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Financial Stability Report

November 2018

Board

Governors

of the

Fe d e r a l Re s e rv e Sy s t e m

On December 3, 2018, the data in figure 1-8 were corrected to replace unweighted data with
weighted data, as originally noted.
On June 7, 2019, the data in figures 3-8, 4-2, 4-4, 4-5, and 4-6 were corrected to fix a coding
error, and figure 4-5 and associated text were corrected to clarify that investment-grade bond
mutual funds hold other types of assets besides corporate bonds.

Financial Stability Report

November 28, 2018

Board

Governors

of the

Fe d e r a l Re s e rv e Sy s t e m

This and other Federal Reserve Board reports and publications are available
online at www.federalreserve.gov/publications/default.htm.
To order copies of Federal Reserve Board publications
offered in print, see the Board’s Publication Order Form
(www.federalreserve.gov/pubs/orderform.pdf)
or contact:
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Washington, DC 20551
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(e-mail) Publications-BOG@frb.gov

iii

Contents
Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Framework. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1. Asset valuation pressures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2. Borrowing by businesses and households . . . . . . . . . . . . . . . . . . . . . . . . . 17
3. Leverage in the financial sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
4. Funding risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Near-term risks to the financial system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Note: This report generally reflects information that was available as of October 31, 2018.

Purpose
This report summarizes the Federal Reserve Board’s framework for assessing the resilience
of the U.S. financial system and presents the Board’s current assessment. By publishing this
report, the Board intends to promote public understanding and increase transparency and
accountability for the Federal Reserve’s views on this topic.
Promoting financial stability is a key element in meeting the Federal Reserve’s dual mandate
for monetary policy regarding full employment and stable prices. As we saw in the 2007–09
financial crisis, in an unstable financial system, adverse events are more likely to result in
severe financial stress and disrupt the flow of credit, leading to high unemployment and
great financial hardship. Monitoring and assessing financial stability also support the Federal Reserve’s regulatory and supervisory activities, which promote the safety and soundness
of our nation’s banks and other important financial institutions. Information gathered while
monitoring the stability of the financial system helps the Federal Reserve develop its view of
the salient risks to be included in the scenarios of the stress tests and its setting of the countercyclical capital buffer.1
The Board’s Financial Stability Report is similar to those published by other central banks
and complements the annual report of the Financial Stability Oversight Council, which is
chaired by the Secretary of the Treasury and includes the Federal Reserve Board Chairman
and other financial regulators.

More information on the Federal Reserve’s supervisory and regulatory activities is available on the Board’s website; see
the Supervision and Regulation Report (https://www.federalreserve.gov/supervisionreg/supervision-and-regulation-report.
htm) as well as the Supervision and Regulation (https://www.federalreserve.gov/supervisionreg.htm) and Payment Systems
(https://www.federalreserve.gov/paymentsystems.htm) sections of the site. Moreover, additional details about the conduct of
monetary policy may also be found on the Board’s website; see the Monetary Policy Report (https://www.federalreserve.gov/
monetarypolicy/mpr_default.htm) and the Monetary Policy (https://www.federalreserve.gov/monetarypolicy.htm) section of
the site.

Framework
A stable financial system, when hit by adverse events, or “shocks,” continues to meet the
demands of households and businesses for financial services, such as credit provision and
payment services. In contrast, in an unstable system, these same shocks are likely to have
much larger effects, disrupting the flow of credit and leading to declines in employment and
economic activity.
Consistent with this view of financial stability, the Federal Reserve Board’s monitoring
framework distinguishes between shocks to and vulnerabilities of the financial system.
Shocks, such as sudden changes to financial or economic conditions, are typically surprises
and are inherently difficult to predict. Vulnerabilities tend to build up over time and are the
aspects of the financial system that are most expected to cause widespread problems in times
of stress. As a result, the framework focuses primarily on monitoring vulnerabilities and
emphasizes four broad categories based on research.2
1. Elevated valuation pressures are signaled by asset prices that are high relative to economic
fundamentals or historical norms and are often driven by an increased willingness of
investors to take on risk. As such, elevated valuation pressures imply a greater possibility
of outsized drops in asset prices.
2. Excessive borrowing by businesses and households leaves them vulnerable to distress if
their incomes decline or the assets they own fall in value. In the event of such shocks,
businesses and households with high debt burdens may need to cut back spending
sharply, affecting the overall level of economic activity. Moreover, when businesses and
households cannot make payments on their loans, financial institutions and investors
incur losses.
3. Excessive leverage within the financial sector increases the risk that financial institutions
will not have the ability to absorb even modest losses when hit by adverse shocks. In those
situations, institutions will be forced to cut back lending, sell their assets, or, in extreme
cases, shut down. Such responses can lead to credit crunches in which access to credit for
households and businesses is substantially impaired.
4. Funding risks expose the financial system to the possibility that investors will “run” by
withdrawing their funds from a particular institution or sector. 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 the funds in illiquid assets that
are hard to sell quickly or in assets that have a long maturity. This liquidity and maturity
2

For a review of the research literature in this area and further discussion, see Tobias Adrian, Daniel Covitz, and Nellie Liang
(2015), “Financial Stability Monitoring,” Annual Review of Financial Economics, vol. 7 (December), pp. 357–95.

Framework

transformation can create an incentive for investors to withdraw funds quickly in adverse
situations. Facing a run, financial institutions may need to sell assets quickly at “fire sale”
prices, thereby incurring substantial losses and potentially even becoming insolvent. Historians and economists often refer to widespread investor runs as “financial panics.”
These vulnerabilities often interact with each other. For example, elevated valuation pressures tend to be associated with excessive borrowing by businesses and households because
both borrowers and lenders are more willing to accept higher degrees of risk and leverage
when asset prices are appreciating rapidly. The associated debt and leverage, in turn, make
the risk of outsized declines in asset prices more likely and more damaging. Similarly, the
risk of a run on a financial institution and the consequent fire sales of assets are greatly
amplified when there is significant leverage involved.
It is important to note that liquidity and maturity transformation and lending to households,
businesses, and financial firms are key aspects of how the financial system supports the
economy. For example, banks provide safe, liquid assets to depositors and long-term loans
to households and businesses; businesses rely on loans or bonds to fund investment projects;
and households benefit from a well-functioning mortgage market when buying a home.
The Federal Reserve’s monitoring framework also tracks domestic and international developments 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 play out through the U.S. financial system, given our current
assessment of the four areas of vulnerabilities.
While this framework provides a systematic way to assess financial stability, some potential
risks do not fit neatly into it because they are novel or difficult to quantify. For example,
cybersecurity and developments in crypto-assets are the subject of monitoring and policy
efforts that may be addressed in future discussions of risks.3 In addition, some vulnerabilities are difficult to measure with currently available data, and the set of vulnerabilities may
evolve over time. Given these limitations, we continually rely on ongoing research by the
Federal Reserve staff, academics, 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.

Federal Reserve actions to promote the resilience of the financial system
The assessment of financial vulnerabilities informs Federal Reserve actions to promote the
resilience of the financial system. The Federal Reserve works with other domestic agencies
directly and through the Financial Stability Oversight Council (FSOC) to monitor risks to
3

This report does not currently report a standard set of metrics for determining the cyber resiliency of systems that are
deemed to be critical to maintaining U.S. financial stability. Nonetheless, the Federal Reserve is utilizing the available information and working with the relevant domestic agencies to develop resiliency expectations and measures.

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

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 particular, large bank
holding companies (BHCs), the U.S. operations of certain foreign banking organizations,
and financial market utilities. Specifically, in the post-crisis period, for the largest, most
systemically important BHCs, these actions have included requirements for more and
higher-quality capital, an innovative stress-testing regime, new liquidity regulation, and
improvements in the resolvability of such BHCs.
In addition, the Federal Reserve’s assessment of financial vulnerabilities informs the design
of stress-test scenarios and decisions regarding the countercyclical capital buffer (CCyB).
The stress scenarios incorporate some systematic elements to make the tests more stringent
when financial imbalances are rising, and the assessment of vulnerabilities also helps identify
salient risks that can be included in the scenarios. 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.

