Speech by Governor Cook on financial stability

My own work as an academic has frequently reinforced the importance of financial stability in the United States and abroad. Early in my career, I examined the impact of underdevelopment in the Russian banking system on growth in post-Soviet Russia and the instability that can occur in a poorly regulated financial system. Years later, as an economist on the Council of Economic Advisers, I saw how weaknesses in the financial system contributed to instability in the euro area. These formative experiences shaped my view that the Federal Reserve’s work on financial stability is critical to the well-being of households, businesses, and the broader economy. This is one reason I particularly value the opportunity to serve on the Board’s Committee on Financial Stability.

I will focus my remarks on my assessment of financial stability risks, based on the Federal Reserve’s framework for monitoring vulnerabilities in the financial system. In my view, our financial system is substantially more resilient than it was in the mid-2000s, reflecting progress by regulators and the private sector in boosting resilience. That said, we cannot be complacent, and I see some important risks.

Based on this experience, other historical episodes, and academic research, we focus, in the Board’s FSR and other work, on assessing vulnerabilities across four broad categories related to asset valuations, borrowing by businesses and households, financial-sector leverage, and funding risks. We also consider, through contacts with market participants and experts, near-term risks that, if they were to come to pass, could interact with these vulnerabilities.

This year, asset valuations have generally risen notably above their historical levels. In particular, prices of residential and commercial properties remain above levels historically associated with fundamentals. House prices, relative to rents, are near all-time highs. Further, prices have started increasing again in recent months after falling for more than a year. Commercial property prices also remain high relative to rental income. I am watching closely the extent to which post-pandemic supply and demand patterns normalize. Demand in the office sector has remained weak, particularly in central business districts and coastal cities, with vacancy rates increasing further and rent growth declining. Finally, average delinquency rates for commercial mortgage-backed securities have moved up recently, as office and retail loan performance has deteriorated. If delinquency rates generate selling pressure or increase notably further and result in forced sales of properties, then CRE prices could decline sharply.

Another notable market development has been the significant increase in longer-term bond yields since June. Decompositions between changes in expected rates and term premiums depend on the specific models and assumptions used, but I would say that an expectation of higher near-term policy rates does not appear to be causing the increase in longer-term rates.

Business and Household Borrowings

Valuation pressures are especially concerning if they are associated with excessive borrowing. If households or businesses borrow too much, they may be unable to service debt or could find themselves underwater if assets decline in value. Such stresses can propagate through the financial system, causing funding shortages that curtail credit and hamper economic activity. Of course, it’s very difficult to tell in real time whether households and businesses are, in fact, borrowing “too much,” so we rely on a range of benchmarks.

Currently, business debt is at historically high levels relative to such benchmarks as gross domestic product (GDP) or business assets, although those ratios are significantly lower than the record highs reached at the onset of the pandemic. However, measures of the ability of firms to service their debt remain strong overall, supported by resilient corporate profits and limited effects to date from higher interest rates. The pass-through of higher interest rates into debt-servicing costs appears to be muted by the large share of long-term, fixed-rate liabilities. However, I note that for risky borrowers or those with high-yield or unrated debt, the 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.

The household sector, taken as a whole, looks quite resilient. Household debt, including home mortgages, auto and student loans, and credit cards, remains at modest levels relative to GDP, and most of that debt is owed by households with strong credit histories or considerable home equity. Of course, we are seeing emerging signs of stress for households with lower credit scores, and individual borrowers may struggle with debt burdens in the face of economic hardships.

Financial-Sector Leverage

Now to financial-sector leverage. As I mentioned earlier, we pay careful attention to our financial system’s ability to support the activities of businesses and households. When financial institutions are overly indebted, adverse shocks can cause them to retrench more than they otherwise would, resulting in greater declines in economic activity. In extreme circumstances, such effects can lead to credit crunches and widespread economic dislocations. Similarly, some institutions may be forced to rapidly deleverage, stressing markets and forcing other institutions to also pull back.

The United States has a large and vibrant financial system, so it is important to assess leverage across the broad array of nonbanks and banks of all sizes that provide credit to our economy. Starting with banks: The banking sector remains sound and resilient overall. Most banks continue to report solid capital levels well above regulatory requirements.

The rise in interest rates over the past two years has contributed to robust bank profitability, as banks earned higher interest income on floating-rate loans while interest expense on many deposits remained well below market rates. At the same time, higher long-term interest rates also substantially affected the fair value of banks’ holdings of fixed-rate assets. As we saw earlier this year, fair value losses on bank balance sheets, when combined with poor liquidity and interest rate risk management, can leave banks exposed to additional risk. While acute stresses have abated, I continue to monitor this situation closely.

Some nonbanks can be quite leveraged. For example, available data suggest that hedge fund leverage remains elevated, especially for the largest hedge funds. It is important to better understand how their leveraged activities could impact the functioning of underlying markets.

Funding Risks

Looking at funding, many financial institutions raise funds from the public with a commitment to return their 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 strains across markets or institutions, particularly in the absence of a lender of last resort such as the Fed’s discount window for commercial banks.

In the banking industry, the deposit volatility that we saw earlier this year has abated. That said, some banks have had to turn to higher-cost funding sources to make up for lost deposits and face reduced market values for investment securities.

Outside of banking, we also monitor a wide range of nonbank financial institutions (NBFIs) such as money market funds, open-end funds, insurers, central counterparties, and digital assets. Many of their activities give rise to a liquidity mismatch that could amplify market stress. They have daily or frequent redemption possibilities on the liability side, while holding less-liquid assets. I think the Securities and Exchange Commission’s recent reform on money market funds and proposal for open-end funds are encouraging steps toward mitigating funding risks arising from nonbanks.