or even shut down. Such responses can impair credit access for households and businesses, further weakening economic activity (see Section 3, Leverage in the Financial Sector). 4. Funding risks expose the financial system to the possibility that investors will rapidly withdraw their funds from a particular institution or sector, creating strains across markets or institutions. Many financial institutions raise funds from the public with a commitment to return their investors’ money on short notice, but those institutions then invest much of those funds in assets that are hard to sell quickly or have a long maturity. This liquidity and maturity transformation can create an incentive for investors to withdraw funds quickly in adverse situations. Facing such withdrawals, financial institutions may need to sell assets quickly at “fire sale” prices, thereby incurring losses and potentially becoming insolvent, as well as causing additional price declines that can create stress across markets and at other institutions (see Section 4, Funding Risks). The Federal Reserve’s monitoring framework also tracks domestic and international develop- ments to identify near-term risks—that is, plausible adverse developments or shocks that could stress the U.S. financial system. The analysis of these risks focuses on assessing how such potential shocks may spread through the U.S. financial system, given our current assessment of vulnerabilities. While this framework provides a systematic way to assess financial stability, some potential risks may be novel or difficult to quantify and therefore are not captured by the current approach. Given these complications, we rely on ongoing research by the Federal Reserve staff, academ- ics, and other experts to improve our measurement of existing vulnerabilities and to keep pace with changes in the financial system that could create new forms of vulnerabilities or add to existing ones. Purpose and Framework v Federal Reserve actions to promote the resilience of the financial system The assessment of financial vulnerabilities informs Federal Reserve actions to promote the resil- ience of the financial system. The Federal Reserve works with other domestic agencies directly and through the Financial Stability Oversight Council to monitor risks to financial stability and to undertake supervisory and regulatory efforts to mitigate the risks and consequences of financial instability. Actions taken by the Federal Reserve to promote the resilience of the financial system include its supervision and regulation of financial institutions. In the aftermath of the 2007–09 financial crisis, these actions have included requirements for more and higher-quality capital, an innova- tive stress-testing regime, and new liquidity regulations applied to the largest banks in the United States. In addition, the Federal Reserve’s assessment of financial vulnerabilities informs deci- sions regarding the countercyclical capital buffer (CCyB). The CCyB is designed to increase the resilience of large banking organizations when there is an elevated risk of above-normal losses and to promote a more sustainable supply of credit over the economic cycle. 1 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-sector leverage, and funding risks. It also highlights several near-term risks that, if realized, could interact with these vulnerabilities. A summary of the developments in the four broad categories of vulnerabilities since the May 2023 Financial Stability Report is as follows: Overview of financial system vulnerabilities Borrowing by businesses Leverage in the Asset valuations Funding risks and households financial sector • Equity price-to-earnings • The ratio of total • The banking system • Most domestic banks ratios reached elevated private debt to gross remained sound and maintained high levels levels. domestic product (GDP) resilient, as risk-based of liquid assets and continued to edge down capital ratios remained stable funding. • Risk premiums in and remained close to close to average levels corporate bond markets its historical average. over the past decade. • However, a subset of remained near the banks continued to middle of their historical • The business • Nonetheless, high face funding pressures, distributions. debt-to-GDP ratio interest rates reflecting concerns over remained high, but debt continued to depress uninsured deposits and • Prices of residential and issuance by the riskiest the fair value of other factors. commercial properties companies continued longer-maturity, remained high relative to to be subdued. Firms’ fixed-rate assets that, • Structural fundamentals. ability to service their for some banks, were vulnerabilities persisted debt remained solid sizable. at money market funds, despite declining some other mutual interest coverage ratios. • Leverage remained funds, and stablecoins. high at the largest • Household debt was at hedge funds. • Liquidity risks for life modest levels relative to insurers remained GDP and concentrated • Broker-dealer leverage elevated as the share of among prime-rated illiquid and risky assets remained near borrowers. continued to edge up. historically low levels. 2 Financial Stability Report 1. Asset valuations. Equity prices grew faster than expected earnings, pushing the forward price-to-earnings ratio into the upper ranges of its historical distribution. Risk premiums in corporate bond markets narrowed somewhat and remained near the middle of their historical distributions. Prices of residential and commercial properties remained high relative to fundamentals (see Section 1, Asset Valuations). 2. Borrowing by businesses and households. Balance sheets of many nonfinancial businesses and households remained solid. Growth of business debt continued to decline through the first half of the year, although business debt remained high when measured relative to gross domestic product (GDP) or business assets. Measures of the ability of firms to service their debt remained strong. Household debt remained at modest levels relative to GDP, with most of that debt owed by households with strong credit histories or considerable home equity (see Section 2, Borrowing by Businesses and Households). 3. Leverage in the financial sector. The banking sector remains sound and resilient overall, and most banks continued to report capital levels well above regulatory requirements. That said, the increase in interest rates over the past two years has contributed to declines in the fair value of longer-maturity, fixed-rate assets that, for some banks, were sizable. Outside the banking sector, available data suggest that hedge fund leverage remained somewhat elevated, especially for the largest hedge funds. Leverage at life insurance companies remained near the middle of its historical range, while broker-dealer leverage remained historically low (see Section 3, Leverage in the Financial Sector). 4. Funding risks. Most domestic banks have ample liquidity and limited reliance on short- term wholesale funding; nevertheless, some banks continued to face funding strains, likely owing to vulnerabilities associated with high levels of uninsured deposits and declines in the fair value of assets. The Bank Term Funding Program (BTFP) helped mitigate these strains. Structural vulnerabilities remained in other short-term funding markets. Prime and tax-exempt money market funds (MMFs), as well as other cash- investment vehicles and stablecoins, remained vulnerable to runs. Bond and loan funds that hold assets that can become illiquid during periods of stress remained susceptible to large redemptions. Life insurers continued to rely on a higher-than-average share of runnable liabilities (see Section 4, Funding Risks). This report also discusses potential near-term risks 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 conducted from August through early October (discussed in the box “Survey of Salient Risks to Financial Stability”). The two most frequently cited topics in this survey—the risk of persistent inflationary pressures leading to a more restrictive monetary policy stance and the potential for large losses on commercial real estate (CRE) and residential real Overview 3 estate—were mentioned by three-fourths of all survey participants, up from one-half of all partici- pants in the previous survey. Risks associated with the reemergence of banking-sector stress and risks associated with market liquidity strains and volatility continued to feature prominently. Addi- tionally, in the most recent survey, respondents were increasingly attentive to risks posed from economic weakness in China as well as from fiscal debt sustainability in advanced economies. Note that data and survey results for this report closed on October 4, 2023 and do not reflect the escalation of geopolitical tensions following the attack on Israel. In addition, the Federal Reserve is working to understand the risks that climate change may pose to individual banking organizations and the financial system. The box “An Approach to Assessing Climate-Related Financial Risks” contains information on some steps the Federal Reserve has taken to collect data to better understand climate-related risks to financial institutions and financial markets. Survey of salient risks to the financial system Survey respondents cited several emerging and existing events or conditions as presenting risks to the U.S. financial system and the broader global economy. For more information, see the box “Survey of Salient Risks to Financial Stability.” Persistent inflation; Commercial and Banking-sector Market liquidity strains Weakness in Chinese monetary tightening residential real estate stress and volatility economy/financial sector 72% 72% 56% 56% 44% October of contacts of contacts of contacts of contacts of contacts 2023 surveyed surveyed surveyed surveyed surveyed 56% 52% 56% 40% 12% May 2023 of contacts of contacts of contacts of contacts of contacts surveyed surveyed surveyed surveyed surveyed 5 1 Asset Valuations Asset valuation pressures rose to a notable level Since the May 2023 report, valuations in equity markets increased modestly from an already high level even as yields on Treasury securities increased substantially. Corporate credit spreads edged down and were somewhat below their historical averages. Liquidity in Treasury markets remained challenged. While trading conditions largely recovered from the notable strains seen following Silicon Valley Bank’s failure, they could again deteriorate in the face of further negative shocks. Property prices remain elevated relative to fundamentals. In the market for residential real estate, house prices started increasing again in recent months and prices relative to rents remained near all-time highs. In the market for CRE, rental income relative to property prices remained low from a historical perspective, despite recent declines in property values. Fundamentals in the market for office properties were especially weak, as vacancy rates have risen and rent growth slowed. Farmland prices were historically elevated relative to rents, reflecting higher crop prices and lim- ited inventories of land. Table 1.1 shows the sizes of the asset markets discussed in this section. The largest asset mar- kets are those for residential real estate, equities, Treasury securities, and CRE. Treasury yields increased substantially and now stand at the highest levels in the past 15 years Yields on Treasury securities moved notably higher since the May report and now stand close to their highest levels over the past decade and a half (figure 1.1). A model-based estimate of the nominal Treasury term premium—a measure of the compensation that investors require to hold longer-term Treasury securities rather than shorter-term ones—increased but remained low rela- tive to its long-run history (figure 1.2). Interest rate volatility implied by options remained elevated by historical norms, reflecting, in part, uncertainty about the economic outlook and the path of monetary policy (figure 1.3). Equity market valuation pressures remained notable Valuations in equity markets increased modestly from an already high level since the May report. The pace of equity price increases exceeded that of expected earnings, and the forward price-to- earnings ratio rose to a level further above its historical median (figure 1.4). 6 Financial Stability Report Table 1.1. Size of selected asset markets Growth, Average annual growth, Outstanding Item 2022:Q2–2023:Q2 1997–2023:Q2 (billions of dollars) (percent) (percent) Residential real estate 56,301 −1.2 6.4 Equities 53,457 15.0 8.2 Treasury securities 24,772 6.5 8.4 Commercial real estate 24,003 2.5 6.4 Investment-grade corporate bonds 7,369 5.3 8.0 Farmland 3,288 8.1 5.7 High-yield and unrated corporate bonds 1,667 −6.0 6.4 Leveraged loans1 1,394 −1.5 13.0 Price growth (real) Commercial real estate2 −3.9 3.3 Residential real estate3 −1.3 2.7 Note: The data extend through 2023:Q2. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period. Equities, real estate, and farmland are at nominal market value; bonds and loans are at nominal book value. 1 The amount outstanding shows institutional leveraged loans and generally excludes loan commitments held by banks. For example, lines of credit are generally excluded from this measure. Average annual growth of leveraged loans is from 2001 to 2023:Q2, as this market was fairly small before then. 2 One-year growth of commercial real estate prices is from June 2022 to June 2023, and average annual growth is from June 1999 to June 2023. Both growth rates are calculated from equal-weighted nominal prices deflated using the consumer price index (CPI). 3 One-year growth of residential real estate prices is from June 2022 to June 2023, and average annual growth is from June 1998 to June 2023. Nominal prices are deflated using the CPI. Source: For leveraged loans, PitchBook Data, Leveraged Commentary & Data; for corporate bonds, Mergent, Inc., Fixed Income Securities Data- base; for farmland, Department of Agriculture; for residential real estate price growth, CoreLogic, Inc.; for commercial real estate price growth, CoStar Group, Inc., CoStar Commercial Repeat Sale Indices; for all other items, Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” Figure 1.1. Nominal Treasury yields rose substantially in the third quarter of 2023 Percent, annual rate 8 Monthly 7 2-year 6 10-year Sept. 5 4 3 2 1 0 1998 2003 2008 2013 2018 2023 Source: Federal Reserve Board, Statistical Release H.15, “Selected Interest Rates.” Asset Valuations 7 Figure 1.2. An estimate of the nominal Figure 1.3. Interest rate volatility remained Treasury term premium increased but elevated by historical norms remained relatively low Basis points 250 Percentage points Monthly 2.5 Monthly 2.0 200 1.5 150 1.0 Sept. 0.5 100 Sept. 0.0 Median = 79.37 50 −0.5 −1.0 0 −1.5 2005 2008 2011 2014 2017 2020 2023 1998 2003 2008 2013 2018 2023 Source: For data through July 13, 2022, Barclays and Source: Department of the Treasury; Wolters Kluwer, S&P Global; for data from July 14, 2022, onward, ICAP, Blue Chip Financial Forecasts; Federal Reserve Bank Swaptions and Interest Rate Caps and Floors Data. of New York; Federal Reserve Board staff estimates. The difference between the forward earnings-to-price ratio and the real 10-year Treasury yield— a measure of the additional return that investors require for holding stocks relative to risk-free bonds (the equity premium)—declined since the May report to levels well below historical norms (figure 1.5).2 Equity market volatility continued to decline from the elevated levels reached earlier this year and currently stands slightly above its historical median (figure 1.6). Figure 1.4. The price-to-earnings ratio of Figure 1.5. An estimate of the equity premium S&P 500 firms increased to levels further fell further below its historical median above its historical median Percentage points 10 Ratio Monthly 30 Monthly 8 27 24 6 Sept. 21 Median = 4.73 4 18 Sept. 2 15 Median = 15.55 12 0 9 −2 6 1991 1999 2007 2015 2023 1991 1999 2007 2015 2023 Source: Federal Reserve Board staff calculations Source: Federal Reserve Board staff calculations using Refinitiv, Institutional Brokers’ Estimate using Refinitiv, Institutional Brokers’ Estimate System estimates; Department of the Treasury; System estimates. Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters. 2 This estimate is constructed based on expected corporate earnings for 12 months ahead. Alternative measures of the equity premium that incorporate longer-term earnings forecasts suggest more elevated equity valuation pressures. 8 Financial Stability Report Figure 1.6. Volatility in equity markets stood slightly above its historical median Percent 80 Monthly Option-implied volatility 70 Realized volatility 60 50 40 30 Sept. 20 10 0 1998 2003 2008 2013 2018 2023 Source: Refinitiv, DataScope Tick History; Federal Reserve Board staff estimates. Spreads in corporate debt markets narrowed modestly Yields on corporate bonds rose since the May report and remain above the median of their histor- ical distributions, as yields on comparable-maturity Treasury securities also increased (figure 1.7). Corporate bond spreads, measured as the difference in yields between corporate bonds and comparable-maturity Treasury securities, narrowed modestly and currently stand a bit below their historical median (figure 1.8). However, the excess bond premium—a risk premium measure that captures the gap between corporate bond spreads and expected credit losses—remained near its historical mean (figure 1.9). The trailing 12-month default rate for all corporate bonds edged up over the past year but stands well below its historical median. For speculative-grade corporate bonds in particular, the trailing 12-month default rate moved up more over the same time period and stands at about its historical median. Valuations in leveraged loan markets were little changed from the previous report. The average spread on leveraged loans above their benchmark rates in the secondary market fell modestly Figure 1.7. Corporate bond yields rose above their historical medians Percent 24 Monthly 22 20 Triple-B 18 High-yield 16 14 12 10 Sept. 8 6 4 2 0 1998 2003 2008 2013 2018 2023 Source: ICE Data Indices, LLC, used with permission. Asset Valuations 9 Figure 1.8. Corporate bond spreads narrowed modestly Percentage points Percentage points 12 24 11 Monthly 22 10 Triple-B (left scale) 20 9 High-yield (right scale) 18 8 16 7 14 6 12 5 10 4 8 3 Sept. 6 2 4 1 2 0 0 1998 2003 2008 2013 2018 2023 Source: ICE Data Indices, LLC, used with permission. and remained near its average over the past decade (figure 1.10). The trailing 12-month loan default rate increased further since the last report and stands well above its historical median since the Great Recession, but the year-ahead expected default rate declined moderately. Figure 1.9. The excess bond premium stayed Figure 1.10. Spreads on leveraged loans fell near its historical mean modestly Percentage points Percentage points 4 30 Monthly 3 B 25 BB 2 Monthly to weekly 20 1 15 0 10 Sept. Sept. 29 −1 5 −2 0 1998 2003 2008 2013 2018 2023 1998 2003 2008 2013 2018 2023 Source: Federal Reserve Board staff calculations Source: PitchBook Data, Leveraged Commentary based on Lehman Brothers Fixed Income Database & Data. (Warga); Intercontinental Exchange, Inc., ICE Data Services; Center for Research in Security Prices, CRSP/Compustat Merged Database, Wharton Research Data Services; S&P Global, Compustat. Market liquidity stayed near the lower end of its historical range Market liquidity refers to the ease and cost of buying and selling an asset. Low liquidity can amplify the volatility of asset prices and result in larger price moves in response to shocks. In extreme cases, low liquidity can threaten market functioning, leading to a situation in which par- ticipants are unable to trade without incurring a significant cost. 10 Financial Stability Report Treasury market liquidity is important because of the key role these securities play in the financial system. Various measures of market liquidity, such as market depth, suggest that while Treasury market liquidity was largely in line with expectations given interest rate volatility, it remained below historical norms (figures 1.11 and 1.12). This low level of market depth could indicate that liquidity providers are being particularly cautious, and liquidity may be less resilient than usual. In other markets, liquidity conditions were little changed since the previous report and present a more mixed picture. In corporate bond markets, bid-ask spreads remained well below pandemic levels, suggesting ample liquidity, while in equity markets, depth in the S&P 500 futures markets stayed at below-average levels (figure 1.13). Figure 1.11. Treasury market depth remained below historical norms Millions of dollars Millions of dollars 35 350 5-day moving average 30 5-year (right scale) 300 10-year (right scale) 25 30-year (left scale) 250 20 200 15 150 10 Oct. 100 3 5 50 0 0 Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. 2019 2020 2021 2022 2023 Source: Inter Dealer Broker Community. Figure 1.12. On-the-run market depth improved in recent months but remained below historical norms Millions of dollars Millions of dollars 60 300 5-day moving average 50 2-year OTR market depth (right scale) 250 10-year OTR market depth (left scale) 40 200 30 150 20 100 Oct. 10 3 50 0 0 Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. 2019 2020 2021 2022 2023 Source: BrokerTec; Federal Reserve Board staff calculations. Asset Valuations 11 Figure 1.13. A measure of liquidity in equity markets remained below average Market depth (number of contracts) 300 5-day moving average 250 200 150 100 50 Oct. 2 0 Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. 2019 2020 2021 2022 2023 Source: Refinitiv, DataScope Tick History; Federal Reserve Board staff calculations. Commercial real estate valuations remained elevated, even as prices continued to decline Aggregate CRE prices measured in inflation-adjusted terms continued declining through August (figure 1.14). Capitalization rates at the time of property purchase, which measure the annual income of commercial properties relative to their prices, have increased modestly from recent his- torically low levels but have not increased as much as real Treasury yields, suggesting that prices remain high relative to rental income (figure 1.15). CRE valuations are particularly elevated for the Figure 1.14. Commercial real estate prices, Figure 1.15. Income of commercial properties adjusted for inflation, continued to decline relative to prices continued to grow but remained well below historical norms Jan. 2001 = 100 180 Monthly Percent 10.0 160 Monthly 9.5 9.0 140 8.5 Aug. 120 8.0 7.5 100 7.0 6.5 80 Aug. 6.0 60 5.5 2003 2008 2013 2018 2023 5.0 2003 2007 2011 2015 2019 2023 Source: Real Capital Analytics; consumer price index, Bureau of Labor Statistics via Haver Analytics. Source: Real Capital Analytics; Andrew C. Florance, Norm G. Miller, Ruijue Peng, and Jay Spivey (2010), “Slicing, Dicing, and Scoping the Size of the U.S. Commercial Real Estate Market,” Journal of Real Estate Portfolio Management, vol. 16 (May–August), pp. 101–18. 12 Financial Stability Report office sector, where fundamentals are especially weak for offices in central business districts, with vacancy rates increasing further and rent growth declining since the May report. In the April and July 2023 Senior Loan Officer Opinion Survey (SLOOS), banks reported weaker demand and tighter standards for all CRE loan categories over the first half of 2023 (figure 1.16). Figure 1.16. Banks reported tightening lending standards in commercial real estate loans Net percentage of banks reporting 100 Quarterly 80 Q2 60 40 20 0 −20 −40 −60 −80 −100 1998 2003 2008 2013 2018 2023 House prices started increasing again in recent months, and valuations remained high Since the last report, valuations in residential real estate markets increased from already ele- vated levels. House prices, after holding steady earlier this year, started rising again in recent months (figure 1.17). A model of house price valuation based on prices relative to owners’ gninethgiT gnisaE Source: Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank Lending Practices; Federal Reserve Board staff calculations. Figure 1.17. House prices started increasing again in recent months 12-month percent change 25 Monthly 20 15 10 5 0 −5 Zillow −10 CoreLogic Case-Shiller −15 −20 −25 2003 2008 2013 2018 2023 Source: Zillow, Inc., Real Estate Data; CoreLogic, Inc., Real Estate Data; S&P Case-Shiller Home Price Indices. Asset Valuations 13 equivalent rent and the real 10-year Treasury yield suggests that valuations in housing markets were increasingly stretched (figure 1.18). Moreover, the median price-to-rent ratio measured across a wide distribution of geographical areas remained close to its previous peak in the mid- 2000s (figure 1.19). That said, credit conditions for borrowers remained considerably tighter than in the early 2000s. Figure 1.18. Model-based measures of house price valuations remained historically high Percent 40 Quarterly 30 Owners’ equivalent rent Market-based rents Q3 20 10 0 −10 −20 −30 1983 1988 1993 1998 2003 2008 2013 2018 2023 Source: For house prices, Zillow, Inc., Real Estate Data; for rent data, Bureau of Labor Statistics. Figure 1.19. House price-to-rent ratios remained elevated across geographic areas Jan. 2010 = 100 220 Monthly Median Middle 80 percent of markets 180 Aug. 140 100 60 1998 2003 2008 2013 2018 2023 Source: For house prices, Zillow, Inc., Real Estate Data; for rent data, Bureau of Labor Statistics. Farmland valuations remained elevated Farmland prices increased since the May report, reaching values near the peak of their historical distribution (figure 1.20). Similarly, the ratios of farmland prices to rents remained historically high (figure 1.21). These high valuations were driven by strong agricultural commodity prices, limited inventory of farmland, and significant increases in cropland revenues that had more than offset higher operating costs. 14 Financial Stability Report Figure 1.20. Farmland prices stayed near historical highs 2022 dollars per acre 8000 Annual Midwest index 7000 U.S. 6000 5000 Median = $3,433.33 4000 3000 2000 1000 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 2018 2023 Source: Department of Agriculture; Federal Reserve Bank of Minneapolis staff calculations. Figure 1.21. Farmland prices grew faster than rents Ratio 40 Annual 35 Midwest index 30 U.S. 25 20 Median = 18.18 15 10 5 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 2018 2023 Source: Department of Agriculture; Federal Reserve Bank of Minneapolis staff calculations. 15 2 Borrowing by Businesses and Households Vulnerabilities from business and household debt remained moderate Balance sheets of many nonfinancial businesses and households remained solid, with vulner- abilities at moderate levels. That said, there are increasing signs that higher interest rates are beginning to strain some borrowers. For businesses, both the business debt-to-GDP ratio and gross leverage remained at high levels, although they were significantly lower than the record highs reached at the onset of the pan- demic. Interest coverage ratios (ICRs)—defined as the ratio of earnings before interest and tax to interest expense—moved down in the most recent data but remain solid, suggesting that firms, overall, have sufficient cash flows to cover rising borrowing costs. Indicators of household vul- nerabilities, including the household debt-to-GDP ratio and the aggregate household debt service ratio, remained at modest levels. An economic downturn resulting in lower business earnings and household incomes could weaken the debt service capacities of smaller, at-risk businesses with already low ICRs as well as particularly indebted households. Table 2.1 shows the amounts outstanding and recent historical growth rates of forms of debt owed by nonfinancial businesses and households as of the second quarter of 2023. The com- bined total debt of nonfinancial businesses and households grew more slowly than nominal GDP in recent quarters, leading to a decline in the debt-to-GDP ratio, which is now at the level that pre- vailed over most of the past decade (figure 2.1). The drop in the overall ratio was driven in equal parts by declines in both the household and business debt-to-GDP ratios (figure 2.2). Business debt vulnerabilities remain moderate relative to historical levels Overall vulnerabilities from nonfinancial business debt increased slightly since the May report but remained moderate overall. While measures of leverage remained high, debt growth continued to decline. Firms’ ability to service their debt, as measured by ICRs, edged down a bit in the most recent data but remained solid owing to resilient earnings. However, risky borrowers’ ability to service their debt burdens has started to show signs of weakness, as would be expected in a rising interest rate environment, and could become further strained if corporate earnings fall due to a sharper-than-expected slowdown in economic activity. 16 Financial Stability Report Table 2.1. Outstanding amounts of nonfinancial business and household credit Growth, Average annual growth, Outstanding Item 2022:Q2–2023:Q2 1997–2023:Q2 (billions of dollars) (percent) (percent) Total private nonfinancial credit 39,915 3.7 5.5 Total nonfinancial business credit 20,335 3.6 5.9 Corporate business credit 13,003 3.2 5.4 Bonds and commercial paper 7,720 2.3 5.5 Bank lending 2,101 8.7 4.5 Leveraged loans1 1,358 3.2 13.1 Noncorporate business credit 7,332 4.2 6.9 Commercial real estate credit 2,971 5.4 6.2 Total household credit 19,580 3.8 5.1 Mortgages 12,850 4.1 5.1 Consumer credit 4,943 5.3 5.4 Student loans 1,765 1.2 8.0 Auto loans 1,533 6.1 5.4 Credit cards 1,225 11.5 3.5 Nominal GDP 26,799 6.1 4.6 Note: The data extend through 2023:Q2. Outstanding amounts are in nominal terms. Growth rates are measured from Q2 of the year immedi- ately preceding the period through Q2 of the final year of the period. The table reports the main components of corporate business credit, total household credit, and consumer credit. Other, smaller components are not reported. The commercial real estate (CRE) row shows CRE debt owed by both nonfinancial corporate and noncorporate businesses as defined in Table L.220: Commercial Mortgages in the “Financial Accounts of the United States.” Total household-sector credit includes debt owed by other entities, such as nonprofit organizations. GDP is gross domestic product. 