Overview
In the years leading up to the 2007–09 financial crisis, many parts of the U.S. financial system grew dangerously overextended. By early 2007, house prices were extremely high, and
relaxed lending standards resulted in excessive mortgage debt. Financial institutions relied
heavily on short-term, uninsured liabilities to fund longer-term, less-liquid investments.
Money market mutual funds and other investment vehicles were highly susceptible to investor runs. Over-the-counter derivatives markets were largely opaque. And banks, especially
the largest banks, had taken on significant risks without maintaining resources sufficient to
absorb potential losses.
As a result of these vulnerabilities, a drop in house prices precipitated a financial panic.
A broad initial retrenchment in asset prices led to sharp withdrawals of short-term funding from a wide range of institutions. These funding pressures resulted in fire sales, which
contributed to additional declines in asset prices and generated further losses and even more
withdrawals of funding. Some financial institutions failed, and many more pulled back on
lending. As home prices continued to fall, and mortgage credit became scarce, millions of
mortgages, many held in complex financial vehicles that increased investor leverage, could
not be refinanced. Many mortgages ultimately went into default, creating devastating and
widespread losses for homeowners.
Reforms undertaken since the financial crisis have made the U.S. financial system far more
resilient than it was before the crisis. Working with other agencies, the Federal Reserve has
taken steps to ensure that financial institutions and markets can support the needs of households and businesses through good times and bad. Banking institutions have built stronger
capital and liquidity buffers that, together with reforms to the rules governing money market
funds, strengthen the ability of institutions to withstand adverse shocks and reduce their susceptibility to destabilizing runs. Recovery and resolution plans have helped ensure that risks
leading to the failure of financial intermediaries are borne by the institutions and investors
taking the risks and not U.S. taxpayers. Reforms to derivatives markets have rendered them
less opaque and have reduced credit exposures between derivatives counterparties.
Despite this important progress, vulnerabilities may build over time. This report examines a
variety of quantitative and qualitative indicators across a range of markets and institutions
to evaluate developments in the four broad areas of potential vulnerabilities described in the
previous section. Our assessment of the current level of vulnerabilities is as follows:
• Valuation pressures are generally elevated, with investors appearing to exhibit a high tolerance for risk-taking, particularly with respect to assets linked to business debt.

oVerVIew

• Borrowing by households has risen roughly in line with household incomes. However,
debt owed by businesses relative to gross domestic product (GDP) is historically high, and
there are signs of deteriorating credit standards.
• The nation’s largest banks are strongly capitalized, and leverage of broker-dealers is substantially below pre-crisis levels. Insurance companies have also strengthened their financial position since the crisis.
• Funding risks in the financial system are low relative to the period leading up to the crisis.
Banks hold more liquid assets, and money market mutual funds are less vulnerable to
destabilizing runs by investors.

1. Asset valuation pressures
Overall, asset valuations and risk appetite are elevated
Asset valuations appear high relative to their historical ranges in several major markets, suggesting that investor appetite for risk is elevated. Spreads on high-yield corporate bonds and
leveraged loans over benchmark rates are near the low ends of their ranges since the financial crisis. Equity price-to-earnings ratios have been trending up since 2012 and are generally
above their median values over the past 30 years despite recent price declines. Commercial
real estate (CRE) prices have been growing faster than rents for several years, and, as a result,
commercial property capitalization rates relative to Treasury securities are near the bottom
of their post-crisis range. While farmland values have fallen in recent years, they remain very
high by historical standards. Residential real estate price-to-rent ratios have generally been
rising since 2012 and are now a bit higher than estimates of their long-run trend.
Table 1 shows the size of the asset classes discussed in this section. The largest asset classes
are those for equities, residential real estate, and CRE.
Table 1. Size of Selected asset markets

Item

outstanding
(billions of dollars)

Growth from
2017:Q2–2018:Q2
(percent)

average annual growth,
1997–2018:Q2
(percent)

equities

33,837

12.3

8.4

residential real estate

33,274

7.0

5.6

Commercial real estate

21,191

8.9

7.1

Treasury securities
Investment-grade
corporate bonds

14,934

6.9

7.5

5,512

3.9

8.5

Cropland
High-yield and unrated
corporate bonds

2,219

2.6

6.3

1,302

–.4

6.3

Leveraged loans*

1,044

12.9

15.1

Commercial real estate**

3.5

4.0

residential real estate***

3.1

2.6

Price growth (real)

Note: The data extend through 2018:Q2. equities, real estate, and cropland are at market value; bonds and loans are at book value.
* 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 2000 to 2018:Q2, as this market was fairly
small before then.
** average annual growth of commercial real estate prices is from 1998 to august 2018, and one-year growth is from august 2017 to
august 2018.
*** average annual growth of residential real estate prices is from 1997 to august 2018, and one-year growth is from august 2017 to
august 2018.
Source: For leveraged loans, S&P Global market Intelligence, Leveraged Commentary & Data; for corporate bonds, mergent, Inc., Corporate
Fixed Income Securities Database; for cropland, Department of agriculture; for residential real estate price growth, CoreLogic; for commercial
real estate price growth, CoStar Group, Inc., CoStar Commercial repeat Sale Indices (CCrSI); for all other items, Federal reserve Board, Statistical release Z.1, “Financial accounts of the United States.”

aSSeT VaLUaTIoN PreSSUreS

In Treasury markets, yields and term premiums are low . . .
While short-term Treasury yields have moved up steadily since the Federal Open Market
Committee (FOMC) began gradually raising its target range at the end of 2015, longer-term
yields have risen more slowly, narrowing the gap between short- and long-term yields
(figure 1-1). Treasury term premiums capture
1-1. Yields on Nominal Treasury Securities
the extra yield investors require for holding
Percent, annual rate
8
longer-term Treasury securities, whose realized
10-year Treasury rate
Monthly
7
2-year Treasury rate
returns are more sensitive to risks from future
6
inflation or volatility in interest rates than
5
4
shorter-term securities. Estimates of term preOct.
3
miums have been low for some time, reflecting
2
in part the low and stable level of U.S. inflation
1
0
over many years (figure 1-2). Forward-looking
1998
2002
2006
2010
2014
2018
measures of Treasury market volatility derived
Note: The 2-year and 10-year Treasury rates are the
from options prices are also low by historical
constant-maturity yields based on the most actively
traded securities.
standards, indicating that it is relatively inexSource: Federal Reserve Board, Statistical Release H.15,
pensive for investors to buy protection against
“Selected Interest Rates.”
changes in Treasury yields (figure 1-3).

1-2. Term Premium on 10-Year Nominal Treasury
Securities
Percentage points
Monthly

2.5
2.0

1-3. Option-Implied Volatility on the 10-Year
Swap Rate
Basis points
Monthly

150

1.5
1.0
Oct.

200

100

0.5

Oct.

0.0

−0.5
1998

2002

2006

2010

2014

2018

Note: Term premiums are estimated from a three-factor
term structure model using Treasury yields and Blue Chip
interest rate forecasts.
Source: Department of the Treasury; Wolters Kluwer, Blue
Chip Financial Forecasts; Federal Reserve Bank of New York;
Federal Reserve Board staff estimates.

0
1998

2002

2006

2010

2014

2018

Note: Implied volatility on the 10-year swap rate 1 year
ahead, derived from swaptions.
Source: Barclays PLC, Barclays Live.

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

. . . and spreads on high-yield corporate bonds and leveraged loans are low even as some
credit risks have grown
1-4. Corporate Bond Yields
Consistent with the low level of interest rates
Percent
overall, corporate bond yields have been low by
18
Monthly
16
historical standards for much of the post-crisis
10-year high-yield
14
period, though they have moved up a bit in
12
recent years as Treasury yields have begun to
10
8
rise (figure 1-4). Spreads on corporate bonds
6
over comparable-maturity Treasury securities
4
10-year triple-B
Oct.
2
reflect the premium investors require to hold
0
debt subject to default or liquidity risks. High1998
2002
2006
2010
2014
2018
yield corporate bond spreads are near the
Note: The 10-year triple-B reflects the effective yield of the
ICE BofAML 7-to-10-year triple-B U.S. Corporate Index
lower end of their historical range (figure 1-5).
(C4A4), and the 10-year high-yield reflects the effective yield
of the ICE BofAML 7-to-10-year U.S. Cash Pay High Yield
Low expected default rates cannot completely
Index (J4A0).
explain the low level of bond spreads; the excess
Source: ICE Data Indices, LLC, used with permission.
bond premium, an estimate of the gap between
bond spreads and expected credit losses, is also near the lower end of its historical distribution (figure 1-6).4

1-6. Corporate Bond Premium over Expected
Losses

1-5. Corporate Bond Spreads to Similar Maturity
Treasury Securities
8
7

Percentage points

Monthly

10-year triple-B
(left scale)

3
1

3
2

8
6

2006

2010

2014

2018

Note: The 10-year triple-B reflects the effective yield of the
ICE BofAML 7-to-10-year triple-B U.S. Corporate Index (C4A4),
and the 10-year high-yield reflects the effective yield of the
ICE BofAML 7-to-10-year U.S. Cash Pay High Yield Index (J4A0).
Treasury yields from smoothed yield curve estimated from
off-the-run securities.
Source: ICE Data Indices, LLC, used with permission;
Department of the Treasury.

0
−1

0
2002

Oct.

4
2

Oct.

1998

Monthly

10-year high-yield
(right scale)

Standard deviations from mean
16

−2
1998

2002

2006

2010

2014

2018

Note: Data are normalized to have a sample mean of zero
and standard deviation of one.
Source: Federal Reserve Board staff calculations based on
Lehman Brothers Fixed Income Database (Warga);
Intercontinental Exchange, Inc., ICE Data Services; Center for
Research in Security Prices, CRSP/Compustat Merged data,
Wharton Research Data Services; S&P Global Market
Intelligence, Compustat.

For a description of the bond risk premium, see Simon Gilchrist and Egon Zakrajšek (2012), “Credit Spreads and Business
Cycle Fluctuations,” American Economic Review, vol. 102 (June), pp. 1692–1720.

aSSeT VaLUaTIoN PreSSUreS

Spreads on newly issued leveraged loans widened a bit over the past few months but remain
in the lower end of their range since the financial crisis (figure 1-7). The still relatively low
level of spreads is notable given evidence that lenders have become more willing to extend
loans with fewer credit protections to higher-risk borrowers. Moody’s Loan Covenant Quality Indicator suggests that loan covenants are at their weakest levels since the index began in
2012, although this may reflect, in part, a greater prevalence of investors who do not traditionally exercise loan covenants. The Federal Reserve’s Senior Loan Officer Opinion Survey
on Bank Lending Practices (SLOOS) indicates that a moderate net fraction of domestic
banks have recently eased lending standards for commercial and industrial loans to middleand large-sized firms (figure 1-8).
1-7. Spreads on Newly Issued Institutional
Leveraged Loans

1-8. Change in Bank Lending Standards for
C&I Loans

Sept.

