Banking sector
Starting with the banking sector, the events of earlier this year have underscored the strength and resilience of the overall U.S. banking system. The vast majority of U.S. banks are adequately managing their interest rate and credit risk and maintaining prudent capital and liquidity positions.
While the banking sector is expected to experience higher funding costs and some deposit outflows as a result of tighter monetary policy and higher interest rates, these outcomes can create vulnerabilities for some banks. Banks relying on more expensive deposits and that also have large holdings of long-term assets like longer-dated loans or securities with low, fixed rates will likely continue to experience a drag on earnings, especially if interest rates stay higher for longer. Should a bank be forced to sell long-term assets, the realized losses can negatively impact regulatory capital. A rising interest rate environment may also erode the credit quality of bank loan portfolios should economic activity and incomes soften, posing an additional source of risk to bank earnings and capital. It is important to monitor these evolving risks, and if necessary, take action to minimize the possible spillover effects on the wider banking and financial system. In the United States, the Federal Reserve's recent stress test of the largest banks' capital positions featured a scenario with extreme declines in asset valuations and a steep rise in unemployment. All banks subject to this test passed.3
In March of this year, we saw a run on the deposits of Silicon Valley Bank and other related banking sector stresses which highlighted banking system vulnerability to an erosion of confidence. This erosion of confidence—even when it starts at a single institution with its own unique and isolated issues—can pose risks to a larger set of institutions based on, among other things, similarities in size, business model, or customer base. As we have seen in the past, an erosion of confidence can lead to sudden large deposit outflows. Today, social media and technology can accelerate the spread of fear among depositors and bank investors, exacerbating contagion risk.
Commercial real estate
Another concern relates to the potential decline in commercial real estate (CRE) property values and a resulting degradation of CRE loan quality in certain markets. Low return-to-office rates and a current trend toward businesses opting to reduce office footprints may lead to higher vacancy rates, which may put downward pressure on property values, especially in certain localities and sectors, including city centers and retail properties. Should the economy slow considerably, CRE loan quality could deteriorate as interest rates stay high or property values soften. Since 2008, underwriting standards and loan-to-value ratios on most U.S. CRE loans have become much more conservative. However, there is still a risk that a decline in property values, reduced rental income cash flows, or other shocks could impair CRE portfolios, especially if those loans mature and are refinanced at higher interest rates.
While many banks are well-positioned to work with their borrowers to restructure loans or to mitigate risks of related losses, some banks with large undiversified and geographically concentrated CRE portfolios may be at greater risk. I am also monitoring the potential financial stability implications of nonperforming CRE loans that are packaged as part of commercial mortgage-backed securities (CMBS). It is much more difficult to restructure a nonperforming loan that is part of a CMBS pool when compared with nonperforming loans held directly by the lender. Pooled CMBS investments are often held in significant volumes or in concentrated shares by institutions that include large insurance companies and pension plans. Were these institutions to suffer significant losses on their CMBS holdings, there could be broader effects on the securitization pipeline for CMBS and on the CRE market.
Nonbank financial institutions
I am also closely watching other financial stability vulnerabilities posed by large nonbank financial institutions. Hedge fund leverage remains elevated and prime money market funds, insurance companies, and some corporate bond mutual funds remain vulnerable to run risks. In addition to this risk, it is also important to monitor the interest rate and funding vulnerabilities of these entities in the current macroeconomic and interest rate environment. These are not novel vulnerabilities, however, as the nonbank financial institution sector continues to expand, monitoring these risks has become especially important.
U.S. Treasury markets
U.S. Treasury market stress events—including the repo-market stress in September 2019 and the March 2020 dash for cash—have raised concerns about the resiliency of U.S. Treasury markets. Last year's government securities market stress in the United Kingdom also highlighted how disruptions in the functioning of these markets can disrupt central bank plans including the path of balance sheet reduction, even if temporarily. Indicators of U.S. Treasury market liquidity have remained stable, and Treasury markets have continued to function, but risks remain.4 It will be important to watch for signs of impaired Treasury market functioning, especially as the Federal Reserve continues to reduce its holdings of Treasury securities and Treasury auction volumes expand to meet issuance needs.
Designing and Calibrating Policies to Promote Financial Stability
As a general principle, central banks and other regulatory authorities may choose to proactively use supervisory and regulatory tools to mitigate financial stability risks and vulnerabilities. Should financial stability risks be realized, it may become necessary to implement central bank and other targeted emergency liquidity or lending facilities. A central bank's implementation of monetary policy may influence the financial stability risks that are most salient. In many jurisdictions, including the United States, financial stability tools separate and distinct from monetary policy tools may be most effective to mitigate and address financial stability risks. The separation of these tools can allow monetary policy decisionmaking to remain focused on achieving central bank monetary policy goals.5
That said, not all of the financial stability risks and vulnerabilities that I have highlighted require policy changes. In fact, it is possible that an overreaction in adjusting policies in light of recent stresses could worsen conditions rather than ameliorate them.
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