1 Leveraged loans included in this table are an estimate of the leveraged loans that are made to nonfinancial businesses only and do not include the small amount of leveraged loans outstanding for financial businesses. The amount outstanding shows institutional leveraged loans and generally excludes loan commitments held by banks. For example, lines of credit are generally excluded from this measure. Average annual growth of leveraged loans is from 2001 to 2023:Q2, as this market was fairly small before then. Source: For leveraged loans, PitchBook Data, Leveraged Commentary & Data; for GDP, Bureau of Economic Analysis, national income and product accounts; for all other items, Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” Figure 2.1. The total debt of businesses and households relative to GDP declined further Ratio 2.0 Quarterly 1.7 Q2 1.4 1.1 0.8 1981 1987 1993 1999 2005 2011 2017 2023 Source: Federal Reserve Board staff calculations based on Bureau of Economic Analysis, national income and product accounts, and Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” Borrowing by Businesses and Households 17 Figure 2.2. Both business and household debt-to-GDP ratios edged down Ratio Ratio 1.1 1.0 Quarterly 1.0 0.9 0.9 0.8 0.8 Q2 0.7 0.7 0.6 Nonfinancial business 0.6 0.5 (right scale) 0.4 Household (left scale) 0.5 0.3 0.4 1981 1987 1993 1999 2005 2011 2017 2023 Source: Federal Reserve Board staff calculations based on Bureau of Economic Analysis, national income and product accounts, and Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” The growth of nonfinancial business debt Figure 2.3. Business debt adjusted for adjusted for inflation declined over the past inflation continued to decline year (figure 2.3), and net issuance of risky Percent change, annual rate 20 debt—defined as the difference between Quarterly issuance of high-yield bonds, unrated bonds, 15 and leveraged loans minus retirements and 10 repayments—remained subdued as firms 5 repaid existing leveraged loans at a faster 0 Q2 pace than new loans were issued (figure 2.4). −5 The net issuance of high-yield and unrated −10 1998 2003 2008 2013 2018 2023 bonds was also subdued through the third Source: Federal Reserve Board, Statistical Release Z.1, quarter of 2023. “Financial Accounts of the United States.” Figure 2.4. Net issuance of risky debt remained subdued Billions of dollars 120 Quarterly Institutional leveraged loans 100 High-yield and unrated bonds 80 60 40 Q3 20 0 −20 −40 −60 2005 2008 2011 2014 2017 2020 2023 Source: Mergent, Inc., Fixed Income Securities Database; PitchBook Data, Leveraged Commentary & Data. 18 Financial Stability Report Gross leverage—the ratio of debt to assets—of all publicly traded nonfinancial firms remained high by historical standards (figure 2.5). Net leverage—the ratio of debt less cash to total assets—continued to edge up among all large publicly traded businesses and remained high relative to its history. Meanwhile, firms’ ability to service their debt remained solid overall, despite some emerging signs of weakness among riskier firms. The median ICR has been steadily declin- ing from its peak reached during the post-pandemic earnings boom and inched down further in Q2 (figure 2.6). The decline partially reflects modest pass-through of higher interest rates to firms’ borrowing costs, because most of the debt issued by large firms carries fixed rates.3 Corporate earnings remained solid for the first half of 2023. However, signs of stress in debt servicing and deterioration in credit quality are emerging for the most vulnerable and lowest-rated firms as elevated borrowing costs begin to weigh on interest expenses.4 Figure 2.5. Gross leverage of large businesses Figure 2.6. Firms’ ability to service their debt, remained at high levels by historical standards as measured by the interest coverage ratio, continued to decline from post-pandemic highs Percent 55 Quarterly Ratio 6 75th percentile 50 Quarterly All firms 45 5 Median for all firms Q2 40 Median for all non-investment-grade firms 4 35 3 30 Q2 2 25 1 20 2002 2005 2008 2011 2014 2017 2020 2023 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Federal Reserve Board staff calculations based on S&P Global, Compustat. Source: Federal Reserve Board staff calculations based on S&P Global, Compustat. The credit performance of outstanding corporate bonds remained solid, but signs of deterioration have emerged since the May report. The volume of downgrades and defaults remained low, but realized defaults and market expectations of defaults over the next year have been trending up in recent months as pressures from rising interest rates and economic uncertainty mount. More than half of investment-grade bonds outstanding continued to be rated in the lowest category of the investment-grade range (triple-B). If a large share of these bonds were downgraded, debt cost would increase when the bonds need to roll over, putting pressure on firms’ balance sheets. 3 Only about 5 percent of outstanding bonds rated triple-B and 1 percent of outstanding high-yield bonds are due within a year. 4 While these firms represent a large share of the number of publicly traded firms (85 percent), their debt constitutes only 35 percent of the total debt in the sector. Borrowing by Businesses and Households 19 Small and middle-market firms that are privately held—which have less access to capital markets and primarily borrow from banks, private credit and equity funds, and sophisticated investors— account for roughly 60 percent of outstanding U.S. debt. Available data for these firms indicate that vulnerabilities inched up as higher interest rates started to reduce earnings and raise debt service costs.5 Since the last report, leverage for these firms increased slightly following several quarters of post-pandemic declines and is currently roughly in line with leverage levels among publicly traded firms. The ICR for the median firm in this category declined notably but remained at a high level, above that of publicly traded firms. The credit quality of outstanding and newly issued leveraged loans remained solid through the first half of 2023 but continued to show some signs of deterioration. The volume of credit rating downgrades exceeded the volume of upgrades over this period, and default rates have Figure 2.7. Default rates on leveraged loans continued to inch up from their historic lows inched up from historically low levels reached in 2021 (figure 2.7). The share of Percent 14 newly issued loans to large corporations with Monthly 12 debt multiples—defined as the ratio of debt to 10 earnings before interest, taxes, depreciation, 8 6 and amortization—greater than 4 has fallen to 4 its lowest level in the past decade, suggest- Aug. 2 ing limited investor tolerance for riskier loans 0 −2 (figure 2.8). As noted, a potential slowdown 1999 2003 2007 2011 2015 2019 2023 in earnings growth posed by the less favor- Source: PitchBook Data, Leveraged Commentary & Data. able economic outlook combined with rising Figure 2.8. New leveraged loans with debt multiples less than 4 continued to rise Percent Debt multiples ≥ 6x Debt multiples 5x–5.99x Debt multiples 4x–4.99x Debt multiples < 4x Q2 100 80 60 40 20 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Mergent, Inc., Fixed Income Securities Database; PitchBook Data, Leveraged Commentary & Data. 5 An important caveat is that the data on smaller middle-market firms are not as comprehensive as those on large firms. 20 Financial Stability Report interest rates could put pressure on the credit quality of outstanding leveraged loans, as their floating debt service costs would increase. Delinquencies at small businesses edged up, but credit quality remained solid Credit quality for small businesses remained relatively solid, though delinquency rates continued to edge up in recent months from relatively low levels. Borrowing costs increased in the first half of 2023 to levels not seen since prior to the Great Recession. In addition, the share of small busi- nesses that borrow regularly declined since the beginning of the year, according to the National Federation of Independent Business Small Business Economic Trends Survey, and was somewhat low relative to historical levels. The share of firms reporting unmet financing needs remained quite low. Loan originations for small businesses remained in line with pre-pandemic levels. Vulnerabilities from household debt remained moderate Household balance sheets remained strong overall. Many households that purchased homes or refinanced when interest rates were low continued to benefit from lower interest rate payments, strengthening their current financial position. That said, some borrowers, especially those with newly originated debt as interest rates have increased over the past year and a half, remained financially stretched and more vulnerable to future shocks. Outstanding household debt adjusted for Figure 2.9. Real household debt edged down inflation ticked down in the second quarter, Trillions of dollars (real) with the decline in the most recent data 16 Quarterly Prime Near prime 14 broad based across the credit score distri- Subprime 12 bution (figure 2.9). The ratio of total required 10 household debt payments to total disposable Q2 8 6 income (the household debt service ratio) 4 increased slightly since the May report. None- 2 theless, the ratio remained at modest levels 0 1999 2003 2007 2011 2015 2019 2023 after reaching a historical low in the first Source: Federal Reserve Bank of New York Consumer quarter of 2021 amid credit card paydowns Credit Panel/Equifax; consumer price index, Bureau of Labor Statistics via Haver Analytics. with low interest rates at the time. Higher interest rates over the past year have only partially passed through to household interest expenses because, except for credit card debt, only a small share of household debt is subject to floating rates. For most other types of household debt, rising interest rates increase borrowing costs only for new loan originations. Borrowing by Businesses and Households 21 Mortgage credit risk remained generally low Mortgage debt, which accounts for roughly Figure 2.10. A model-based estimate of two-thirds of total household debt, grew a housing leverage was flat bit more slowly than GDP over the past four 1999:Q1 = 100 180 quarters. Estimates of housing leverage when Quarterly Relative to model-implied values 160 measuring home values as a function of rents Relative to market value 140 and other market fundamentals remained flat 120 and significantly lower than their peak levels 100 before 2008 (figure 2.10, black line). The over- Q2 all mortgage delinquency rate was essentially 80 unchanged in the most recent data after edg- 60 1999 2003 2007 2011 2015 2019 2023 ing up from the historically low levels reached Source: Federal Reserve Bank of New York Consumer in 2021, and the share of mortgage balances Credit Panel/Equifax; Zillow, Inc., Real Estate Data; Bureau of Labor Statistics via Haver Analytics. in loss-mitigation programs remained low (figure 2.11). A very low share of borrowers had negative home equity in the most recent data through June 2023 (figure 2.12). Figure 2.11. Mortgage delinquency rates Figure 2.12. Very few homeowners had remained near historically low levels negative equity in their homes Percent of mortgages Percent of mortgages 10 30 Quarterly Monthly 25 8 20 6 15 4 10 Delinquent Q2 Delinquent/loss mitigation 2 June 5 0 0 2002 2005 2008 2011 2014 2017 2020 2023 2011 2013 2015 2017 2019 2021 2023 Source: Federal Reserve Bank of New York Consumer Source: CoreLogic, Inc., Real Estate Data. Credit Panel/Equifax. New mortgage extensions, which have been skewed heavily toward prime borrowers over the past decade, continued to decline sharply in 2023 as mortgage rates remained elevated (figure 2.13). The early payment delinquency rate—the share of balances becoming delinquent within one year of mortgage origination—continued to rise from its 2020 low, likely reflecting increasing strains associated with higher interest expenses on newly originated mortgages. 22 Financial Stability Report Figure 2.13. New mortgage extensions to nonprime borrowers were subdued Billions of dollars (real) 1600 Annual Subprime Near prime 1200 Prime 800 400 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Federal Reserve Bank of New York Consumer Credit Panel/Equifax; consumer price index, Bureau of Labor Statistics via Haver Analytics. Credit risk of outstanding household debt remained generally low, but borrowers with low credit scores continued showing signs of stress Consumer debt—which accounts for the Figure 2.14. Real consumer credit edged down in the first half of 2023 remaining one-third of household debt and consists primarily of student, auto, and credit Billions of dollars (real) 2000 Quarterly card loans—edged down in real terms since Student loans 1800 Auto loans 1600 the last report (figure 2.14) and, in nominal Credit cards 1400 terms, increased at a slightly slower pace Q2 1200 than nominal GDP. However, delinquency 1000 800 rates on newly issued consumer loans rose, 600 particularly among borrowers with low credit 400 200 scores, as interest rates continued to rise. 1999 2003 2007 2011 2015 2019 2023 Source: Federal Reserve Bank of New York Consumer Credit Panel/Equifax; consumer price index, Bureau Real auto loan balances ticked up for prime of Labor Statistics via Haver Analytics. borrowers but declined modestly for near- prime and subprime borrowers (figure 2.15). Smoothing through the quarter-to-quarter variation over the first half of 2023, the share of auto loan balances in loss mitigation moved sideways and remained roughly in line with its historical median. Those in delinquent status also remained essentially flat, although at a level above the historical median (figure 2.16). That said, the aggregate delinquency rates mask a much sharper rise in auto loan delinquency rates for subprime borrowers in the second quarter of 2023, which increased to a level that was elevated relative to where it stood pre-pandemic. Borrowing by Businesses and Households 23 Figure 2.15. Real auto loans outstanding Figure 2.16. Auto loan delinquencies remained ticked up for prime borrowers at levels above their historical median Billions of dollars (real) Percent 900 10 Quarterly Quarterly Prime 800 Near prime 700 Delinquent 8 Subprime Delinquent/loss mitigation Q2 600 6 500 Q2 400 4 300 2 200 100 0 1999 2003 2007 2011 2015 2019 2023 2002 2005 2008 2011 2014 2017 2020 2023 Source: Federal Reserve Bank of New York Consumer Source: Federal Reserve Bank of New York Consumer Credit Panel/Equifax; consumer price index, Bureau Credit Panel/Equifax. of Labor Statistics via Haver Analytics. Aggregate real credit card balances continued to increase over the first half of the year, and the increases were broad based across the credit score distribution (figure 2.17). Rates paid on these balances increased in line with short-term interest rates over the past year. However, delin- quency rates have continued to increase over the same period (figure 2.18). After rising rapidly for more than a decade, student loan debt, after adjusting for inflation, began to decline with the onset of the pandemic. Student loan repayments, which had been on hold since March 2020, are set to resume in October. Figure 2.17. Real credit card balances rose in Figure 2.18. Credit card delinquencies the first half of 2023 increased further in the first half of 2023 Billions of dollars (real) Percent 600 8 Quarterly Quarterly 450 6 Q2 300 Q2 4 Prime Near prime 150 2 Subprime 0 0 1999 2003 2007 2011 2015 2019 2023 2002 2005 2008 2011 2014 2017 2020 2023 Source: Federal Reserve Bank of New York Consumer Source: Federal Reserve Bank of New York Consumer Credit Panel/Equifax; consumer price index, Bureau Credit Panel/Equifax. of Labor Statistics via Haver Analytics. 25 3 Leverage in the Financial Sector While the overall banking system remains sound, declines in the fair value of assets at some banks remained sizable and leverage at some nonbanks continued to be somewhat elevated Measures of regulatory capital for banks increased over the first half of the year and remained solid. Nevertheless, declines in the fair value of fixed-rate assets have been sizable relative to the regulatory capital at some banks, especially for a subset of large (but non–global systemi- cally important) banks and regional banks. Outside the banking sector, leverage at broker-dealers stayed near historically low levels, but limited capacity or willingness of broker-dealers to interme- diate in Treasury markets during periods of stress remained a concern for liquidity in these mar- kets. Hedge funds continued to operate with somewhat elevated leverage, and their exposures are difficult to monitor due to lags in existing data. Table 3.1 shows the sizes and growth rates of the types of financial institutions discussed in this section. Table 3.1. Size of selected sectors of the financial system, by types of institutions and vehicles Growth, Average annual growth, Total assets Item 2022:Q2–2023:Q2 1997–2023:Q2 (billions of dollars) (percent) (percent) Banks and credit unions 25,865 1.4 6.0 Mutual funds 18,850 6.1 8.2 Insurance companies 12,447 5.4 5.4 Life 9,269 4.7 5.4 Property and casualty 3,178 7.5 5.5 Hedge funds1 9,094 −6.0 8.2 Broker-dealers2 5,471 8.0 4.7 Outstanding (billions of dollars) Securitization 13,441 6.4 5.6 Agency 11,954 7.0 6.0 Non-agency3 1,486 2.2 3.6 Note: The data extend through 2023:Q2 unless otherwise noted. Outstanding amounts are in nominal terms. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period. Life insurance companies’ assets include both gen- eral and separate account assets. 1 Hedge fund data start in 2012:Q4 and are updated through 2022:Q4. Growth rates for the hedge fund data are measured from Q4 of the year immediately preceding the period through Q4 of the final year of the period. 2 Broker-dealer assets are calculated as unnetted values. 3 Non-agency securitization excludes securitized credit held on balance sheets of banks and finance companies. Source: Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States”; Federal Reserve Board, “Enhanced Financial Accounts of the United States.” 26 Financial Stability Report Bank profitability remained robust amid further declines in the fair value of some assets held on banks’ balance sheets Amid the considerable increase in interest rates over the past year and a half, the overall banking sector remained profitable. Net interest margins, which measure banks’ yield on their interest-earning assets after netting out interest expenses, remained relatively constant in the aggregate, reflecting higher interest income on floating-rate loans coupled with interest expense on many deposits that remained well below market rates (figure 3.1). However, pressures to raise deposit rates to compete with higher-yielding alternatives to bank deposits as well as banks shifting to more expensive alternative sources of funding may continue to affect profit margins for some banks. Figure 3.1. Banks’ average interest rate on interest-earning assets remained significantly above the average expense rate on liabilities Percent 6 Quarterly Average interest rate on interest-earning assets 5 Average interest expense rate on liabilities 4 Q2 3 2 1 0 2015 2017 2019 2021 2023 Source: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Holding Companies. Higher interest rates also substantially affected the fair value of banks’ existing holdings of fixed- rate assets over this period. At the onset of the coronavirus pandemic, when longer-term interest rates were low relative to current levels and banks experienced sizable inflows of deposits, banks invested heavily in fixed-rate long-duration securities—primarily U.S. Treasury securities and agency-guaranteed mortgage-backed securities. As interest rates rose over the past year and a half, the fair value of these securities declined. As of the end of the second quarter of 2023, banks had declines in fair value of $248 billion in available-for-sale (AFS) portfolios and $310 bil- lion in held-to-maturity portfolios (figure 3.2). Policy interventions by the U.S. Department of the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation played a key role in mitigating the stresses in the banking sys- tem that emerged in March. Since then, a number of banks continued to reduce their holdings of securities, but declines in the fair value of bank securities holdings remained large relative to historical norms. Leverage in the Financial Sector 27 Figure 3.2. The fair values of banks’ securities portfolios declined in the second quarter of 2023 as interest rates rose Billions of dollars 300 Quarterly 200 100 Q2 0 −100 −200 −300 Available-for-sale securities −400 Held-to-maturity securities −500 −600 −700 −800 2017 2018 2019 2020 2021 2022 2023 Source: Federal Financial Institutions Examination Council, Call Report Form FFIEC 031, Consolidated Reports of Condition and Income (Call Report); Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Holding Companies. Banks’ risk-based capital increased, but tangible common equity remained below its average over the past decade The common equity Tier 1 (CET1) ratio—a regulatory risk-based measure of bank capital adequacy—increased during the second quarter of the year across all bank categories and stood around the median of its range since the end of the Great Recession (figure 3.3). Global system- ically important banks (G-SIBs) increased their CET1 ratios in the first half of the year as they cut back on stock repurchases. Figure 3.3. Banks’ risk-based capital ratio remained near the median level since the Great Recession Percent of risk-weighted assets 14 Quarterly Q2 12 10 8 G-SIBs 6 Large non–G-SIBs Other BHCs 4 2 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Holding Companies. An alternative measure of bank capital is the ratio of tangible common equity to total tangible assets. The tangible common equity ratio has similarities to the CET1 ratio in that both exclude intangible items such as goodwill from the measurement of capital, but there are also important differences between the two. In contrast with CET1, the tangible common equity ratio does not 28 Financial Stability Report account for the riskiness of assets, but it does include fair value declines on AFS securities for all banks. The tangible common equity ratio edged up across all bank categories in the first half of the year, especially at G-SIBs (figure 3.4). Nonetheless, it remained at a level well below its average over the past decade, partly due to a substantial drop in tangible equity from declines in fair value on Treasury and agency-guaranteed mortgage-backed securities in AFS portfolios. Figure 3.4. The ratio of tangible common equity to tangible assets increased for banks of all categories Percent of tangible assets 12 Quarterly 10 8 Q2 6 G-SIBs 4 Large non–G-SIBs Other BHCs 2 0 1987 1993 1999 2005 2011 2017 2023 Source: For data through 1996, Federal Financial Institutions Examination Council, Call Report Form FFIEC 031, Consolidated Reports of Condition and Income (Call Report). For data from 1997 onward, Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Holding Companies; and Federal Financial Institutions Examination Council, Call Report Form FFIEC 031, Consolidated Reports of Condition and Income (Call Report). On July 27, 2023, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation requested comment on a proposal to increase the strength and resilience of the banking system.6 The proposal would modify large bank capital requirements to better reflect underlying risks and increase the consistency of how banks mea- sure their risks. The changes would implement the final components of the regulatory reforms introduced in response to the Great Recession. Additionally, following the banking turmoil in March 2023, the proposal seeks to further strengthen the banking system by applying a more stringent set of capital requirements to a broader set of banks, specifically those with more than $100 billion in assets. Banks’ vulnerability to future credit losses appeared to be moderate Aggregate credit quality in the nonfinancial sector remained solid, and loan delinquency rates remained low overall. However, the quality of outstanding loans worsened in some sectors, as the delinquency rates for consumer and CRE loans—especially those backed by office 6 See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (2023), “Agencies Request Comment on Proposed Rules to Strengthen Capital Require- ments for Large Banks,” joint press release, July 27, https://www.federalreserve.gov/newsevents/pressreleases/ bcreg20230727a.htm. Leverage in the Financial Sector 29 properties—increased in the first half of 2023. Additionally, borrower leverage for bank commer- cial and industrial (C&I) loans increased over the same period (figure 3.5). Data from the April and July 2023 SLOOS indicated that banks continued to tighten lending standards on C&I and CRE loans in the first half of 2023 amid concerns about the economic outlook and loan perfor- mance (figure 3.6; see also figure 1.16).7 In response to a set of special questions about the level of lending standards, banks reported that, on balance, levels of lending standards were on the tighter end of their historical ranges for all loan categories. Meanwhile, banks reported that demand for most categories of loans continued to weaken. Figure 3.5. Borrower leverage for bank commercial and industrial loans increased Debt as percentage of assets 36 Quarterly 34 32 Q2 30 Non-publicly-traded firms 28 Publicly traded firms 26 24 2013 2015 2017 2019 2021 2023 Source: Federal Reserve Board, Form FR Y-14Q (Schedule H.1), Capital Assessments and Stress Testing. Figure 3.6. Banks reported tightening lending standards in commercial and industrial loans Net percentage of banks reporting 100 Quarterly 80 60 40 Q2 20 0 −20 −40 −60 −80 −100 1998 2003 2008 2013 2018 2023 7 The SLOOS is available on the Federal Reserve Board’s website at https://www.federalreserve.gov/data/sloos.htm. gninethgiT gnisaE Source: Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank Lending Practices; Federal Reserve Board staff calculations. 30 Financial Stability Report Leverage at broker-dealers remained low Broker-dealer leverage ratios remained largely flat over the first half of 2023 at near historically low levels (figure 3.7). Dealers’ equity growth has generally kept up with the growth of their assets, boosted in part by solid trading profits (figures 3.8 and 3.9). Net secured borrowing of primary dealers increased slightly since the May report, consistent with an increase in net securi- ties positions. Primary dealer Treasury market activities, including market making and repurchase agreements, increased during the first half of 2023. Figure 3.7. Leverage at broker-dealers Figure 3.8. Trading profits in June were near remained historically low their average levels since 2018 Ratio of assets to equity Millions of dollars 50 1000 Quarterly Monthly average 900 40 800 700 30 600 June 500 20 400 Q2 300 10 200 100 0 0 1995 1999 2003 2007 2011 2015 2019 2023 2018 2019 2020 2021 2022 2023 Source: Federal Reserve Board, Statistical Source: Federal Reserve Board, Reporting, Release Z.1, “Financial Accounts of the United Recordkeeping, and Disclosure Requirements States.” Associated with Regulation VV (Proprietary Trading and Certain Interests in and Relationships with Covered Funds, 12 C.F.R. pt. 248). Figure 3.9. Equities dropped slightly as a share of trading profits in the most recent data Percent Monthly average Equity Fixed income, rates, and credit Other June 100 80 60 40 20 0 2018 2019 2020 2021 2022 2023 Source: Federal Reserve Board, Reporting, Recordkeeping, and Disclosure Requirements Associated with Regulation VV (Proprietary Trading and Certain Interests in and Relationships with Covered Funds, 12 C.F.R. pt. 248). Leverage in the Financial Sector 31 In the September 2023 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), which covered the period between mid-May 2023 and mid-August 2023, dealers reported that terms under which they facilitated securities and derivatives transactions were largely unchanged for most types of clients.8 Additionally, some dealers continued to report that they had increased the resources and attention they devoted to managing their concentrated credit exposure to other dealers and other financial intermediaries over the past three months. Leverage at life insurers edged up but remained near the middle of its historical range While leverage at property and casualty insurers stayed low relative to historical norms, leverage at life insurers remained near the middle of its historical range and well below its pandemic peak despite increasing slightly, on net, since the previous report (figure 3.10). Life insurers con- Figure 3.10. Leverage at life insurance tinued to allocate a high percentage of assets companies remained near the middle of its historical range to risky instruments, such as leveraged loans, high-yield corporate bonds, privately placed Ratio of assets to equity 15 corporate bonds, and alternative investments. Quarterly Life Property and casualty 12 Moreover, insurance companies are large holders of commercial mortgage-backed 9 Q2 securities (CMBS), and they also have mate- 6 rial exposures to commercial mortgages. A 3 significant correction in commercial property 0 values could lead to credit losses by insur- 2002 2005 2008 2011 2014 2017 2020 2023 ance companies, putting pressure on their Source: Generally accepted accounting principles data from 10-Q and 10-K filings accessed via S&P capital positions. Global, Capital IQ Pro. Leverage at hedge funds continued to be somewhat elevated Comprehensive data collected by the Securities and Exchange Commission (SEC) indicate that measures of leverage averaged across all hedge funds remained above their historical norms in the first quarter of 2023. These somewhat elevated levels hold true for both average on-bal- ance-sheet leverage (blue line in figure 3.11)—which captures financial leverage from secured financing transactions, such as repurchase agreements and margin loans, but does not capture leverage embedded through derivatives—as well as for average gross leverage of hedge funds 8 The SCOOS is available on the Federal Reserve Board’s website at https://www.federalreserve.gov/data/scoos.htm. 32 Financial Stability Report (black line in figure 3.11)—a broader measure that incorporates off-balance-sheet derivatives exposures. Leverage at the largest funds was significantly higher, with the average on-bal- ance-sheet leverage of the top 15 hedge funds by gross asset value rising in the first quarter of 2023 to about 17-to-1 (figure 3.12). These high levels of leverage were facilitated, in part, by low haircuts on Treasury collateral in some markets where many hedge funds obtain short- term financing.9 More recent data from the September 2023 SCOOS suggested that the use of financial leverage by hedge funds remained largely unchanged between mid-May 2023 and mid-August 2023 (figure 3.13). Figure 3.11. Leverage at hedge funds Figure 3.12. Leverage at the largest hedge remained somewhat elevated funds increased Ratio Ratio 10 30 Quarterly Quarterly 9 25 8 Top 15, by GAV 7 16–50, by GAV 20 51+, by GAV 6 15 5 Mean gross leverage Q1 4 10 Mean balance sheet leverage 3 Q1 5 2 1 0 0 2013 2015 2017 2019 2021 2023 2013 2015 2017 2019 2021 2023 Source: Securities and Exchange Commission, Source: Securities and Exchange Commission, Form PF, Reporting Form for Investment Advisers to Form PF, Reporting Form for Investment Advisers to Private Funds and Certain Commodity Pool Operators Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors. and Commodity Trading Advisors. Figure 3.13. Dealers indicated that the use of leverage by hedge funds remained largely unchanged Net percentage 40 Quarterly 20 Q3 0 −20 Hedge funds Trading REITs −40 Insurance companies Mutual funds −60 −80 2013 2015 2017 2019 2021 2023 Source: Federal Reserve Board, Senior Credit Officer Opinion Survey on Dealer Financing Terms. 