1998

2002

2006

2010

2014

Monthly

29
26

Oct.
Median

23
20
17
14
11
8
5

2003

2008

2013

2002

2006

2010

2014

2018

Equity prices are somewhat high relative to
forecast earnings
Ratio

1998

100
80
60
40
20
0
−20
−40
−60
−80
−100

Note: Banks’ responses are weighted by their C&I loan market
shares. Results are shown for loans to large and medium-sized
firms. The shaded bars indicate periods of business recession as
defined by the National Bureau of Economic Research. C&I is
commercial and industrial.
Source: Federal Reserve Board, Senior Loan Officer Opinion
Survey on Bank Lending Practices; Federal Reserve Board staff
calculations.

1-9. Forward Price-to-Earnings Ratio of
S&P 500 firms

1993

Quarterly

1998

2018

Note: Breaks in the series represent periods with no
issuance. Spreads are calculated against three-month
LIBor (London interbank offered rate). The spreads do
not include up-front fees.
Source: S&P Global, Leveraged Commentary & Data.

1988

Net percentage of banks reporting
Tightening

monthly
B+/B
BB/BB−

6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0

Easing

Percentage points

2018

Note: Aggregate forward price-to-earnings ratio of S&P
500 firms. Based on expected earnings for 12 months ahead.
Source: Federal Reserve Board staff calculations using
Refinitiv (formerly Thomson Reuters), IBES Estimates.

For several years, broad U.S. equity market
indexes have been moving upward more quickly
than forward-looking corporate earnings
forecasts. Although this trend has reversed this
year, the S&P 500 forward price-to-earnings
ratio remains above its median value over the
past 30 years (figure 1-9). The gap between the
forward earnings-to-price ratio and the 10-year
real Treasury yield, a rough measure of the
premium investors require for holding equities, is near the lower end of its range over the
post-crisis period but still well above the very

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

low levels seen during the dot-com era (figure 1-10). Both realized and option-implied equity
market volatility were low throughout 2017 and much of this year, although both measures
jumped up in February and October (figure 1-11).
1-10. Spread of Forward Earnings-to-Price
Ratio of S&P 500 Firms to 10-Year Real Treasury
Bond Yield
Percentage points

1-11. S&P 500 Return Volatility
Percent
Monthly average

Monthly
Oct.

S&P 500 volatility
index (VIX)
Realized volatility

50
40

Median

Oct.

-2
1988

1993

1998

2003

2008

2013

2018

Note: Aggregate forward earnings-to-price ratio of
S&P 500 firms. Based on expected earnings for 12 months
ahead. Treasury yields from smoothed yield curve estimated
from off-the-run securities.
Source: Federal Reserve Board staff calculations using
Refinitiv (formerly Thomson Reuters), IBES Estimates;
Department of the Treasury.

30
20
10

2
0

0
1998

2002

2006

2010

2014

2018

Note: Realized volatility estimated from five-minute
returns using an exponentially weighted moving average
with 75 percent of the weight distributed over the past
20 days.
Source: Bloomberg Finance LP.

Commercial real estate prices have grown faster than rents for several years, . . .
CRE prices have been about flat this year after having risen substantially over the previous
seven years (figure 1-12). Capitalization rates, which measure annual income relative to prices
for recently transacted properties, have been falling even as Treasury yields have increased
(figure 1-13). As a result, spreads of capitalization rates over yields on 10-year Treasury1-12. Commercial Real Estate Prices (Real)
Jan. 2001 = 100
Monthly
Aug.

1-13. Capitalization Rate at Property Purchase
200
180

Percent
Monthly

160
140
120
100
Sept.

80
60
1998

2002

2006

2010

2014

2018

Note: Series deflated using the consumer price index
for all urban consumers less food and energy and
seasonally adjusted by Board staff.
Source: CoStar Group, Inc., CoStar Commercial
Repeat Sale Indices (CCRSI); Bureau of Labor
Statistics consumer price index via Haver Analytics.

2002

2006

2010

2014

2018

Note: The data are three-month moving averages of
weighted capitalization rates in the industrial, retail, office,
and multifamily sectors, based on national square footage
in 2009.
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.

10.0
9.5
9.0
8.5
8.0
7.5
7.0
6.5
6.0
5.5

aSSeT VaLUaTIoN PreSSUreS

securities are now near post-crisis lows, though well above lows seen before the crisis
(figure 1-14). Returns to CRE property investors thus reflect a relatively low premium
over very safe alternative investments. Data from the SLOOS indicated that CRE lending
standards, which had been tightening in 2016 and 2017, have eased a bit over the past year
(figure 1-15).
1-14. Spread of Capitalization Rate at Property
Purchase to 10-Year Treasury Yield

Sept.

2002

2006

2010

2014

6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0

2018

Tightening

Monthly

Net percentage of banks reporting
Quarterly

Easing

Percentage points

1-15. Change in Bank Standards for CRE Loans

1998

2002

2006

2010

2014

100
80
60
40
20
0
−20
−40
−60
−80
−100

2018

Note: Banks’ responses are weighted by their CRE loan
market shares. The shaded bars indicate periods of business
recession as defined by the National Bureau of Economic
Research. CRE is commercial real estate.
Source: Federal Reserve Board, Senior Loan Officer
Opinion Survey on Bank Lending Practices; Federal Reserve
Board staff calculations.

. . . farmland prices are near historical highs, . . .
Agricultural land values nationally and in several midwestern states are down from their 2016
peak but remain at exceptionally high levels (figure 1-16). And farmland price-to-rent ratios
are at historic highs (figure 1-17). Many farms face possible income losses from retaliatory
tariffs on agricultural commodities and other factors, which may not yet be fully reflected in
available farmland price measures.
1-17. Cropland Price-to-rent ratio

1-16. Cropland Values
2015 dollars per acre
annual

6000

midwest index
United States

2018

ratio

7000

annual

5000

2018

midwest index
United States

3000

median
(1967–2018)

2000
1000
1968

1978

1988

1998

2008

2018

Note: The data for the United States start in 1997.
midwest index is a weighted average of Corn Belt and
Great Plains states. Values are given in real terms.
Source: Department of agriculture.

30
25

4000

median
(1967–2018)

15
10

1968

1978

1988

1998

2008

2018

Note: The data for the United States start in 1998.
midwest index is the weighted average of Corn Belt and
Great Plains states.
Source: Department of agriculture.

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

. . . and home prices have been rising, but less so in recent months
House prices have risen substantially since
1-18. Growth of Nominal Prices of existing Homes
2012, although the rate of price appreciation
Percent change, annual rate
appears to have slowed significantly in recent
20
monthly
Zillow
15
months (figure 1-18). The aggregate house
CoreLogic
10
price-to-rent ratio is currently somewhat higher
Sept.
5
than an estimate of its long-run historical trend
aug.
0
but still well below the extraordinarily high
−5
levels seen in the years just before the financial
−10
crisis (figure 1-19). House price-to-rent ratios
−15
differ significantly across regional markets, and
2012
2014
2016
2018
Source: CoreLogic; Zillow.
in some markets, price-to-rent ratios that experienced large declines during the financial crisis
are once again relatively high (figure 1-20). Measures of house prices relative to household income also suggest somewhat elevated valuation pressures in residential real estate
nationwide.

1-19. Housing Price-to-Rent Ratio
Trend at Aug. 2018 = 100
Monthly

Price-to-rent ratio

Aug.

Long−run trend

1988

1994

2000

2006

2012

150
140
130
120
110
100
90
80
70
60

1-20. Selected Local Housing Price-to-rent
ratio Indexes
Jan. 2010 = 100
monthly

miami
Phoenix
median

Los angeles

aug.

middle 80% of markets

2018

Note: Chart shows the log of the price-to-rent ratio.
Long-run trend is estimated using data from 1978 to 2001,
with the last value of the trend normalized to equal 100.
Source: For house prices, CoreLogic; for rent data,
Bureau of Labor Statistics.

1994

2000

2006

2012

2018

Note: Seasonally adjusted. The data for Phoenix
start in 2002. monthly rent values for Phoenix are
interpolated from semiannual numbers. Percentiles are
based on 25 metropolitan statistical areas.
Source: For house prices, CoreLogic; for rent data,
Bureau of Labor Statistics.

