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From Banking and Finance Law Daily, November 28, 2018

Fed’s first ‘Financial Stability Report’ raises few concerns, Powell says

By Richard A. Roth, J.D.

The Federal Reserve Board’s first "Financial Stability Report" shows the financial system generally is stable, according to Fed Chairman Jerome H. Powell, but business borrowers’ debt loads and financial institution loan underwriting quality are reasons to worry. In remarks prepared for The Economic Club of New York on Nov. 28, 2018, Powell added that three of the four vulnerabilities the Fed watches for currently do not show a reason for concern.

Powell said that the Fed’s monitoring framework keeps an eye on four potential vulnerabilities:

  1. too much leverage in the financial sector;
  2. funding risk;
  3. excess household and business debt loads; and
  4. asset values higher than "conventional, historically-observed benchmarks" (also known as "bubbles").

Only the third currently is of any concern, Powell said. Companies that already have high leverage and high interest payment burdens have been increasing their borrowing the most. Also, underwriting quality has declined, and leverage multiples have increased. These borrowers could face the biggest problems in an economic downturn, and losses among their investors could make such a downturn worse.

"For now, my view is that such losses are unlikely to pose a threat to the safety and soundness of the institutions at the core of the system and, instead, are likely to fall on investors in vehicles like collateralized loan obligations with stable funding that present little threat of damaging fire sales," Powell then said.

In sum, "overall financial stability vulnerabilities are at a moderate level," according to the Fed chairman.

Powell also said that the Federal Open Market Committee’s policy interest rates are near a neutral level—i.e., near a level that will neither stimulate nor slow economic growth.

Financial Stability Report. The Financial Stability Report describes the framework the Fed will be using to monitor stability risks, Powell said. That framework is the basis for the four vulnerabilities the Fed is watching. However, the report also notes that some risks do not neatly fit into the framework because they are novel or cannot be quantified or measured easily.

In an analysis that corresponds broadly to Powell’s remarks, the report said that:

  • asset valuation pressures are "generally elevated";
  • household borrowing has risen in a way that corresponds to increases in income, but business borrowing is "historically high" and shows signs of deteriorating credit standards;
  • large banks, broker-dealers, and insurance companies all have improved their capital positions since the financial crisis; and
  • financial system funding risks are relatively low because banks are holding more liquid assets and money market mutual funds are less subject to runs.

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