9 Ayelen Banegas and Phillip Monin (2023), “Hedge Fund Treasury Exposures, Repo, and Margining,” FEDS Notes (Washington: Board of Governors of the Federal Reserve System, September 8), https://doi.org/10.17016/ 2380-7172.3377. Leverage in the Financial Sector 33 Data from the Commodity Futures Trading Commission (CFTC) Traders in Financial Futures report showed that leveraged funds’ short Treasury futures positions increased notably since the beginning of the year. In the past, high levels of short positions in Treasury futures held by leveraged funds coincided with hedge fund activities in Treasury cash-futures basis trades— trades that involve the sale of a Treasury future and the purchase of a Treasury security, funded by repurchase agreement, deliverable into the futures contract—and several indicators suggest that the trade likely gained in popularity recently as well. The data from the CFTC Traders in Financial Futures report suggest that the recent growth of the trade could be, in part, attributed to increased demand from asset managers—including mutual funds, pension funds, and other investor types—for exposure to interest rates in the futures market. Because the basis trade is often highly leveraged, a funding shock or heightened volatility in Treasury markets could force leveraged funds to abruptly unwind their positions at potentially distressed prices. This delever- aging could amplify initial disruptions in Treasury markets, possibly impairing market liquidity and market functioning. However, recent SCOOS surveys suggest that these risks are likely mitigated by tighter financing terms applied to hedge funds by dealer counterparties over the past several quarters. Issuance of non-agency securities by securitization vehicles remained subdued Non-agency securitization issuance—which increases the amount of leverage in the financial system—was relatively subdued after a notable slowdown since 2022 amid weak demand for loans that are used as collateral in securitization deals (figure 3.14).10 Credit spreads on major Figure 3.14. Issuance of non-agency securitized products has slowed significantly since 2022 Billions of dollars (real) 3200 Annual 2800 Other Private-label RMBS 2400 Non-agency CMBS 2000 Auto loan/lease ABS CDOs (including CLOs and ABS CDOs) 1600 1200 800 400 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Green Street, Commercial Mortgage Alert’s CMBS Database and Asset-Backed Alert’s ABS Database; consumer price index, Bureau of Labor Statistics via Haver Analytics. 10 Securitization allows financial institutions to bundle loans or other financial assets and sell claims on the cash flows generated by these assets as tradable securities, much like bonds. By funding assets with debt issued by invest- ment funds known as special purpose entities (SPEs), securitization can add leverage to the financial system, in part because SPEs are generally subject to regulatory regimes, such as risk retention rules, that are less stringent than 34 Financial Stability Report securitized products generally narrowed since the last report but remained relatively wide com- pared with historical norms. Measures of credit performance across securitized products backed by riskier loan collateral indicated signs of credit deterioration. Specifically, loan delinquency rates in below-prime consumer asset-backed securities deals and leveraged loan downgrades in collateralized loan obligations increased. Loan delinquency rates in non-agency CMBS deals remained relatively low, on average, but rose for deals backed by office properties. Bank lending to nonbank financial institutions remained high Bank lending to nonbank financial institutions (NBFIs), which can be informative about the amount of leverage used by NBFIs and shed light on their interconnectedness with the rest of the financial system, resumed growing in the second quarter of 2023 (figure 3.15). The year- over-year growth rate in committed amounts was largely due to loans to special purpose entities and securitization vehicles, which grew about 25 percent at the end of the second quarter of 2023 (figure 3.16). Utilization rates on credit lines to NBFIs remained steady and averaged about 50 percent of total committed amounts. Delinquency rates on banks’ lending to NBFIs have been lower than delinquency rates for the nonfinancial business sector since the data became avail- able in 2013. Because NBFIs rely primarily on their bank credit lines to meet their liquidity needs, loan commitments can experience sudden, correlated drawdowns. These drawdowns could be material relative to banks’ available buffers of high-quality liquid assets (HQLA) and thus could generate liquidity pressures at large banks during times of financial stress. More generally, infor- mation on NBFIs’ alternative funding sources, and the extent to which those sources may be frag- ile, is limited, and this lack of data could mask additional vulnerabilities in the financial sector. Figure 3.15. Bank credit commitments to nonbank financial institutions remained high Billions of dollars 2250 Quarterly Q2 1 2000 1. Financial transactions processing 2 2. Private equity, BDCs, and credit funds 3 1750 4 3. Broker-dealers 6 5 1500 4. Insurance companies 1250 5. REITs 7 1000 6. Open-end investment funds 7. Special purpose entities, CLOs, and ABS 8 750 8. Other financial vehicles 500 9. Real estate lenders and lessors 9 250 10. Consumer lenders, other lenders, and lessors 10 0 2018 2019 2020 2021 2022 2023 Source: Federal Reserve Board, Form FR Y-14Q (Schedule H.1), Capital Assessments and Stress Testing. banks’ regulatory capital requirements. Examples of the resulting securities include collateralized loan obligations (predominantly backed by leveraged loans), asset-backed securities (often backed by credit card and auto debt), CMBS, and residential mortgage-backed securities. Leverage in the Financial Sector 35 Figure 3.16. Aggregate credit commitments to nonbank financial institutions increased over the past year but varied across sectors Percent 40 Committed amounts 30 Utilized amounts 20 10 0 −10 −20 −30 −40 REITs Financial Consumer, Insurance PE, Broker- Open-end SPEs, Real Other Total transactions leasing, companies BDCs, dealers investment CLOs, estate financial processing & other & credit funds & ABS lenders vehicles lenders funds & lessors Source: Federal Reserve Board, Form FR Y-14Q (Schedule H.1), Capital Assessments and Stress Testing. 37 4 Funding Risks The banking industry maintained a high level of liquidity overall, but some banks continued to face funding pressures; meanwhile, structural vulnerabilities persisted in other sectors engaged in liquidity transformation The banking industry overall maintained a high level of liquidity since the May report. Funding risks for most banks remained low, and large banks that are subject to the liquidity coverage ratio (LCR) continued to maintain ample levels of HQLA given the risk of their funding structures. That said, banks that came under stress and experienced large deposit outflows in March continued to face funding pressure. Since March, volatility has abated and deposit outflows have largely stabilized—owing, in part, to actions by the Department of the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation—but these banks nonetheless continued to face challenges navigating changes in depositor behavior, higher funding costs, and reduced market values for investment securities. Prime MMFs and other cash-investment vehicles remained vulnerable to runs and, hence, contrib- uted to the fragility of short-term funding markets. In addition, some cash-management vehicles, including retail prime MMFs, government MMFs, and short-term investment funds, maintained stable net asset values (NAVs) that make them susceptible to sharp increases in interest rates. The market capitalization of the stablecoin sector continued to decline, but the sector remained vulnerable to liquidity risks like those present in other vehicles that attempt to substitute for cash. Some open-end bond mutual funds continued to be susceptible to large redemptions because they must allow shareholders to redeem every day even though the funds hold assets that can face losses and become illiquid amid stress. Life insurers continued to face liquidity risk owing to heavy reliance on nontraditional liabilities in combination with an increasing share of illiquid and risky assets on their balance sheets. Overall, estimated runnable money-like financial liabilities increased 3.4 percent to $20.3 trillion (75 percent of nominal GDP) over the past year. As a share of GDP, runnable liabilities continued their post-pandemic decline but remained above their historical median (table 4.1 and figure 4.1). Most banks maintained high levels of liquid assets and stable funding Aggregate liquidity in the banking system appeared ample even as HQLA measured relative to total assets decreased among most banks over the past year (figure 4.2). These declines in HQLA were driven by reductions in holdings of central bank reserve balances and by declines 38 Financial Stability Report Table 4.1. Size of selected instruments and institutions Growth, Average annual growth, Outstanding/total assets Item 2022:Q2–2023:Q2 1997–2023:Q2 (billions of dollars) (percent) (percent) Total runnable money-like liabilities1 20,384 3.4 4.6 Uninsured deposits 6,659 −15.6 11.5 Domestic money market funds2 5,372 18.7 5.6 Government 4,463 11.4 15.1 Prime 798 88.9 1.1 Tax exempt 112 13.5 −1.7 Repurchase agreements 4,344 22.7 5.2 Commercial paper 1,418 18.0 3.0 Securities lending3 805 .6 7.0 Bond mutual funds 4,403 −3.2 8.1 Note: The data extend through 2023:Q2 unless otherwise noted. Outstanding amounts are in nominal terms. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period. Total runnable money-like liabilities exceed the sum of listed components. Unlisted components of runnable money-like liabilities include variable-rate demand obligations, federal funds, funding-agreement-backed securities, private liquidity funds, offshore money market funds, short-term investment funds, local government investment pools, and stablecoins. 1 Average annual growth is from 2003:Q1 to 2023:Q2. 2 Average annual growth is from 2001:Q1 to 2023:Q2. 3 Average annual growth is from 2000:Q1 to 2023:Q1. Securities lending includes only lending collateralized by cash. Source: Securities and Exchange Commission, Private Funds Statistics; iMoneyNet, Inc., Offshore Money Fund Analyzer; Bloomberg Finance L.P.; Securities Industry and Financial Markets Association: U.S. Municipal Variable-Rate Demand Obligation Update; Risk Management Association, Securities Lending Report; DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation: commercial paper data; Federal Reserve Board staff calculations based on Investment Company Institute data; Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States”; Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income (Call Report); Morningstar, Inc., Morningstar Direct; DeFiLlama. Figure 4.1. Ratios of runnable money-like liabilities to GDP edged down but remained above their historical medians Percent of GDP 120 Quarterly 1. Other 4. Domestic money market funds 2. Securities lending 5. Repurchase agreements 100 3. Commercial paper 6. Uninsured deposits Q2 80 1 2 60 4 3 40 5 20 6 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Securities and Exchange Commission, Private Funds Statistics; iMoneyNet, Inc., Offshore Money Fund Analyzer; Bloomberg Finance L.P.; Securities Industry and Financial Markets Association: U.S. Municipal Variable- Rate Demand Obligation Update; Risk Management Association, Securities Lending Report; DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation: commercial paper data; Federal Reserve Board staff calculations based on Investment Company Institute data; Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States”; Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income (Call Report); gross domestic product, Bureau of Economic Analysis via Haver Analytics; DeFiLlama. Funding Risks 39 Figure 4.2. The amount of high-quality liquid assets held by most banks continued to decrease in the first half of 2023 Percent of assets 32 Quarterly 28 G-SIBs 24 Q2 Large non–G-SIBs 20 Other BHCs 16 12 8 4 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Holding Companies. in the market values of securities as interest rates increased. Aggregate central bank reserve balances held by banks remained above $3 trillion, significantly higher than pre-pandemic levels. And despite the recent declines, U.S. G-SIBs continued to hold more HQLA than required by their LCR—the requirement that ensures banks hold sufficient HQLA to fund estimated cash outflows for 30 days during a hypothetical stress event. Moreover, banks’ reliance on short-term wholesale funding remained low (figure 4.3). Figure 4.3. Banks’ reliance on short-term wholesale funding remained low Percent of assets 40 Quarterly 35 30 25 20 Q2 15 10 5 2002 2005 2008 2011 2014 2017 2020 2023 Source: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Holding Companies. As interest rates increased throughout 2022, higher-paying alternatives to bank deposits became more attractive to businesses and households and, as a result, core deposits began flowing out of the banking sector. The pace of outflows accelerated temporarily in the wake of the March 2023 stresses in the banking system and, within the banking sector, deposits at some midsize banks were moved to the largest banks. Deposit flows have since stabilized across all bank groups and market sentiment has improved, but many of the vulnerabilities that came to light because of the bank stresses persist for a subset of large banks (outside of the G-SIBs) and regional banks. At the same time, some banks also increased their reliance on wholesale funding 40 Financial Stability Report sources, which are typically more expensive and less stable than retail deposits. As competition for deposits intensified, financial markets continued to signal concerns over banks with high lev- els of uninsured deposits, high reliance on wholesale funding, and significant declines in the fair value of securities. The BTFP was created during the acute Figure 4.4. Credit extended by the Bank Term Funding Program stabilized at around phase of the banking stresses and offers $110 billion loans of up to one year to eligible depository Billions of dollars institutions against high-quality securities 200 Weekly 180 at par value, thereby eliminating an institu- Primary credit 160 Bank Term Funding Program 140 tion’s need to quickly sell those securities 120 should depositors suddenly withdraw their 100 80 funding. The facility helped reassure depos- 60 itors that banks can meet their customers’ 40 20 needs and contributed to the stabilization of 0 Feb. Mar. Apr. May June July Aug. Sept. Oct. deposit flows. Since its inception, the amount 22 22 19 17 14 12 9 6 4 of credit extended by the BTFP increased 2023 steadily and has stabilized at around Source: Federal Reserve Board, Statistical Release H.4.1, “Factors Affecting Reserve Balances.” $110 billion (figure 4.4). Structural vulnerabilities remained at some money market funds and other cash-management vehicles In the immediate aftermath of the failures of Silicon Valley Bank and Signature Bank, prime MMFs experienced a jump in redemptions. Although outflows from prime MMFs eased after a few days, the episode illustrated again that these funds remain a prominent vulnerability due to their sus- ceptibility to large redemptions during episodes of financial stress and the significant role they play in short-term funding markets. Since the May report, assets under management (AUM) in prime MMFs offered to the public increased $100 billion, driven mostly by inflows into retail prime funds (figure 4.5). On July 12, 2023, the SEC voted to adopt amendments to rules that govern MMFs.11 The key elements of the reforms make dynamic liquidity fees mandatory for institutional prime and tax- exempt funds, eliminate temporary gates and redemption fees linked to liquid asset levels with the intent of removing incentives for investors to run preemptively, and increase a fund’s daily liquid asset and weekly liquid asset requirements. On net, the reforms represent significant 11 See Securities and Exchange Commission (2023), “SEC Adopts Money Market Fund Reforms and Amendments to Form PF Reporting Requirements for Large Liquidity Fund Advisers,” press release, July 12, https://www.sec.gov/ news/press-release/2023-129. Funding Risks 41 Figure 4.5. Growth in money market funds was concentrated in retail prime funds Billions of dollars (real) 6000 Monthly 1. Government July 5250 2. Tax exempt 3. Retail prime 4500 4. Institutional prime 3750 3000 1 2250 2 1500 3 750 4 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Federal Reserve Board staff calculations based on Investment Company Institute data; consumer price index, Bureau of Labor Statistics via Haver Analytics. progress in making prime and tax-exempt MMFs more resilient, although these funds remain vul- nerable to runs in periods of significant stress. Other cash-management vehicles, including dollar-denominated offshore MMFs and short-term investment funds, also invest in money market instruments, engage in liquidity transformation, and are vulnerable to runs. Since the May report, estimated aggregate AUM of these cash- management vehicles remained around $1.8 trillion. Currently, between $0.6 trillion and $1.5 tril- lion of these vehicles’ AUM are in portfolios like those of U.S. prime MMFs, and large redemp- tions from these vehicles also have the potential to destabilize short-term funding markets.12 Many cash-management vehicles—including retail and government MMFs, offshore MMFs, and short-term investment funds—seek to maintain stable NAVs that are typically rounded to $1.00. When short-term interest rates rise sharply or portfolio assets lose value for other reasons, the market values of these funds may fall below their rounded share prices, which can put the funds under strain, particularly if they also have large redemptions. The market value of many stablecoins declined, and they remain vulnerable to runs The total market capitalization of stablecoins, which are digital assets designed to maintain a stable value relative to a national currency or another reference asset, fell 21 percent since the beginning of 2022 to $130 billion. While not widely used as a cash-management vehicle by institutional and retail investors or for transactions for real economic activity, stablecoins are important for digital asset investors. They remain structurally vulnerable to runs and lack a 12 Cash-management vehicles included in this total are dollar-denominated offshore MMFs, short-term investment funds, private liquidity funds, ultrashort bond mutual funds, and local government investment pools. 