240
220
200
180
160
140
120
100
80
60
40

2. Borrowing by businesses and households
While household borrowing is at a low-to-moderate level relative to incomes,
business-sector debt relative to GDP is historically high and there are signs of
deteriorating credit standards
Overall, vulnerabilities arising from total private-sector credit appear moderate. Among businesses, debt levels are high, and there are signs of deteriorating credit standards. In addition,
recently, debt has been growing fastest at firms with weaker earnings and higher leverage.
By contrast, household borrowing has advanced more slowly than economic activity and is
largely concentrated among low-credit-risk borrowers.
Table 2 shows the current volume and recent and historical growth rates of forms of debt
owed by businesses and households. Over the year ending in the second quarter of 2018,
business credit grew 4.5 percent, and household credit grew 3.5 percent.
Table 2. outstanding amounts of business and household credit

Item

outstanding
(billions of dollars)

Growth from
2017:Q2–2018:Q2
(percent)

average annual growth,
1997–2018:Q2
(percent)

Total private nonfinancial credit

30,103

4.0

5.6

Total business credit

14,783

4.5

5.7

9,425

4.0

5.1

Bonds and commercial paper

6,214

3.2

5.7

Bank lending

1,421

7.2

3.1

Corporate business credit

992

12.9

15.1

Noncorporate business credit

Leveraged loans*

5,358

5.3

7.2

Commercial real estate

2,364

6.7

6.4

15,320

3.5

5.5

Total household credit
mortgages

10,182

2.9

5.7

Consumer credit

3,865

4.6

5.2

Student loans

1,531

5.7

9.7

auto loans

1,129

3.5

5.1

Credit cards
Nominal GDP

999

4.6

3.1

20,412

5.1

4.2

Note: The data extend through 2018:Q2. 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) line shows Cre debt owed by both corporate
and noncorporate businesses. The total household sector credit includes debt owed by other entities, such as nonprofit organizations. GDP is
gross domestic product.
* 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. The average
annual growth rate shown for leveraged loans is computed from 2000 to 2018:Q2, as this market was fairly small before 2000.
Source: For leveraged loans, S&P Global, 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.”

BorrowING BY BUSINeSSeS aND HoUSeHoLDS

Total private credit has advanced roughly in line with economic activity . . .
Borrowing by businesses and households in excess of their ability to pay back that debt has
often led to strains on borrowers and the financial system. However, over the past several
years, total debt owed by businesses and households expanded at a pace similar to that of
nominal GDP. As a result, the ratio of such debt to GDP has been broadly stable at levels
similar to those in mid-2005, before the period of most rapid credit growth from 2006 to
2007 (figure 2-1).5
2-1. Private Nonfinancial-Sector Credit-to-GDP Ratio
Ratio

2.0

Quarterly

1.6
Q2
1.2

0.8
1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

2018

Note: The shaded bars indicate periods of business recession as defined by the National Bureau of Economic
Research. GDP is gross domestic product.
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.”

Figure 2-2 shows the credit-to-GDP ratio disaggregated across two broad categories of
borrowers: households and businesses. (Note that these businesses are nonfinancial; leverage
of financial firms is discussed in the next section.) Before the crisis, household debt relative
2-2. Business- and Household-Sector Credit-to-GDP Ratio
1.1

Ratio

Ratio
Quarterly

1.0

Business (right scale)
Household (left scale)

0.75
0.70

0.9

0.8

0.65
0.60

0.7
0.6

0.55

0.5

0.50

0.4
0.3

0.45
1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

2018

Note: The shaded bars indicate periods of business recession as defined by the National Bureau of Economic Research.
GDP is gross domestic product.
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.”

An often-used alternative measure to assess whether credit is currently high or low by historical standards is the credit-toGDP gap—that is, where the ratio of the level of total debt to GDP is relative to its longer-run statistical trend. Currently,

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

to GDP rose steadily to levels far above historical trends. After the crisis, household debt
contracted sharply and has grown only moderately since then. Business borrowing tends to
track the economic cycle more closely. After the crisis, business debt also contracted but has
expanded significantly over the past several years.

. . . but debt owed by businesses is historically high, and risky debt issuance has picked
up recently
After growing faster than GDP through most of the current expansion, total business-sector
debt relative to GDP stands at a historically high level. However, growth of this debt slowed
markedly in the first half of 2018 (figure 2-3).6
Growth in riskier forms of business debt—high-yield bonds and leveraged loans—which had
slowed to zero in late 2016, rebounded in recent quarters (figure 2-4). The rebound reflected
a decline in high-yield bonds outstanding more than offset by a notable pickup in growth
of nonfinancial leveraged loans outstanding. On net, total risky debt rose about 5 percent
over the year ending in the third quarter of 2018 and now represents over $2 trillion in debt
outstanding.

2-4. Net Issuance of risky Business Debt

2-3. Growth of Real Aggregate Debt of the
Business Sector

Billions of dollars

Percent change, annual rate
Quarterly

Total
Institutional leveraged loans
High-yield and unrated bonds

Quarterly

10
Q2

−20

−5

Note: Nominal debt growth is seasonally adjusted and
is translated into real terms after subtracting the growth
rate of the price deflator for nonfinancial business-sector
output.
Source: Federal Reserve Board, Statistical
Release Z.1, “Financial Accounts of the United States.”

1997 2000 2003 2006 2009 2012 2015 2018

−10

100

−40
2006

2008

2010

2012

2014

2016

Note: Total net issuance of risky debt is the sum of
the net issuance of speculative-grade and unrated
bonds and leveraged loans. The data are four-quarter
moving averages.
Source: mergent, Fixed Investment Securities
Database (FISD); S&P Global, Leveraged Commentary
& Data.

the ratio of total debt to GDP is noticeably below an estimate of its trend, implying a sizable negative gap. However, such
comparisons need to be treated with caution because interpreting long-run trends involves a fair amount of judgment. In
fact, alternative indicators for current credit conditions, such as the three-year cumulative credit growth rate of the credit-toGDP ratio, point to a credit level more in line with current economic activity rather than one lagging behind.
While figure 2-3 is about total business debt, most of the business credit discussion that follows is focused on publicly traded
corporations because more information is available regarding their balance sheets. The debt owed by other types of businesses is predominantly in the form of bank loans rather than market-based sources of credit.

BorrowING BY BUSINeSSeS aND HoUSeHoLDS

Moreover, credit standards for some business loans appear to have deteriorated
further . . .
Credit standards for new leveraged loans appear to have deteriorated over the past six
months. The share of newly issued large loans to corporations with high leverage—defined
as those with ratios of debt to EBITDA (earnings before interest, taxes, depreciation, and
amortization) above 6—has increased in recent quarters and now exceeds previous peak
levels observed in 2007 and 2014 when underwriting quality was notably poor (figure 2-5).
Moreover, there has been a recent rise in “EBITDA add backs,” which add back nonrecurring expenses and future cost savings to historical earnings and could inflate the projected
capacity of the borrowers to repay their loans. However, in part reflecting the strong economy, the credit performance of leveraged loans has so far been solid, with the default rate on
leveraged loans at the low end of its historical range (figure 2-6).
2-6. Default Rates of Leveraged Loans

2-5. Distribution of Large Institutional Leveraged
Loan Volumes, by Debt-to-EBITDA Ratio
Percent
Annual
Debt multiples ≤ 4x
Debt multiples 4x–4.99x

Debt multiples 5x–5.99x
Debt multiples ≥ 6x
Q3

Percent
Monthly

160

140

120

100

Oct.

2006

2010

2014

2018

Note: The data for 2018 are quarterly. Volumes are for large
corporations with earnings before interest, taxes, depreciation,
and amortization (EBITDA) greater than $50 billion and exclude
existing tranches of add-ons and amendments and
restatements with no new money.
Source: S&P Global, Leveraged Commentary & Data.

4
2

−2

0
2002

2000

2003

2006

2009

2012

2015

2018

Note: 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
indicate periods of business recession as defined by the
National Bureau of Economic Research.
Source: S&P Global, Leveraged Commentary & Data.

The credit quality of nonfinancial high-yield corporate bonds has been roughly stable over
the past several years, with the share of high-yield bonds outstanding that are rated “deep
junk” (B3/B- or below) staying flat at about one-third from 2015 to early 2018, below the
financial crisis peak of 45 percent in 2009. In contrast, the distribution of ratings among
investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest
investment-grade level (for example, an S&P rating of triple-B) has reached near-record
levels. As of the second quarter of 2018, around 35 percent of corporate bonds outstanding
were at the lowest end of the investment-grade segment, amounting to about $2¼ trillion. In
an economic downturn, widespread downgrades of these bonds to speculative-grade ratings
could induce some investors to sell them rapidly, because, for example, they face restrictions
on holding bonds with ratings below investment grade. Such sales could increase the liquidity
and price pressures in this segment of the corporate bond market.

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

. . . and leverage of some firms is near its highest level seen over the past two decades
A broad indicator of the leverage of businesses, the ratio of debt to assets for all publicly
traded nonfinancial firms, including speculative-grade and unrated firms, has been roughly
flat since 2016 but remains near its highest level in 20 years (figure 2-7). An analysis of
detailed balance sheet information of these firms indicates that, over the past year, firms with
high leverage, high interest expense ratios, and low earnings and cash holdings have been
increasing their debt loads the most. This development is in contrast to previous years when
primarily high-earning firms with relatively low leverage were taking on the most additional
debt. High leverage has historically been linked to elevated financial distress and retrenchment by businesses in economic downturns. Given the valuation pressures associated with
business debt noted in the previous section, such an increase in financial distress, should it
transpire, could trigger a broad adjustment in prices of business debt. That said, with interest
rates low by historical standards, debt service costs are at the lower ends of their historical
ranges, particularly for risky firms, and corporate credit performance remains generally favorable (figure 2-8).
2-8. Interest Expense Ratio for Public
Nonfinancial Corporations

2-7. Gross Balance Sheet Leverage of Public
Nonfinancial Corporations
Percent
Quarterly

Risky firms

50
45

All firms

Percent
Quarterly

40
Q2

Risky firms

All firms

30
25

25
20
2000

2003

2006

2009

2012

2015

2018

Note: Gross leverage is the ratio of the book value of
total debt to the book value of total assets. The sample
of risky firms is composed of firms with positive
short-term or long-term debt that either have an S&P
firm rating of speculative grade or have no S&P rating.
Source: Federal Reserve Board staff calculations
based on S&P Global, Compustat.

