The Federal Reserve warned on Monday that banks’ concerns about slower growth could lead them to make fewer loans, accelerating an economic downturn.
(Bloomberg) — The Federal Reserve warned on Monday that banks’ concerns about slower growth could lead them to make fewer loans, accelerating an economic downturn.
The report from the US central bank on financial stability is the first since four regional lenders collapsed. The episodes prompted weeks of wild trading in bank stocks and forced regulators to take a series of extraordinary steps, including to backstop all depositors at Silicon Valley Bank and Signature Bank.
“Concerns about the economic outlook, credit quality, and funding liquidity could lead banks and other financial institutions to further contract the supply of credit to the economy,” the Fed said in its Financial Stability Report. “A sharp contraction in the availability of credit would drive up the cost of funding for businesses and households, potentially resulting in a slowdown in economic activity.”
The report said that bank funding remains relatively stable on the whole, though it highlighted numerous liquidity risks in other corners of the financial markets
“Overall, domestic banks have ample liquidity and limited reliance on short-term wholesale funding,” the report said. “Structural vulnerabilities remained in short-term funding markets. Prime and tax-exempt money market funds, as well as other cash investment vehicles and stablecoins, remained vulnerable to runs.” Life insurers face elevated liquidity risks, as the share of risky and illiquid assets remained high, according to the report.
Rate Hikes
The US central bank has raised interest rates at the fastest pace since the 1980s as it tried to catch up to surging inflation that it was slow to forecast and respond to. In the middle of last year, the Fed accelerated rate hikes with a string of four 75-basis-point moves. The overnight lending rate stands at 5% to 5.25%, following a quarter-point increase last week.
The jump in rates has stung the banks with losses in their bond portfolios, creating fragility in the banking system. Silicon Valley Bank, which was directly supervised by the Fed, failed March 10 after a deposit run.
The Fed said in a lengthy review of the collapse that the bank failed its own liquidity stress tests, while its examiners didn’t recognize the risk of “critical deficiencies in the firm’s governance, liquidity, and interest rate risk management.”
The central bank’s report also raised issues with bank’s exposures to the commercial real estate market. “Importantly, some banks may have more concentrated exposures to CRE mortgages than average and therefore may experience higher-than-average losses should CRE conditions weaken,” the report said. The Fed said it had increased its monitoring of the issue.
Risk Areas
The report’s framework focuses on four areas of risk, such as asset valuations and funding risk.
Asset Valuations: Property valuations remained elevated. “In residential real estate, valuations remained near all-time highs despite weakening activity and falling prices in recent months,” the report said. “Valuations in the commercial segment also remained near historical highs even though price declines have been widespread.”
Borrowings by businesses and households: Business debt stayed at high levels. Still, interest coverage ratios were high, supported by earnings growth. The report said an economic downturn could weaken debt-servicing capacity at firms. Household debt levels were modest.
Leverage within the financial sector: The Fed said the largest banks have adequate capital. “Notwithstanding the banking stress in March, high levels of capital and moderate interest rate risk exposures mean that a large majority of banks are resilient to potential strains from higher interest,” the report said.
Funding risks: The Fed said that in 2020 and 2021, banks added nearly $2.3 trillion in securities to their balance sheets, primarily fixed-rate US Treasury securities and agency-guaranteed mortgage-backed securities, most of which were placed in their available-for-sale and held-to-maturity securities portfolios. But as rising interest rates began to result in lower bond prices, banks had declines in fair value of $277 billion in AFS portfolios and $341 billion in HTM portfolios, the report said.
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