42 Financial Stability Report comprehensive prudential regulatory framework. Moreover, stablecoins could scale quickly, partic- ularly if the stablecoin is supported by access to an existing customer base. Bond mutual fund asset holdings stabilized, but they remained exposed to liquidity risks Mutual funds that invest substantially in corporate bonds, municipal bonds, and bank loans may be particularly exposed to liquidity transformation risks, given the relative illiquidity of their assets and the requirement that these funds offer redemptions daily. The total outstanding value of U.S. corporate bonds held by mutual funds remained flat during the first half of 2023 following consecutive years of sharp declines, primarily Figure 4.6. Corporate bonds held by bond reflecting a fall in bond values associated mutual funds stabilized in the first half of 2023 with higher interest rates (figure 4.6). Mutual fund holdings through the second quarter Billions of dollars (real) 2100 of 2023 were approximately 13 percent of Quarterly 1800 all U.S. corporate bonds outstanding. Total 1500 AUM at high-yield bond and bank loan mutual Q2 1200 funds, which primarily hold riskier and less 900 liquid assets, continued declining in recent 600 quarters following sharp decreases in real 300 0 terms during 2022 (figure 4.7). Bond and loan 2003 2007 2011 2015 2019 2023 mutual funds experienced negative returns Source: Federal Reserve Board staff estimates based on Federal Reserve Board, Statistical and notable outflows during most of 2022, Release Z.1, “Financial Accounts of the United but outflows have stabilized in the first half of States”; consumer price index, Bureau of Labor Statistics via Haver Analytics. 2023 (figure 4.8). Figure 4.7. Assets held by bank loan and high-yield mutual funds continued to decrease in 2023 Billions of dollars (real) 600 Monthly 525 Bank loan mutual funds 450 High-yield bond mutual funds 375 Aug. 300 225 150 75 0 2002 2005 2008 2011 2014 2017 2020 2023 Source: Investment Company Institute; consumer price index, Bureau of Labor Statistics via Haver Analytics. Funding Risks 43 Figure 4.8. The outflows that bond and bank loan mutual funds experienced in 2022 have stabilized Billions of dollars 150 Monthly Investment-grade bond mutual funds 100 Bank loan mutual funds High-yield bond mutual funds 50 0 −50 −100 −150 Apr. Aug. Dec. Apr. Aug. Dec. Apr. Aug. Dec. Apr. Aug. Dec. Apr. Aug. Dec. Apr. Aug. Dec. Apr. Aug. 2017 2018 2019 2020 2021 2022 2023 Source: Investment Company Institute. Central counterparties’ initial margin levels and prefunded resources remained high, but liquidity risks remain amid elevated volatility Interest rate volatility rose to elevated levels late last year and stressed some central counterpar- ties (CCPs) that focus on clearing interest rate products. As volatility in rates and other markets retreated from recent highs, CCPs’ margin and prefunded resources fell more slowly.13 Taken together, higher initial margins and elevated levels of prefunded resources relative to anticipated volatility likely lowered credit risk at CCPs because the amount of resources readily available in case of default by one or more clearing members is likely to be generally higher relative to the market risk of cleared portfolios. However, CCPs continue to face potentially substantial liquidity needs in the event of a default during highly volatile stressed markets. Further, additional liquidity risk remains around the concentration of clients at the largest clearing members, which could make transferring client positions to other clearing members challenging if it were ever necessary. Life insurers’ reliance on nontraditional liabilities remained high Over the past decade, the liquidity of life insurers’ assets steadily declined, and the liquidity of their liabilities slowly increased, potentially making it more difficult for life insurers to meet a sudden rise in withdrawals and other claims. As of 2022, the share of illiquid assets held on life insurers’ balance sheets—including CRE loans, less liquid corporate debt, and alternative investments—stood at a historic high (figure 4.9). In addition, they have continued to rely on 13 Prefunded resources represent financial assets, including cash and securities, transferred by the clearing members to the CCP to cover that CCP’s potential credit exposure in case of default by one or more clearing members. These prefunded resources are held as initial margin and prefunded mutualized resources, which builds the resilience of CCPs to the possible default of a clearing member or market participant. 44 Financial Stability Report nontraditional liabilities—including funding-agreement-backed securities, Federal Home Loan Bank advances, and cash received through repurchase agreements and securities lending transactions—which offer some investors the opportunity to withdraw funds on short notice (figure 4.10). Figure 4.9. Life insurers held more risky, illiquid assets on their balance sheets Percent share Billions of dollars 60 3000 1. Other ABS 4. Alternative investments Share of life insurer assets (left scale) 50 2. CRE loans 5. Illiquid corporate debt Share of P&C insurer assets (left scale) 2500 3. CRE loans, securitized 6. Illiquid corporate debt, 40 securitized 2000 30 1500 20 1000 10 500 0 0 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: Consumer price index, Bureau of Labor Statistics via Haver Analytics; staff estimates based on data from Bloomberg Finance L.P. and National Association of Insurance Commissioners Annual Statutory Filings. Figure 4.10. Life insurers continued to rely on nontraditional liabilities Billions of dollars (real) 550 Repurchase agreements 500 Securities lending cash collateral 450 FHLB advances Q2 400 Funding-agreement-backed securities 350 300 250 200 150 100 50 0 2007 2009 2011 2013 2015 2017 2019 2021 2023 Source: Consumer price index, Bureau of Labor Statistics via Haver Analytics; Moody’s Analytics, Inc., CreditView, Asset-Backed Commercial Paper Program Index; Securities and Exchange Commission, Forms 10-Q and 10-K; National Association of Insurance Commissioners, quarterly and annual statutory filings accessed via S&P Global, Capital IQ Pro; Bloomberg Finance L.P. 45 5 Near-Term Risks to the Financial System The Federal Reserve routinely engages in discussions with domestic and international policymak- ers, academics, community groups, and others to gauge the set of risks of greatest concern to these groups. As noted in the box “Survey of Salient Risks to Financial Stability,” in recent out- reach, contacts were particularly focused on the risk of persistent inflationary pressures leading to a more restrictive monetary policy stance, the potential for large losses on CRE and residential real estate, the reemergence of banking-sector stress, and risks associated with market liquid- ity strains and volatility. Respondents were increasingly attentive to risks posed from economic weakness in China and high levels of public debt in the U.S. and other advanced economies. Heightened geopolitical tensions continue to pose important risks to global economic activity. The following discussion considers possible interactions of existing domestic vulnerabilities with several potential near-term risks, including international risks. The box “Transmission of Stress Abroad to the U.S. Financial System,” featured in the May 2023 Financial Stability Report, dis- cusses some transmission channels through which shocks originating abroad can transmit back to the U.S. financial system.14 A significant slowdown in economic growth could pose risks to the financial system and precipitate strains in commercial real estate If the economy were to slow unexpectedly, profits of nonfinancial businesses would decrease, and, given the generally high level of leverage in that sector, such decreases would likely lead to financial stress and defaults at some firms. Such dynamics may lead to job losses and strains on households, potentially leading to a mild recession. Investor risk appetite and asset prices might decline, and valuations in the office building sector appear particularly vulnerable given the ongo- ing uncertainty surrounding post-pandemic norms regarding return to work. A correction in office property valuations accompanied by even a mild recession could result in significant losses for a range of financial institutions with sizable exposures, including some regional and community banks and insurance companies. Lenders that experience large losses may reduce their willing- ness to supply credit to the broader economy, which would further weigh on economic activity. While stress tests suggest the largest banks are well positioned to withstand a severe recession and contraction in CRE markets, other financial institutions with concentrated exposures could be forced to retrench. 14 See the box “Transmission of Stress Abroad to the U.S. Financial System” in Board of Governors of the Federal Reserve System (2023), Financial Stability Report (Washington: Board of Governors, May), pp. 63–65, https://www. federalreserve.gov/publications/files/financial-stability-report-20230508.pdf. 46 Financial Stability Report Persistent inflation in the U.S. and other advanced economies could pose risks to the global financial system Energy prices have increased notably in recent months, leading to renewed cost pressures that businesses might pass on to their customers. Unexpected persistence in inflation from any source could prompt upward revisions to the path of policy rates. A sharp increase in rates could lead to heightened volatility in financial markets, stresses to market liquidity, and an adjustment in asset prices. In the U.S., higher rates and lower real incomes would strain the balance sheets of some households and businesses and, in conjunction with other adverse shocks, could lead to a significant economic slowdown. Collectively, these factors could lead to pronounced losses among financial intermediaries and a consequent reduction in the supply of credit. High interest rates in foreign economies, particularly if they persist, could negatively affect the debt servicing capacity of households, businesses, and governments abroad. This stress could spill over to the U.S. through strains in dollar funding markets, rapid rebalancing of portfolios, and diminished credit provisions by foreign lenders to U.S. entities. A further slowdown in Chinese growth could worsen financial stresses in China and strain markets worldwide In China, a further slowdown in economic growth could increase distress among borrowers and worsen financial stresses. Many Chinese firms are struggling to service very high debt burdens, especially in the property sector, and local governments are also facing increasing fiscal strains. Stresses originating from China could spill over to other emerging market economies (EMEs), par- ticularly those that are dependent on trade with China or on credit provided by Chinese entities. The spillovers could result in significant capital outflows from EMEs, where generally heightened debt levels may make these economies more susceptible to external shocks. Given the size of its economy and financial system, financial stresses in China also could strain global markets more broadly through disruptions to economic activity, deterioration of risk sentiment, and possibly a sharp appreciation of the dollar, potentially affecting the U.S. A worsening of global geopolitical tensions could lead to broad adverse spillovers to global markets The attack on Israel, in conjunction with Russia’s ongoing war against Ukraine, has ratcheted up geopolitical tensions. These tensions pose important risks to global economic activity, including the possibility of sustained disruptions to regional trade in food, energy, and other commodities. Escalation of these conflicts or a worsening in other geopolitical tensions could reduce economic activity and boost inflation worldwide, particularly in the event of prolonged disruptions to supply chains and interruptions in production. The global financial system could be affected by a pull- back from risk-taking, declines in asset prices, and losses for exposed businesses and investors, including those in the U.S. Near-Term Risks to the Financial System 4477 Box 5.1. Survey of Salient Risks to Financial Stability As part of its market intelligence gathering, staff from the Federal Reserve Bank of New York solicited views from a wide range of contacts on risks to U.S. fi nancial stability. From August 10 to October 4, the staff surveyed 25 contacts, including professionals at broker-dealers, investment funds, research and advisory fi rms, and academics (fi gure A). Several risks that featured prominently in the survey conducted in the spring remained top-of-mind, including the risk of persistent infl ationary pressures leading to a more restrictive monetary policy stance, the potential for large losses on CRE and resi- dential real estate, and the reemergence of banking-sector stress (fi gure B). Contacts continued to express concern over potential market liquidity strains, with some highlighting risks stemming from rising long-term interest rates. Respondents were increasingly attentive to risks posed from economic weakness in China and high levels of public debt in advanced economies. Although geopolitical ten- sions from both the Russia–Ukraine war and U.S.