15
10
5

2000

2003

2006

2009

2012

2015

2018

Note: Series calculated as the ratio of total interest
expenses to earnings before interest, depreciation, and
taxes. The sample of risky firms is composed of firms
with positive short-term or long-term debt that either
have an S&P firm rating of speculative grade or have no
S&P rating.
Source: Federal Reserve Board staff calculations
based on S&P Global, Compustat.

Borrowing by households, however, has risen in line with incomes and is concentrated
among low-credit-risk borrowers
Expansion of household debt has been in line with income gains, and, for the past several
years, all of the net increase in total household debt has been among borrowers with prime
credit scores and very low historical delinquency rates. Loan balances for borrowers with a
prime credit score, who account for about one-half of all borrowers and about two-thirds of
all balances, continued to grow in the first half of 2018, reaching their pre-crisis levels (after
an adjustment for general price inflation). In contrast, loan balances for the remaining one-

BorrowING BY BUSINeSSeS aND HoUSeHoLDS

half of borrowers with near-prime and subprime credit scores were essentially unchanged
from 2014 to the middle of 2018 (figure 2-9). These trends are particularly evident in new
mortgage extensions and underscore the marked shift toward less-risky lending and borrowing that is broadly consistent with stronger underwriting standards (figure 2-10).
2-9. Total Household Loan Balances
Billions of dollars (real)
Quarterly

Prime

Near prime
Subprime

9800
9000
8200
7400
6600
5800
5000
4200
3400
2600
1800
1000

2-10. estimate of New mortgage Volume to
Households
Billions of dollars (real)
Subprime
Near prime
Prime

1200
1000
800
600
400
200

2000 2003 2006 2009 2012 2015 2018
Note: Near prime are those with an Equifax Risk
Score 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 2018 dollars using the consumer
price index.
Source: FRBNY Consumer Credit Panel/Equifax;
Bureau of Labor Statistics consumer price index.

1400

2000

2003

2006

2009

2012

2015

2018

Note: Year-over-year change in balances for the
second quarter of each year among those households
whose balance increased over this window. Near prime
are those with an equifax risk Score from 620 to 719;
prime are greater than 719. Scores were measured a
year ago. The data are converted to constant 2018
dollars using the consumer price index.
Source: FrBNY Consumer Credit Panel/equifax;
Bureau of Labor Statistics consumer price index.

Credit risk of outstanding mortgage debt appears to be generally solid . . .
Mortgages represent two-thirds of overall household debt outstanding. An early indicator
of payment difficulties in this segment is the rate at which existing mortgages transition into
2-11. Transition Rates into Mortgage Delinquency delinquency. This transition rate has been very
low for several years among borrowers with
Percent of previously current loans
7
prime and nonprime credit scores and for
Monthly
6
loans in programs offered by the Federal HousNonprime
5
ing Administration and U.S. Department of
4
Veterans Affairs (figure 2-11). Similarly, delin3
Apr.
quency rates for newly originated mortgages,
2
FHA/VA
Aug.
Prime
which give us a sense of recent underwriting
1
Aug.
standards, have also been low. In addition, the
0
2000 2003 2006 2009 2012 2015 2018
ratio of outstanding mortgage debt to home
Note: Percent of previously current mortgages that
values is at the moderate level seen in the relatransition from being current to being at least 30 days
delinquent each month. The data are three-month moving
tively calm housing markets of the late 1990s,
averages. FHA is Federal Housing Administration; VA is
U.S. Department of Veterans Affairs. Prime and nonprime
suggesting that home mortgages are backed
are defined among conventional loans.
by sufficient collateral (figure 2-12).7 Similarly,
Source: For prime and FHA/VA, Black Knight McDash
Data; for nonprime, CoreLogic.

Home values, in this context, are computed both using current market values and using the level of house prices predicted
by a staff model based on rents, interest rates, and a time trend shown in figure 1-19. To the extent that aggressive mortgage

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

the share of outstanding mortgages with negative equity—mortgages where the amount
owed on a property exceeds the value of the underlying home—has continued to trend down
(figure 2-13).

2-13. estimate of mortgages with Negative equity

2-12. estimates of Housing Leverage
1999:Q1 = 100
Quarterly
relative to modelimplied values

Percent

150

Zillow
CoreLogic

140
130

relative to
market value

40
30

120
110
Q2

100

90
80

10
June

70
2000 2003 2006 2009 2012 2015 2018
Note: This measure is estimated as an index of the ratio
of the average outstanding mortgage loan balance for
owner-occupied homes with a mortgage to (1) current
home values using the CoreLogic national house price
index and (2) model-implied house prices estimated by a
staff model based on rents, interest rates, and a time trend.
Source: FrBNY Consumer Credit Panel/equifax;
CoreLogic; Bureau of Labor Statistics.

0
2012

2014

2016

2018

Note: estimated share of mortgages with negative
equity according to CoreLogic and Zillow. For
CoreLogic, the data are monthly. For Zillow, the data
are quarterly and, for 2017, are available only for the
ﬁrst and fourth quarters.
Source: CoreLogic; Zillow.

. . . although some households are struggling with their debt
Student loans, auto loans, and credit card loans 2-14. Consumer Credit Balances
represent the majority of the remaining overall
Billions of dollars (real)
1800
household debt outstanding (figure 2-14). StuQuarterly
1600
Student loans
dent loans are the largest of these, with aggre1400
1200
gate balances of about $1.5 trillion at
Q2
1000
the end of the second quarter of 2018. Over
800
90 percent of these loans are guaranteed by
Credit cards
600
Auto loans
the U.S. Department of Education and were
400
200
extended through programs that did not involve
2000 2003 2006 2009 2012 2015 2018
traditional loan underwriting. Through the first
Note: The data are converted to constant 2018 dollars
using the consumer price index.
half of 2018, student loan delinquency rates
Source: FRBNY Consumer Credit Panel/Equifax;
continued to improve gradually but remain
Bureau of Labor Statistics consumer price index.
elevated by longer-run standards. Growth in
auto loans to borrowers with subprime and near-prime credit scores and growth in credit
card debt owed by borrowers with nonprime credit scores seem to have peaked after having

lending is associated with rapid increases in home prices (as in the early-to-middle 2000s), it is preferable, when assessing
systemic vulnerabilities, to relate mortgage debt to home values that are closer to what would be implied by economic fundamentals instead of market values.

BorrowING BY BUSINeSSeS aND HoUSeHoLDS

been relatively strong for several years (figure 2-15). Responses to the SLOOS suggest that
the leveling off in nonprime credit card borrowing may reflect some tightening of lending
standards. Similarly, payment delinquency rates for subprime credit cards and auto loans,
which were on the rise for the past few years, also seem to be stabilizing, although, in the
latter case, they remain relatively high (figure 2-16). In addition, early payment delinquencies
(delinquencies occurring on relatively new credit accounts) remain high for credit cards and
have continued to rise for auto loans in the first half of 2018, suggesting that underwriting
standards might continue to be looser than usual in these two segments and underscoring the
need for ongoing monitoring of associated vulnerabilities.
2-16. Auto Loan Delinquency Rates

2-15. Auto Loan Balances
Billions of dollars (real)
Quarterly
Q2
Prime
Near prime
Subprime

2000 2003 2006 2009 2012 2015 2018
Note: Near prime are those with an Equifax Risk
Score from 620 to 719; prime are greater than 719.
Scores are measured contemporaneously. The data are
converted to constant 2018 dollars using the consumer
price index.
Source: FRBNY Consumer Credit Panel/Equifax;
Bureau of Labor Statistics consumer price index.

600
550
500
450
400
350
300
250
200
150

Percent
Quarterly
Subprime
Q2
Near prime
Prime

2000

2003

2006

2009

2012

2015

2018

Note: Delinquency is at least 30 days past due,
excluding severe derogatory loans. The data are
four-quarter moving averages. Near prime are those with
an Equifax Risk Score from 620 to 719; prime are greater
than 719. Credit scores are lagged four quarters.
Source: FRBNY Consumer Credit Panel/Equifax.

16
14
12
10
8
6
4
2
0

3. Leverage in the financial sector
Leverage in the financial sector has been low in recent years
Leverage at financial firms is low relative to historical standards, in part because of regulatory reforms enacted since the financial crisis. In particular, regulators require that banks—
especially the largest banks—meet much higher standards in the amount and quality of
capital on their balance sheets and in the ways they assess and manage their financial risks.
A greater amount and a higher quality of capital improve the ability of banks to bear losses
while continuing to lend and support the economy. Capital levels at broker-dealers have
also increased substantially relative to pre-crisis levels, and major insurance companies have
strengthened their financial positions since the crisis. However, some indicators suggest that
hedge fund leverage is at post-crisis highs.
To put into perspective the relative size of the types of financial institutions discussed in this
section, table 3 shows the level and the growth rates, recently and over a longer period, of
their total assets.
Table 3. Size of selected types of financial institutions and vehicles

Item

Total assets
(billions of dollars)

Growth from
2017:Q2–2018:Q2
(percent)

average annual growth,
1997–2018:Q2
(percent)

Banks and credit unions

18,976

2.9

5.8

mutual funds

16,078

8.7

9.9

Insurance companies

10,065

2.5

5.7

Life

7,664

2.1

5.8

Property and casualty

2,401

4.0

5.4

Hedge funds*

7,270

13.5

7.9

Broker-dealers

3,139

–2.4

4.7

10,096

2.6

5.4

agency

8,939

3.4

6.0

Non-agency

1,157

–3.1

3.1

outstanding
(billions of dollars)
Securitization

Note: The data extend through 2018:Q2.
* Hedge fund data start in 2013:Q4 and are updated through 2017:Q4.
Source: Federal reserve Board, Statistical release Z.1, “Financial accounts of the United States”; Federal reserve Board staff calculations
based on Securities and exchange Commission, Form PF, reporting Form for Investment advisers to Private Funds and Certain Commodity
Pool operators and Commodity Trading advisors.

