Fed report warns of US financial system ‘vulnerabilities’

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The semi-annual Financial Stability Report, released Thursday by the US Federal Reserve, warned that growing hedge fund debt, much of which is unrecorded by regulators, poses growing risks to the stability of the financial system .

The Federal Reserve in Washington [Credit: AP Photo/Patrick Semansky, File]

Key aspects of the report were highlighted in an opening statement by Fed Governor Lael Brainard, who chairs the Fed’s Financial Stability Committee. She noted that “vulnerabilities associated with a high risk appetite are increasing.”

The report says short-term funding markets are now functioning normally, following the collapse of March 2020 and the turmoil at the end of February of this year. However, “the structural vulnerabilities of certain non-bank financial institutions (NBFIs) could amplify the shocks on the financial system in times of crisis”.

In his statement, Brainard said valuations for a range of assets continued to rise from their high levels last year, with stock prices hitting new highs. Relative to expected future earnings, they were “near the top of their historical distribution.”

Risk appetite had increased as demonstrated by the “same stock” episode. This refers to the rise in the share price earlier this year of video game retailer GameStop, due to its promotion on Reddit and other social media platforms. And this despite the company’s business model experiencing significant difficulties.

Brainard said corporate bond markets were also experiencing a “high risk appetite,” the difference between the interest rates on lower-grade speculative-grade bonds and those on Treasury bonds among the lowest on record.

“This combination of stretched valuations with very high levels of corporate leverage is worth watching because of the potential for amplifying the effects of a price revaluation event,” she said. In other words, a rapid downturn in one area of ​​the market would be quickly transmitted through the financial system.

Brainard highlighted the failure in March of the Archegos Capital family hedge fund, mobilized by banks to the tune of $ 50 billion, and the associated losses suffered by these banks. It highlights, she said, “the potential for non-bank financial institutions such as hedge funds and other leveraged investors to generate large losses in the financial system.”

The Archegos event illustrated “the limited visibility on hedge fund exposures and reminds that the available measures of hedge fund leverage may not capture significant risks.”

Reading between the lines, the meaning of this statement is that the Fed is concerned that there are more capital cities in Archegos, but has no real idea of ​​where they are or where they are. level of exposure of banks to them.

Brainard noted that “the possibility that significant difficulties in hedge funds affect broader financial conditions underscores the importance of more detailed and frequent disclosures.”

The report highlighted a number of areas of potential instability and how it could be conveyed.

“Bank loans to NBFIs represent a potential channel for transmitting stress from one part of the financial system to another. Amounts of committed credit from major banks to NBFIs, which consist primarily of revolving lines of credit and include undrawn amounts, increased in the latter part of last year to a record $ 1.6 trillion. dollars at the end of the year. “

Under the heading “Funding risk”, the report indicates that in 2020, the amount of liabilities “potentially vulnerable to breaches, including those of non-banks, would have increased by 13.6% to reach $ 17.7 trillion” , or an amount equivalent to about 85% of GDP.

He said “structural vulnerabilities” remained in NBFIs, including MMFs, and “regulatory agencies are exploring options for reforms that will address these vulnerabilities.”

The admission that nothing is in place at the present time underlines one of the main characteristics of the financial system. Whenever the Fed or other regulators attempt to control or even exercise oversight over some of the more speculative trades, market participants are devising new ways to get around them.

Outlining the short-term risks to the financial system, the report says that if the pandemic persists longer than expected, especially in the event that new variants of the virus emerge, it could derail the recovery of the U.S. economy.

“If these developments occur, a number of vulnerabilities … could interact with the negative shock to the economy and present additional risk to the US financial system.”

While indebtedness was low among banks and brokers, “the leverage of some NBFIs, such as life insurance companies and some hedge funds, is high, which exposes them to sharp declines. asset prices and financing risks. “

He noted that, given that European banks play an important role in the global financial system and have “notable financial and economic ties” with the United States, financial strains in Europe resulting from the continuation of the pandemic could also have a negative effect.

Likewise, if emerging market economies face rising interest rates unaccompanied by an improving global economic outlook, it could impact U.S. financial firms that have strong ties to these countries and their countries. companies.

Commenting on the Fed report, George Selgin, senior researcher at the Cato Institute, pointed out some of the conflicts inherent in the Fed’s policies as it continues to pump money into the financial system.

“The real story here is the tension – if not the blatant contradiction – of the Fed’s pursuit of quantitative easing (QE), the purpose of which is to lower long-term rates and encourage the search for yield,” and their concern that people are actually achieving the return, ”he told Bloomberg.

The tension arises from the fact that while the stated intention of the ultra-low interest rate regime is to promote greater risk-taking through investment in the real economy – the financing of productive activity, the real investment in factories, equipment and technology – most of the money is used to finance speculation in increasingly risky financial assets.

Selgin called on the Fed to “reduce its QE activities to counter this risk-taking as the recovery continues.”

However, the financial system has become so dependent on the continued influx of essentially free money that any move in that direction could trigger a major crisis.

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