–China relations featured prominently in the May 2023 report, these risks had slipped out of the top fi ve cited concerns for the current survey, which closed before the attack on Israel. This discussion summarizes the most cited risks from this round of outreach. Persistent inflation and monetary tightening Contacts continued to highlight the risk of persistent or reaccelerating infl ationary pressures, partic- ularly in the U.S. amid a more resilient economic outlook, that could lead to further monetary policy tightening and volatile market conditions. Some contacts worried that persistent elevated infl ation might entrench expectations of higher infl ation, which could lead to higher realized infl ation and require an even more restrictive monetary policy stance that could either induce or exacerbate a recession. Commercial real estate Many contacts saw real estate as a potential trigger for systemic stress, most notably in the com- mercial sector, where concerns over higher interest rates, declining property prices, and structural shifts in demand for offi ce space may prompt large realized losses. Survey respondents viewed small and regional domestic banks as particularly vulnerable due to their higher concentration of CRE expo- sures, which could lead to tighter bank lending conditions. Reemergence of banking-sector stress Although survey respondents noted the banking sector has stabilized since the period of acute stress earlier this year, many highlighted risks of renewed deposit outfl ows given that large portions of deposits remain uninsured. Many respondents continued to link risks of reemerging banking-sector stress to potential losses on CRE exposures, particularly among smaller and regional banks. Market liquidity strains and volatility Respondents expressed concern over strained liquidity conditions and intermediation capacity in sovereign bond markets during periods of market stress, which could exacerbate volatile trading con- ditions. Contacts noted these factors could weigh on investor sentiment and risky asset prices while also exposing vulnerabilities among highly levered NBFIs, which could be forced to liquidate assets, putting downward pressure on market prices, potentially tightening fi nancial conditions. Weakness in the Chinese economy and financial sector Contacts frequently noted slowing growth in China and highlighted several risks that could emerge from continued economic weakness, including capital fl ight, which could contribute to a stronger U.S. dollar and put downward pressure on Chinese assets and other Asian fi nancial markets. Respondents also cited that weak growth in China, alongside weakness in Europe, increased the likelihood of a global recession, despite economic resilience in the U.S. Increased foreign exchange market volatility and the implementation of capital controls were also cited as risks. (continued) 4488 Financial Stability Report Box 5.1—continued Fiscal debt sustainability Respondents noted possible risks emanating from higher levels of public debt and wider fi scal defi - cits in advanced economies, particularly in the U.S., which could drive Treasury market volatility and strain Treasury market liquidity. Higher long-term interest rates and bond term premia were noted as possible effects of expected increases in sovereign bond issuance. Figure A. Fall 2023: Most cited potential risks over the next 12 to 18 months Persistent inflation; monetary tightening Commercial and residential real estate Banking-sector stress Market liquidity strains and volatility Fiscal debt sustainability China economy/financial sector Under-regulated nonbanks Foreign divestment from U.S. assets Higher long-term rates Leverage buildup Russia–Ukraine war Percentage of respondents 0 10 20 30 40 50 60 70 80 Source: Federal Reserve Bank of New York survey of 25 market contacts from August to October. Figure B. Spring 2023: Most cited potential risks over the next 12 to 18 months Persistent inflation; monetary tightening Banking-sector stress U.S.–China tensions Commercial and residential real estate Russia–Ukraine war Debt limit Market liquidity strains and volatility Under-regulated nonbanks Fiscal debt sustainability Percentage of respondents 0 10 20 30 40 50 60 70 Source: Federal Reserve Bank of New York survey of 25 market contacts from February to April. Near-Term Risks to the Financial System 4499 Box 5.2. An Approach to Assessing Climate-Related Financial Risks The Federal Reserve’s responsibilities with respect to climate change are narrow but important. These responsibilities are tightly linked to its role in promoting the safety and soundness of individ- ual fi nancial institutions as well as the stability of the fi nancial system. Hence, the Federal Reserve, much like many fi nancial market participants, is working to better understand the risks that climate change may pose to individual banking organizations and the fi nancial system. A key area of focus is identifying the appropriate data and tools needed to assess climate-related fi nancial risks that could affect the goals mandated to the Federal Reserve by Congress. These efforts focus on the translation of physical and transition risks associated with climate change into fi nancial risks. To do so, climate data need to be processed into a form that can be merged with fi nancial data. In addition, exposures of fi nancial institutions to those risks need to be assessed, which requires analyses of fi nancial institution disclosures. To go beyond exposures of individual institutions, models or scenarios are used to evaluate the transfer of climate-related risks within the fi nancial system and to assess the signifi cance of climate-related risks to fi nancial stability. Because the effects of climate change are highly uncertain, geographically diffuse, and realized over time, it is important to scrutinize underlying assumptions, consider alternative estimation methodolo- gies, and utilize a wide range of data. Accordingly, a focus of this work is on coordinating with domes- tic and international groups to develop models and to address data gaps in order to improve fi nancial stability risk assessments. Measurement of climate-related fi nancial risks to individual fi nancial institutions and to fi nancial mar- kets requires data and methodologies that may be new to fi nancial institutions, market participants, and regulators. Because other regulators face similar challenges, the Federal Reserve is engaging both with Financial Stability Oversight Council members and with international groups, such as the Financial Stability Board, the Basel Committee on Banking Supervision, the Network of Central Banks and Supervisors for Greening the Financial System, and the International Monetary Fund.1 1 See, for example, Financial Stability Board (2021), FSB Roadmap for Addressing Climate-Related Financial Risks (Basel: FSB, July 7), https://www.fsb.org/wp-content/uploads/P070721-2.pdf. 51 Appendix Figure Notes Figure 1.1. Nominal Treasury yields rose substantially in the third quarter of 2023 The 2-year and 10-year Treasury rates are the monthly average of the constant-maturity yields based on the most actively traded securities. Figure 1.2. An estimate of the nominal Treasury term premium increased but remained relatively low Term premiums are estimated from a 3-factor term structure model using Treasury yields and Blue Chip interest rate forecasts. Figure 1.3. Interest rate volatility remained elevated by historical norms The data begin in April 2005. Implied volatility on the 10-year swap rate, 1 month ahead, is derived from swaptions. Figure 1.4. The price-to-earnings ratio of S&P 500 firms increased to levels further above its historical median The figure shows the aggregate forward price-to-earnings ratio of S&P 500 firms, based on expected earnings for 12 months ahead. Figure 1.5. An estimate of the equity premium fell further below its historical median The data begin in October 1991. The figure shows the difference between the aggregate for- ward earnings-to-price ratio of S&P 500 firms and the expected real Treasury yields, based on expected earnings for 12 months ahead. Expected real Treasury yields are calculated from the 10-year consumer price index inflation forecast, and the smoothed nominal yield curve is esti- mated from off-the-run securities. Figure 1.6. Volatility in equity markets stood slightly above its historical median Realized volatility is computed from an exponentially weighted moving average of 5-minute daily realized variances with 75 percent of the weight distributed over the past 20 business days. Figure 1.7. Corporate bond yields rose above their historical medians The triple-B series reflects the effective yield of the ICE Bank of America Merrill Lynch (BofAML) triple-B U.S. Corporate Index (C0A4), and the high-yield series reflects the effective yield of the ICE BofAML U.S. High Yield Index (H0A0). Figure 1.8. Corporate bond spreads narrowed modestly The triple-B series reflects the option-adjusted spread of the ICE Bank of America Merrill Lynch (BofAML) triple-B U.S. Corporate Index (C0A4), and the high-yield series reflects the option-adjusted spread of the ICE BofAML U.S. High Yield Index (H0A0). 52 Financial Stability Report Figure 1.9. The excess bond premium stayed near its historical mean The excess bond premium (EBP) is a measure of bond market investors’ risk sentiment. It is derived as the residual of a regression that models corporate bond spreads after controlling for expected default losses. By construction, its historical mean is zero. Positive (negative) EBP val- ues indicate that investors’ risk appetite is below (above) its historical mean. Figure 1.10. Spreads on leveraged loans fell modestly The data show secondary-market discounted spreads to maturity. Spreads are the constant spread used to equate discounted loan cash flows to the current market price. B-rated spreads begin in July 1997. The black dashed line represents the data transitioning from monthly to weekly in November 2013. Figure 1.11. Treasury market depth remained below historical norms Market depth is defined as the average top 3 bid and ask quote sizes for on-the-run Treasury securities. Figure 1.12. On-the-run market depth improved in recent months but remained below historical norms The data show the time-weighted average market depth at the best quoted prices to buy and sell, for 2-year and 10-year Treasury notes. OTR is on-the-run. Figure 1.13. A measure of liquidity in equity markets remained below average The data show the depth at the best quoted prices to buy and sell, defined as the ask size plus the bid size divided by 2, for E-mini S&P 500 futures. Figure 1.14. Commercial real estate prices, adjusted for inflation, continued to decline The data are deflated using the consumer price index. Figure 1.15. Income of commercial properties relative to prices continued to grow but remained well below historical norms The data are a 12-month moving average of weighted capitalization rates in the industrial, retail, office, and multifamily sectors, based on national square footage in 2009. Figure 1.16. Banks reported tightening lending standards in commercial real estate loans Banks’ responses are weighted by their commercial real estate loan market shares. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research: March 2001–November 2001, December 2007–June 2009, and February 2020–April 2020. Survey respondents to the Senior Loan Officer Opinion Survey on Bank Lending Practices are asked about the changes over the quarter. Figure 1.17. House prices started increasing again in recent months The data extend through August 2023 for Zillow and CoreLogic and July 2023 for Case-Shiller. Figure Notes 53 Figure 1.18. Model-based measures of house price valuations remained historically high The values for 2023:Q3 are based on monthly data through July 2023. The data for the market-based rents model begin in 2004:Q1. Valuation is measured as the deviation from the long-run relationship between the price-to-rent ratio and the real 10-year Treasury yield. Figure 1.19. House price-to-rent ratios remained elevated across geographic areas The data are seasonally adjusted. Percentiles are based on 19 large metropolitan statistical areas. Figure 1.20. Farmland prices stayed near historical highs The data for the U.S. begin in 1997. Midwest index is a weighted average of Corn Belt and Great Plains states derived from staff calculations. Values are given in real terms. The value for 2023 is based on monthly data through July 2023. Figure 1.21. Farmland prices grew faster than rents The data for the U.S. begin in 1998. Midwest index is a weighted average of Corn Belt and Great Plains states derived from staff calculations. The value for 2023 is based on monthly data through July 2023. Figure 2.1. The total debt of businesses and households relative to GDP declined further The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research: January 1980–July 1980, July 1981–November 1982, July 1990– March 1991, March 2001–November 2001, December 2007–June 2009, and February 2020– April 2020. GDP is gross domestic product. Figure 2.2. Both business and household debt-to-GDP ratios edged down The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research: January 1980–July 1980, July 1981–November 1982, July 1990– March 1991, March 2001–November 2001, December 2007–June 2009, and February 2020– April 2020. GDP is gross domestic product. Figure 2.3. Business debt adjusted for inflation continued to decline Nominal debt growth is seasonally adjusted and is translated into real terms after subtracting the growth rate of the price deflator for the core personal consumption expenditures price index. Figure 2.4. Net issuance of risky debt remained subdued The data begin in 2004:Q2. Institutional leveraged loans generally exclude loan commitments held by banks. The key identifies bars in order from top to bottom (except for some bars with at least one negative value). Figure 2.5. Gross leverage of large businesses remained at high levels by historical standards Gross leverage is an asset-weighted average of the ratio of firms’ book value of total debt to book value of total assets. The 75th percentile is calculated from a sample of the 2,500 largest firms by assets. The dashed sections of the lines in the first quarter of 2019 reflect the structural 54 Financial Stability Report break in the series due to the 2019 compliance deadline for Financial Accounting Standards Board rule Accounting Standards Update 2016-02. The accounting standard requires operating leases, previously considered off-balance-sheet activities, to be included in measures of debt and assets. Figure 2.6. Firms’ ability to service their debt, as measured by the interest coverage ratio, continued to decline from post-pandemic highs The interest coverage ratio is earnings before interest and taxes divided by interest payments. Firms with leverage less than 5 percent and interest payments less than $500,000 are excluded. Figure 2.7. Default rates on leveraged loans inched up from historically low levels The data begin in December 1998. The default rate is calculated as the amount in default over the past 12 months divided by the total outstanding volume at the beginning of the 12-month period. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research: March 2001–November 2001, December 2007– June 2009, and February 2020–April 2020. Figure 2.8. New leveraged loans with debt multiples less than 4 continued to rise Volumes are for large corporations with earnings before interest, taxes, depreciation, and amor- tization greater than $50 million and exclude existing tranches of add-ons and amendments as well as restatements with no new money. The key identifies bars in order from top to bottom. Figure 2.9. Real household debt edged down Subprime are those with an Equifax Risk Score less than 620; near prime are from 620 to 719; prime are greater than 719. Scores are measured contemporaneously. Student loan balances before 2004 are estimated using average growth from 2004 to 2007, by risk score. The data are converted to constant 2023 dollars using the consumer price index. Figure 2.10. A model-based estimate of housing leverage was flat Housing leverage is estimated as the ratio of the average outstanding mortgage loan balance for owner-occupied homes with a mortgage to (1) current home values using the Zillow national house price index and (2) model-implied house prices estimated by a staff model based on rents, interest rates, and a time trend. Figure 2.11. Mortgage delinquency rates remained near historically low levels Loss mitigation includes tradelines that have a narrative code of forbearance, natural disaster, payment deferral (including partial), loan modification (including federal government plans), or loans with no scheduled payment and a nonzero balance. Delinquent includes loans reported to the credit bureau as at least 30 days past due. Figure 2.13. New mortgage extensions to nonprime borrowers were subdued Year-over-year change in balances for the second quarter of each year among those households whose balance increased over this window. Subprime are those with an Equifax Risk Score less than 620; near prime are from 620 to 719; prime are greater than 719. Scores were measured Figure Notes 55 1 year ago. The data are converted to constant 2023 dollars using the consumer price index. The key identifies bars in order from left to right. Figure 2.14. Real consumer credit edged down in the first half of 2023 The data are converted to constant 2023 dollars using the consumer price index. Student loan data begin in 2005. Figure 2.15. Real auto loans outstanding ticked up for prime borrowers Subprime are those with an Equifax Risk Score less than 620; near prime are from 620 to 719; prime are greater than 719. Scores are measured contemporaneously. The data are converted to constant 2023 dollars using the consumer price index. Figure 2.16. Auto loan delinquencies remained at levels above their historical median Loss mitigation includes tradelines that have a narrative code of forbearance, natural disaster, payment deferral (including partial), loan modification (including federal government plans), or loans with no scheduled payment and a nonzero balance. Delinquent includes loans reported to the credit bureau as at least 30 days past due. The data for auto loans are reported semiannually by the Risk Assessment, Data Analysis, and Research Data Warehouse until 2017, after which they are reported quarterly. The data for delinquent/loss mitigation begin in the first quarter of 2001. Figure 2.17. Real credit card balances rose in the first half of 2023 Subprime are those with an Equifax Risk Score less than 620; near prime are from 620 to 719; prime are greater than 719. Scores are measured contemporaneously. The data are converted to constant 2023 dollars using the consumer price index. Figure 2.18. Credit card delinquencies increased further in the first half of 2023 Delinquency measures the fraction of balances that are at least 30 days past due, excluding severe derogatory loans. The data are seasonally adjusted. Figure 3.1. Banks’ average interest rate on interest-earning assets remained significantly above the average expense rate on liabilities Average interest rate on interest-earning assets is total interest income divided by total interest-earning assets. Average interest expense rate on liabilities is total interest expense divided by total liabilities. The shaded bar with a top cap indicates a period of business recession as defined by the National Bureau of Economic Research: February 2020–April 2020. Figure 3.2. The fair values of banks’ securities portfolios declined in the second quarter of 2023 as interest rates rose The figure plots the difference between the fair and amortized cost values of the securities. The sample consists of all bank holding companies and commercial banks. 56 Financial Stability Report Figure 3.3. Banks’ risk-based capital ratio remained near the median level since the Great Recession The data are seasonally adjusted by Federal Reserve Board staff. The sample consists of domes- tic bank holding companies (BHCs) and intermediate holding companies (IHCs) with a substan- tial U.S. commercial banking presence. G-SIBs are global systemically important banks. Large non–G-SIBs are BHCs and IHCs with greater than $100 billion in total assets that are not G-SIBs. Before 2014:Q1 (advanced-approaches BHCs) or before 2015:Q1 (non-advanced-approaches BHCs), the numerator of the common equity Tier 1 ratio is Tier 1 common capital. Afterward, the numerator is common equity Tier 1 capital. The denominator is risk-weighted assets. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research: March 2001–November 2001, December 2007–June 2009, and February 2020–April 2020. Figure 3.4. The ratio of tangible common equity to tangible assets increased for banks of all categories The data are seasonally adjusted by Federal Reserve Board staff. The sample consists of domestic bank holding companies (BHCs), intermediate holding companies (IHCs) with a sub- stantial U.S. commercial banking presence, and commercial banks. G-SIBs are global system- ically important banks. Large non–G-SIBs are BHCs and IHCs with greater than $100 billion in total assets that are not G-SIBs. Bank equity is total equity capital net of preferred equity and intangible assets. Bank assets are total assets net of intangible assets. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research: July 1990–March 1991, March 2001–November 2001, December 2007–June 2009, and February 2020–April 2020. Figure 3.5. Borrower leverage for bank commercial and industrial loans increased The figure shows the weighted median leverage of nonfinancial firms that borrow using commer- cial and industrial loans from the 24 banks that have filed in every quarter since 2013:Q1. Lever- age is measured as the ratio of the book value of total debt to the book value of total assets of the borrower, as reported by the lender, and the median is weighted by committed amounts. Figure 3.6. Banks reported tightening lending standards in commercial and industrial loans Banks’ responses are weighted by their commercial and industrial loan market shares. Survey respondents to the Senior Loan Officer Opinion Survey on Bank Lending Practices are asked about the changes over the quarter. Results are shown for loans to large and medium-sized firms. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research: March 2001–November 2001, December 2007–June 2009, and February 2020–April 2020. Figure 3.7. Leverage at broker-dealers remained historically low Leverage is calculated by dividing total assets by equity. Figure Notes 57 Figure 3.8. Trading profits in June were near their average levels since 2018 The sample includes all trading desks of bank holding companies subject to the Volcker rule reporting requirement. Figure 3.9. Equities dropped slightly as a share of trading profits in the most recent data The sample includes all trading desks of bank holding companies subject to the Volcker rule reporting requirement. The “other” category comprises desks trading in municipal securities, foreign exchange, and commodities, as well as any unclassified desks. The key identifies series in order from top to bottom. Figure 3.10. Leverage at life insurance companies remained near the middle of its historical range Ratio is calculated as (total assets – separate account assets)/(total capital – accumulated other comprehensive income) using generally accepted accounting principles. The largest 10 publicly traded life and property and casualty insurers are represented. Figure 3.11. Leverage at hedge funds remained somewhat elevated Means are weighted by net asset value (NAV). On-balance-sheet leverage is the ratio of gross asset value to NAV. Gross leverage is the ratio of gross notional exposure to NAV. Gross notional exposure includes both on-balance-sheet exposures and off-balance-sheet derivative notional exposures. Options are delta adjusted, and interest rate derivatives are reported at 10-year bond equivalent values. The data are reported on a 2-quarter lag beginning in the first quarter of 2013. Figure 3.12. Leverage at the largest hedge funds increased Leverage is measured by gross asset value (GAV) divided by net asset value (NAV). Funds are sorted into cohorts based on GAV. Average leverage is computed as the NAV-weighted mean. Figure 3.13. Dealers indicated that the use of leverage by hedge funds remained largely unchanged Net percentage equals the percentage of institutions that reported increased use of financial leverage over the past 3 months minus the percentage of institutions that reported decreased use of financial leverage over the past 3 months. REIT is real estate investment trust. Figure 3.14. Issuance of non-agency securitized products has slowed significantly since 2022 The data from the first and second quarters of 2023 are annualized to create the 2023 bar. RMBS is residential mortgage-backed securities; CMBS is commercial mortgage-backed secu- rities; CDO is collateralized debt obligation; CLO is collateralized loan obligation. The “other” category consists of other asset-backed securities (ABS) backed by credit card debt, student loans, equipment, floor plans, and miscellaneous receivables; resecuritized real estate mortgage investment conduit (Re-REMIC) RMBS; and Re-REMIC CMBS. The data are converted to constant 2023 dollars using the consumer price index. The key identifies bars in order from top to bottom. Figure 3.15. Bank credit commitments to nonbank financial institutions remained high Committed amounts on credit lines and term loans extended to nonbank financial institutions by a balanced panel of 24 bank holding companies that have filed Form FR Y-14Q in every quarter 58 Financial Stability Report since 2018:Q1. Nonbank financial institutions are identified based on reported North American Industry Classification System (NAICS) codes. In addition to NAICS codes, a name-matching algorithm is applied to identify specific entities such as real estate investment trusts (REITs), spe- cial purpose entities, collateralized loan obligations (CLOs), and asset-backed securities (ABS). BDC is business development company. REITs incorporate both mortgage (trading) REITs and equity REITs. Broker-dealers also include commodity contracts dealers and brokerages and other securities and commodity exchanges. Other financial vehicles include closed-end investment and mutual funds. Figure 3.16. Aggregate credit commitments to nonbank financial institutions increased over the past year but varied across sectors 2023:Q2-over-2022:Q2 growth rates as of the end of the second quarter of 2023. REIT is real estate investment trust; PE is private equity; BDC is business development company; SPE is spe- cial purpose entity; CLO is collateralized loan obligation; ABS is asset-backed securities. The key identifies bars in order from left to right. Figure 4.1. Ratios of runnable money-like liabilities to GDP edged down but remained above their historical medians The black striped area denotes the period from 2008:Q4 to 2012:Q4, when insured deposits increased because of the Transaction Account Guarantee program. The “other” category consists of variable-rate demand obligations (VRDOs), federal funds, funding-agreement-backed securities, private liquidity funds, offshore money market funds, short-term investment funds, local govern- ment investment pools, and stablecoins. Securities lending includes only lending collateralized by cash. GDP is gross domestic product. Values for VRDOs come from Bloomberg beginning in 2019:Q1. See Jack Bao, Josh David, and Song Han (2015), “The Runnables,” FEDS Notes (Washington: Board of Governors of the Federal Reserve System, September 3), https://www. federalreserve.gov/econresdata/notes/feds-notes/2015/the-runnables-20150903.html. Figure 4.2. The amount of high-quality liquid assets held by most banks continued to decrease in the first half of 2023 The sample consists of domestic bank holding companies (BHCs), intermediate holding compa- nies (IHCs) with a substantial U.S. commercial banking presence, and commercial banks. G-SIBs are global systemically important banks. Large non–G-SIBs are BHCs and IHCs with greater than $100 billion in total assets that are not G-SIBs. Liquid assets are cash plus estimates of securi- ties that qualify as high-quality liquid assets as defined by the Liquidity Coverage Ratio require- ment. Accordingly, Level 1 assets and discounts and restrictions on Level 2 assets are incorpo- rated into the estimate. Figure 4.3. Banks’ reliance on short-term wholesale funding remained low Short-term wholesale funding is defined as the sum of large time deposits with maturity less than 1 year, federal funds purchased and securities sold under agreements to repurchase, deposits in foreign offices with maturity less than 1 year, trading liabilities (excluding revaluation Figure Notes 59 losses on derivatives), and other borrowed money with maturity less than 1 year. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research: March 2001–November 2001, December 2007–June 2009, and February 2020–April 2020. Figure 4.4. Credit extended by the Bank Term Funding Program stabilized at around $110 billion The key identifies series in order from top to bottom. Figure 4.5. Growth in money market funds was concentrated in retail prime funds The data are converted to constant 2023 dollars using the consumer price index. Figure 4.6. Corporate bonds held by bond mutual funds stabilized in the first half of 2023 The data show holdings of all U.S. corporate bonds by all U.S.-domiciled mutual funds (holdings of foreign bonds are excluded). The data are converted to constant 2023 dollars using the consumer price index. Figure 4.7. Assets held by bank loan and high-yield mutual funds continued to decrease in 2023 The data are converted to constant 2023 dollars using the consumer price index. The key identi- fies series in order from top to bottom. Figure 4.8. The outflows that bond and bank loan mutual funds experienced in 2022 have stabilized Mutual fund assets under management as of August 2023 included $2,211 billion in investment-grade bond mutual funds, $313 billion in high-yield bond mutual funds, and $78 billion in bank loan mutual funds. Bank loan mutual funds, also known as floating-rate bond funds, are excluded from high-yield bond mutual funds. Figure 4.9. Life insurers held more risky, illiquid assets on their balance sheets The data are converted to constant 2022 dollars using the consumer price index. Securitized products include collateralized loan obligations for corporate debt, private-label commercial mortgage-backed securities for commercial real estate (CRE), and private-label residential mortgage-backed securities and asset-backed securities (ABS) backed by autos, credit cards, consumer loans, and student loans for other ABS. Illiquid corporate debt includes private place- ments, bank and syndicated loans, and high-yield bonds. Alternative investments include assets filed under Schedule BA. P&C is property and casualty. The key identifies bars in order from top to bottom. Figure 4.10. Life insurers continued to rely on nontraditional liabilities The data are converted to constant 2023 dollars using the consumer price index. FHLB is Federal Home Loan Bank. The data are annual from 2006 to 2010 and quarterly thereafter. The key iden- tifies bars in order from top to bottom. 60 Financial Stability Report Box 5.1. Survey of Salient Risks to Financial Stability Figure A. Fall 2023: Most cited potential risks over the next 12 to 18 months Responses are to the following question: “Over the next 12–18 months, which shocks, if real- ized, do you think would have the greatest negative effect on the functioning of the U.S. financial system?” Figure B. Spring 2023: Most cited potential risks over the next 12 to 18 months Responses are to the following question: “Over the next 12–18 months, which shocks, if real- ized, do you think would have the greatest negative effect on the functioning of the U.S. financial system?” Find other Federal Reserve Board publications (www.federalreserve.gov/publications/default.htm) or order those offered in print (www.federalreserve.gov/files/orderform.pdf) on our website. Also visit the site for more information about the Board and to learn how to stay connected with us on social media. www.federalreserve.gov 1023

Federal Reserve (2023, October 19). Financial Stability Report. Financial Stability, Federal Reserve. https://whenthefedspeaks.com/doc/financial_stability_report_20231020

@misc{wtfs_financial_stability_report_20231020,
  author = {Federal Reserve},
  title = {Financial Stability Report},
  year = {2023},
  month = {Oct},
  howpublished = {Financial Stability, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/financial_stability_report_20231020},
  note = {Retrieved via When the Fed Speaks corpus}
}