LeVeraGe IN THe FINaNCIaL SeCTor

Banks have strong capital positions . . .
Capital ratios for the larger banks are well above levels seen before the financial crisis
(figures 3-1 and 3-2). Regulatory capital ratios also exceed the fully phased-in enhanced minimum requirements plus regulatory buffers. Banks appear well positioned to maintain capital
through retained earnings as profitability has advanced beyond post-crisis lows on account
of increased net income and lower tax rates. The scenarios used in the supervisory stress tests
routinely feature a severe global recession, steep declines in asset prices, and a substantial
deterioration in business credit quality. The results of the most recent stress test released in
June by the Federal Reserve Board indicate that the nation’s largest banks would be able to
continue to lend to households and businesses even during such a severe scenario.8
3-1. ratio of Tangible Bank equity to assets
Percent of total assets
Quarterly
Q2

12
10
8
6

other BHCs
Large BHCs

4
2
0

1988

1993

1998

2003

2008

2013

2018

Note: Bank equity is total equity capital net of preferred equity and intangible assets, and assets are total assets. The
data are seasonally adjusted by Board staff. Large bank holding companies (BHCs) are those with greater than $50 billion
in total assets. The shaded bars indicate periods of business recession as deﬁned by the National Bureau of economic
research.
Source: Federal Financial Institutions examination Council, Call report Form FFIeC 031, Consolidated reports of
Condition and Income for a Bank with Domestic and Foreign ofﬁces.

3-2. Common equity Tier 1 ratio of Banks
Percent of risk-weighted assets
Quarterly

14
12
10
8
6

other BHCs
Large BHCs

4
2
0

2003

2006

2009

2012

2015

2018

Note: The data are seasonally adjusted by Board staff. Sample includes banks as of 2018:Q2. Before 2014:Q1, the
numerator of the common equity Tier 1 ratio is Tier 1 common capital for advanced-approaches bank holding companies
(BHCs) (before 2015:Q1, for non-advanced-approaches BHCs). afterward, the numerator is common equity Tier 1
capital. Large BHCs are those with greater than $50 billion in total assets. The denominator is risk-weighted assets. The
shaded bars indicate periods of business recession as deﬁned by the National Bureau of economic research.
Source: Federal reserve Board, Form Fr Y-9C, Consolidated Financial Statements for Holding Companies.

See Board of Governors of the Federal Reserve System (2018), “Federal Reserve Board Releases Results of Supervisory
Bank Stress Tests,” press release, June 21, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20180621a.htm.

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

Across the entire banking sector, the credit quality of bank loans appears strong, although
there are some signs of more aggressive risk-taking by banks. For example, lending standards
for commercial and industrial (C&I) loans and mortgages have been easing somewhat in
recent quarters, and the leverage of borrowers who are receiving C&I loans from the largest
banks has been trending up in recent years, reflecting the overall upward trend in business
leverage (figure 3-3).
3-3. Borrower Leverage for Bank C&I Loans
Debt as percent of assets
Quarterly

36
34

32
30
28

Nonpublicly traded firms
Publicly traded firms

26
24

2013

2014

2015

2016

2017

2018

Note: Weighted median leverage of firms (excluding financials) that borrow using commercial and industrial (C&I) loans from the 26 banks
that have filed in e very quarter since 2013:Q1. Leverage 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.
Source: Federal Reserve Board, Form FR Y-14Q (Schedule H.1), Capital Assessments and Stress T esting.

. . . and broker-dealers and insurance companies have strengthened their financial
positions since the crisis . . .
Leverage of broker-dealers has been trending down and is now substantially below precrisis levels (figure 3-4). At property and casualty insurance firms, leverage has also been
falling, while it has been roughly constant over the past decade for life insurance companies
(figure 3-5).

3-4. Leverage of Broker–Dealers

3-5. Leverage of Insurance Companies

Ratio of assets to equity
Quarterly

Life
Property and casualty

30
Q2

Q2
10
0
1998

2002

2006

2010

2014

2018

Note: Leverage is calculated by dividing financial
assets by equity.
Source: Federal Reserve Board, Statistical Release Z.1,
“Financial Accounts of the United States.”

0
2000

2003

2006

2009

2012

2015

2018

Note: The data extend through 2018:Q2. Ratio is
calculated as (total assets − separate account
assets)/(total capital − accumulated other
comprehensive income).
Source: S&P Global, Inc., S&P Market Intelligence.

LeVeraGe IN THe FINaNCIaL SeCTor

. . . even as there are signs of increased borrowing at other nonbank financial firms
Several indicators suggest that hedge fund leverage has been increasing over the past two
years. A comprehensive measure that incorporates margin loans, repurchase agreements
(repos), and derivatives—but is only available with a significant time lag—suggests that
average hedge fund leverage has risen by about one-third over the course of 2016 and 2017
(figure 3-6). Consistent with this indicator, dealers responding to the Federal Reserve’s Senior
Credit Officer Opinion Survey on Dealer
3-6. Gross Leverage of Hedge Funds
Financing Terms, or SCOOS, reported some
ratio
8
increase in the use of leverage by hedge funds,
monthly
7
on average, over the past two years (figure 3-7)
6
mean
as well as some easing in both price terms (for
5
Dec.
example, interest rates and lending fees) and
4
nonprice terms (for example, margins and loan
3
median
maturities) for credit extended to hedge funds.
2
The increased use of leverage by hedge funds
1
2013
2014
2015
2016
2017
exposes their counterparties to risks and raises
Note: Leverage is computed as the ratio of hedge
the possibility that adverse shocks would result
funds’ gross notional exposure to net asset value,
including derivative notional exposure and short positions.
in forced asset sales by hedge funds that could
Data are reported on a three-quarter lag.
exacerbate price declines. That said, hedge
Source: Federal reserve Board staff calculations
based on Securities and exchange Commission, Form PF,
funds do not play the same central role in the
reporting Form for Investment advisers to Private Funds
and Certain Commodity Pool operators and Commodity
financial system as banks or other institutions.
Trading advisors.

3-7. Change in the Use of Financial Leverage
Net percentage
Quarterly

Hedge funds
Trading REITs

Insurance companies
Mutual funds

60
40

20
0
−20
−40
−60
−80

2012

2013

2014

2015

2016

2017

2018

Note: Net percentage equals the percentage of institutions that reported increased use of financial leverage over the past
three months minus the percentage of institutions that reported decreased use of financial leverage over the past three
months. REIT is real estate investment trust.
Source: Federal Reserve Board, Senior Credit Officer Opinion Survey on Dealer Financing Terms.

In a process known as “securitization,” financial institutions bundle loans or other financial
assets together and sell investors claims on the bundle as securities that can be traded much
like a bond. Examples of the resulting securities, or securitized instruments, are collateralized loan obligations (CLOs), asset-backed securities, and commercial and residential
mortgage-backed securities. By funding assets with debt obligations, securitization can add
leverage to the financial system. Issuance volumes of non-agency securitized instruments
(that is, those for which the instrument is not guaranteed by a government-sponsored enterprise or by the federal government) have been rising in recent years but remain well below the
levels seen in the years ahead of the financial crisis (figure 3-8). A type of securitization that
has grown rapidly over the past year is CLOs, which are predominantly backed by leveraged

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

loans. Amid the general deterioration in the underwriting standards on leveraged loans (discussed in the section on business leverage), gross issuance of CLOs hit $71 billion in the first
half of 2018. This pace represents an increase by about one-third compared with the same
period last year, and CLOs now purchase about 60 percent of leveraged loans at origination.
It is important to continue to monitor developments in this sector.
3-8. Issuance of Non-Agency Securitized Products, by Asset Class
Billions of dollars (real)
Annual

Other
Non-agency CMBS
Private-label RMBS
Esoteric ABS
Auto loan/lease ABS
CDOs (incl. ABS, CDO, and CLO)

2800
2400
2000
1600
1200
800
400
0

2002

2004

2006

2008

2010

2012

2014

2016

2018

Note: The data from the first three quarters of 2018 are annualized to create the 2018 bar. Esoteric asset-backed
securities (ABS) are backed by unsecured personal loans, mobile phones, reperforming residential mortgages, aircraft
and shipping container leases, marketplace lending, and franchise payments. CMBS is commercial mortgage-backed
securities; CDO is collateralized debt obligation; RMBS is residential-mortgage-backed securities; CLO is collateralized
loan obligation. The “Other” category consists of subprime mortgages, real estate mortgage investment conduit
(Re-REMIC) RMBS, Re-REMIC CMBS, and ABS backed by credit card debt, student loans, equipment, and floor plans.
The data are converted to constant 2018 dollars using the consumer price index.
Source: Harrison Scott Publications, Asset-Backed Alert (ABAlert.com) and Commercial Mortgage Alert
(CMAlert.com); Bureau of Labor Statistics, consumer price index via Haver Analytics.

Because information on the financial institutions that operate outside of the banking sector
is limited, data on banks’ lending to these institutions can be informative about nonbanks’
use of leverage. Nonbank financial institutions—such as finance companies, asset managers, securitization vehicles, and mortgage real estate investment trusts—have access to about
$1 trillion in committed lines of credit, an increase of about two-thirds over the past five
years (figure 3-9). To date, borrowing institutions have utilized $300 billion of these lines
of credit.
3-9. Large Bank Lending to Nonbank Financial Firms: Committed Amounts
Billions of dollars
Quarterly

Consumer lenders
Real estate lenders
Other lenders
Broker-dealers
Insurance

Open-end investment funds
Financial planning and pension funds
Other financial vehicles

1200
1000
800
600
400
200
0

2013
2014
2015
2016
2017
2018
Note: Committed amounts on credit lines and term loans extended to nonbank financial firms by a balanced panel of
25 bank holding companies that have filed Form FR Y-14Q in every quarter since 2012:Q3. Nonbank financial firms are
identified based on reported NAICS (North American Industry Classification System) codes, excluding other domestic and
foreign banks, monetary authorities, and credit unions. Broker-dealers also include commodity contracts dealing and
brokerages and other securities and commodity exchanges. Other financial vehicles include closed-end investment and
mutual funds, real estate investment trusts, special purpose vehicles, and other vehicles.
Source: Federal Reserve Board, Form FR Y-14Q, Capital Assessments and Stress Testing.

4. Funding risk
Vulnerabilities from liquidity and maturity mismatches are currently low
A measure of the total amount of liabilities that are most vulnerable to runs, including those
issued by nonbanks, is relatively low (top panel of table 4). Banks are holding higher levels
of liquid assets and relying less on funding sources that proved susceptible to runs than in
the period leading up to the crisis, in part because of liquidity regulations introduced after
the financial crisis and banks’ greater understanding of their liquidity risks. Money market
fund reforms implemented in 2016 have reduced “run risk” in that industry.

Table 4. Size of selected instruments and institutions
Growth from
2017:Q2–2018:Q2
(percent)

average annual growth,
1997–2018:Q2
(percent)

Item

outstanding/Total assets
(billions of dollars)

Total runnable money-like liabilities

13,153

3.1

3.5

Uninsured deposits

4,652

2.1

11.9

repurchase agreements

3,190

–1.6

5.3

Domestic money market funds*

2,821

4.2

3.6

Commercial paper

1,052

13.6

2.4

Securities lending

684

4.0

7.5

Bond mutual funds**

3,920

5.1

9.2

Note: The data extend through 2018:Q2, except for bond mutual fund and money market fund data, which extend through 2018:Q3. average
annual growth rates for total runnable money-like liabilities and securities lending are from 2002:Q2 to 2018:Q2. Securities lending includes only
lending collateralized by cash.
* average annual growth is from 2000 to 2018:Q3, and one-year growth is from 2017:Q3 to 2018:Q3.
** average annual growth is from 1997 to 2018:Q3, and one-year growth is from 2017:Q3 to 2018:Q3.
Source: Securities and exchange Commission, Private Funds Statistics; imoneyNet, Inc., offshore money Fund analyzer; Bloomberg Finance
LP; Securities Industry and Financial markets association: U.S. municipal VrDo 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 H.6, “money Stock and Debt measures”
(m3 monetary aggregate); Federal Financial Institutions examination Council, Consolidated reports of Condition and Income (Call report);
Federal reserve Board, Statistical release Z.1, “Financial accounts of the United States”; morningstar, Inc., morningstar Direct; moody’s
analytics, Inc., CreditView, aBCP Program Index.

FUNDING rISk

Banks have high levels of liquid assets and stable funding
Banks have strong liquidity positions. In total, liquid assets in the banking system have
increased more than $3 trillion since the financial crisis. Large banks in particular hold
substantial amounts of liquid assets, far exceeding pre-crisis levels and well above regulatory
requirements (figure 4-1). Bank funding is less susceptible to runs now than in the period
leading up to the financial crisis—further reducing vulnerabilities from liquidity transformation. Core deposits, which include checking accounts, small-denomination time deposits, and
other retail deposits that are typically insured, are near historical highs as a share of banks’
total liabilities. Core deposits have traditionally been a relatively stable source of funds for
banks, in the sense that they have been less prone to runs. In contrast, short-term wholesale
funding, a source of funds that proved unreliable during the crisis, is near historical lows as a
share of banks’ total liabilities (figure 4-2).

4-1. Liquid Assets Held by Banks

4-2. Short-Term Wholesale Funding of Banks

Percent of assets
Quarterly

Large BHCs
Other BHCs

Percent of assets

Quarterly

0
2003

2006

2009

2012

2015

2018

Note: Liquid assets are excess reserves plus
estimates of securities that qualify as high-quality liqui d
assets. Haircuts and Level 2 asset caps are
incorporated into the estimate. Large bank holding
companies (BHCs) are those with greater than $50
billion in total assets.
Source: Federal Reserve Board, Form FR Y-9C,
Consolidated Financial Statements for Holding
Companies; Federal Reserve Board, Form FR 2900,
Report of Transaction Accounts, Other Deposits and
Vault Cash.

15
10

2000

2003

2006

2009

2012

2015

2018

Note: Short-term wholesale funding is defined as the
sum of large time deposits with maturity less than one
year, federal funds purchased and securities sold under
agreements to repurchase, deposits in foreign offices
with maturity less than one year, trading liabilities
(excluding revaluation losses on derivatives), and other
borrowed money with maturity less than one year. The
shaded bars indicate periods of business recession as
defined by the National Bureau of Economic Research.
Source: Federal Reserve Board, Form FR Y-9C,
Consolidated Financial Statements for Holding
Companies.

Run risk in short-term funding markets has declined substantially since the crisis . . .
During the financial crisis, runs occurred in the markets for asset-backed commercial paper,
repos, and money market fund shares, as well as on individual institutions, greatly aggravating the economic harm from the crisis. An aggregate measure of private short-term, wholesale, and uninsured instruments that could be prone to runs—a measure that includes repos,
commercial paper, money funds, uninsured bank deposits, and other forms of short-term
debt—currently stands at $13 trillion, significantly lower than its peak at the start of the
financial crisis (figure 4-3).

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

4-3. runnable money-Like Liabilities as a Share of GDP, by Instrument and Institution
Percent of GDP
Quarterly

Domestic money market funds
repurchase agreements
Uninsured deposits

other
Securities lending
Commercial paper

120
100
80
60
40
20
0

2003

2006

2009

2012

2015

2018

Note: The black striped area denotes the period from 2008:Q4 to 2012:Q4, when insured deposits increased because
of the Transaction account Guarantee Program. “other” consists of variable-rate demand obligations, federal funds,
funding-agreement-backed securities, private liquidity funds, offshore money market funds, and local government
investment pools. Securities lending includes only lending collateralized by cash. GDP is gross domestic product.
Source: Securities and exchange Commission, Private Funds Statistics; imoneyNet, Inc., offshore money Fund
analyzer; Bloomberg Finance LP; Securities Industry and Financial markets association: U.S. municipal VrDo 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 H.6, “money Stock and Debt measures” (m3 monetary
aggregate); Federal Financial Institutions examination Council, Consolidated reports of Condition and Income (Call
report); Federal reserve Board, Statistical release Z.1, “Financial accounts of the United States”; moody‘s analytics,
Inc., CreditView, aBCP Program Index; Bureau of economic analysis, gross domestic product via Haver analytics.

. . . and money market funds are less susceptible to runs
Money market fund (MMF) reforms implemented in 2016 have reduced run risk in the
financial system. MMFs proved vulnerable to runs in the past, largely because they almost
always maintained stable share prices by rounding net asset values to $1, which created an
incentive for investors to redeem their shares quickly in the face of any perceived risk of
losses to the assets held by the funds. The reforms required institutional prime MMFs, the
most vulnerable segment, to discontinue the use of rounding and instead use “floating”
net asset values that adjust with the market prices of the assets they hold. As the deadline
for implementing the reforms approached, assets under management at prime MMFs fell
sharply (figure 4-4). Many investors in those funds shifted their holdings to government
4-4. Domestic Money Market Fund Assets
Billions of dollars (real)
Monthly

Government−only
Tax−exempt

Retail prime
Institutional prime

5250
4500
3750

Sept.

3000
2250
1500
750
0

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

Note: The data are converted to constant 2018 dollars using the consumer price index.
Source: Federal Reserve Board staff calculations based on Investment Company Institute data; Bureau of Labor
Statistics, consumer price index via Haver Analytics.

FUNDING rISk

MMFs, which continue to use rounded $1 share prices but have assets that are safer and less
prone to losing value in times of financial stress. A shift in investments toward short-term
investment vehicles that provide alternatives to MMFs and could also be vulnerable to runs
or run-like dynamics would increase risk, but assets in these alternatives have increased only
modestly compared to the drop in prime MMF assets.

Mutual funds holding corporate debt have grown in size . . .
Total assets under management in investment-grade and high-yield bond mutual funds and
loan mutual funds have more than doubled in the past decade to over $2 trillion (figure 4-5).
Bond mutual funds are estimated to hold about one-tenth of outstanding corporate bonds,
and loan funds purchase about one-fifth
4-5. Bond and Loan Mutual Fund Assets
of newly originated leveraged loans. The
Billions of dollars (real)
3000
mismatch between the ability of investors
Monthly
in open-end bond or loan mutual funds to
Investment-grade bond mutual funds
Sept. 2500
High-yield corporate bond mutual funds
redeem shares daily and the longer time often
Bank loan mutual funds
2000
required to sell corporate bonds or loans
1500
creates, in principle, conditions that can lead
1000
to runs, although widespread runs on mutual
500
funds other than money market funds have
0
2000
2004
2008
2012
2016
not materialized during past episodes of stress.
Note: The data are converted to constant 2018 dollars using
If corporate debt prices were to move sharply
the consumer price index.
Source: Morningstar, Inc., Morningstar Direct; Bureau of
lower, a rush to redeem shares by investors
Labor Statistics, consumer price index via Haver Analytics.
in open-end mutual funds could lead to large
sales of relatively illiquid corporate bond or
loan holdings, further exacerbating price declines and run incentives. Moreover, as noted
in earlier sections, business borrowing is at historically high levels, and valuations of highyield bonds and leveraged loans appear high. Such valuation pressures may make large price
adjustments more likely, potentially motivating investors to quickly redeem their shares.

. . . and life insurers have increased their holdings of less-liquid assets recently, though
they now make less use of funding sources that suffered runs in the crisis
Funding risks in the insurance industry have declined significantly since the financial crisis.
Life insurance companies’ nontraditional liabilities—repos, funding-agreement-backed securities, securities lending cash collateral, all of which suffered runs during the financial crisis,
and Federal Home Loan Bank, or FHLB, advances—have edged up over the past few years.
However, the amounts of these nontraditional liabilities remain small relative to total assets
of life insurance firms and continue to be below pre-crisis peaks (figure 4-6).9 That said, life
insurers have been shifting their portfolios toward less liquid assets, somewhat weakening
their liquidity positions.
9

The data on securities lending and repos of life insurers are not available for the pre-crisis period. However, the firm American International Group, Inc., or AIG, alone had $88.4 billion in securities lending outstanding at the peak in 2007:Q3. See
American International Group, Form 10-Q Quarterly Report for the Quarterly Period Ended September 30, 2007.

FINaNCIaL STaBILITY rePorT: NoVemBer 2018

4-6. Nontraditional Liabilities of U.S. Life Insurers, by Liability Type
Billions of dollars (real)
Quarterly

FHLB advances
Funding-agreement-backed securities

300
250

Billions of dollars (real)
Quarterly

Repurchase agreements
Securities lending

2008

2010

2012

2014

2016

2018

100

200

150

100

0
2006

120

0
2012

2014

2016

2018

Note: The data are converted to constant 2018 dollars using the consumer price index and extend through 2018:Q2. FHLB is Federal
Home Loan Bank.
Source: Bureau of Labor Statistics, consumer price index via Haver Analytics and Federal Reserve Board staff estimates based on
data from Bloomberg Finance LP; Moody’s Analytics, Inc., CreditView, ABCP Program Index; Securities and Exchange Commission,
Form 10-Q and 10-K; National Association of Insurance Commissioners, quarterly and annual statutory filings accessed via
the S&P Global Market Intelligence Platform.

Central clearing of financial transactions has grown, providing financial stability
benefits but warranting continued attention
Central clearing of derivatives and securities transactions has grown over the past several
decades—both in absolute terms and relative to the size of financial markets. Since the
financial crisis, global regulatory efforts have contributed to this growth by encouraging and,
in some cases, mandating central clearing of over-the-counter derivatives. By some estimates,
the percentage of such activity that is centrally cleared now exceeds 60 percent. Some of the
growth in central clearing of both securities and derivatives transactions has also been driven
by market participants’ recognition of its benefits. Central clearing can improve financial stability by insulating firms from each other’s default, by reducing financial firms’ gross exposures through the netting of positions by central counterparties (CCPs), and by improving
risk management. That said, some CCPs are large, concentrated, highly interconnected, and
systemically important and warrant continued monitoring. CCPs reduce credit risk partly
through the daily exchange of margin. Such practices, however, expose CCPs and their counterparties to liquidity risk that must be managed, especially when volatility rises or financial
conditions deteriorate unexpectedly.

Near-term risks to the financial system
Developments in domestic and international markets could pose near-term risks to the
U.S. financial system. The ultimate effects of shocks arising from such developments likely
depend on the vulnerabilities in the financial system identified in the previous sections of this
report.

Brexit and euro-area fiscal challenges pose risks for U.S. markets and institutions . . .
Large European economies have notable financial and economic linkages with the United
States, and stresses emanating from Europe may pose risks for the U.S. financial system.
Two of those risks are particularly salient now. First, the United Kingdom and the European
Union (EU) have not yet ratified the terms for the U.K. March 2019 withdrawal from the
EU, known as Brexit. Besides its extensive implications for trade and a host of other activities, Brexit calls for a significant reorganization of financial arrangements between U.K.
and EU residents. Without a withdrawal agreement, there will be no transition period for
European entities following the U.K. exit from the EU, and a wide range of economic and
financial activities could be disrupted. Second, confidence in the euro area’s fiscal and financial prospects remains sensitive to ongoing developments despite improvement since
the 2010–12 sovereign debt crisis. Recently, Italy’s new budget proposal, which includes a
wider deficit projection than anticipated, is leading to concerns among market participants
and EU officials that this plan would put Italy’s sovereign debt on an unsustainable path.
European banks are exposed to these fiscal risks as significant investors in euro-area sovereign bonds.
The potential consequences for the U.S. financial system from these European risks arise
through several transmission channels. First, an intensification of sovereign debt concerns or
unresolved uncertainty about the implications of Brexit could lead to market volatility and a
sharp pullback of investors and financial institutions from riskier assets, as occurred following the June 2016 Brexit referendum in the United Kingdom and earlier during the European
debt crisis. Second, spillover effects from U.K. and other European banks could be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through
the common participation of globally active banks in a broad range of activities and markets. Moreover, because London is an important international financial center, U.S. banks
and broker-dealers participate in some of the markets most likely to be affected by Brexit.
Third, an economic downturn in Europe, likely accompanied by dollar appreciation, would
also affect the United States through trade channels, which could harm the creditworthiness
of some U.S. firms, particularly exporters.

. . . and problems in China and other emerging market economies could spill over to
the United States
In China, the pace of economic growth has been slowing recently, and years of rapid credit
expansion have left lenders more exposed in the event of a slowdown. Chinese nonfinancial

Near-Term rISkS To THe FINaNCIaL SYSTem

private credit has almost doubled since 2008, to more than 200 percent of GDP. Against this
backdrop, developments that significantly strain the repayment capacity of Chinese borrowers and financial intermediaries—including an escalation in international trade disputes or a
collapse in Chinese real estate prices—could trigger adverse dynamics.
A number of other emerging market economies (EMEs) have also seen significant increases
in either corporate or sovereign debt that could be difficult to service in the event of an
economic downturn. For some borrowers, much of this debt is denominated in foreign currencies, so as monetary policy normalizes in the United States and in other advanced economies, EMEs may be vulnerable to rising global interest rates or to stronger advancedeconomy currencies. Although the recent market turbulence faced by Argentina and Turkey
in part reflects higher vulnerabilities in those countries, if global interest rates rose faster
than currently anticipated or if other shocks hit the global economy, wider stress in EMEs
could occur.
Should significant problems arise in China or in EMEs more broadly, spillovers, including
dollar appreciation, declines in world trade and commodity prices, and a pullback from
risk-taking by investors outside the affected markets, could be sizable. In addition, the effect
of a stronger dollar and weaker foreign economies on trade could affect the creditworthiness
of U.S. firms, particularly exporters and commodity producers.

Trade tensions, geopolitical uncertainty, or other developments could make investors
more averse, in general, to taking risks
An escalation in trade tensions, geopolitical uncertainty, or other adverse shocks could lead
to a decline in investor appetite for risks in general. The resulting drop in asset prices might
be particularly large, given that valuations appear elevated relative to historical levels. In
addition to generating losses for asset holders, a significant fall in asset prices would make
it more costly for nonfinancial businesses to obtain funding, putting pressure on a sector
where leverage is already high. Markets and institutions that may have become accustomed
to the very low interest rate environment of the post-crisis period will also need to continue
to adjust to monetary policy normalization by the Federal Reserve and other central banks.
Even if central bank policies are fully anticipated by the public, some adjustments could
occur abruptly, contributing to volatility in domestic and international financial markets and
strains in institutions.
The banking sector is resilient, however, as evidenced by high levels of capital and liquidity.
Moreover, stress tests conducted by the Federal Reserve on the largest banks routinely feature large declines in asset prices, suggesting that those institutions are positioned to weather
asset price changes without having to significantly pull back on their lending activities. The
broader financial system is also substantially more resilient, with less leverage and funding
risk than leading up to the financial crisis, so these sources of vulnerability are less likely to
amplify the effects of falling asset prices.

Board of Governors of the Federal Reserve System
www.federalreserve.gov
1118

Full text of Financial Stability Report : November 2018

FRASER