OFR_2016_Financial-Stability-Report

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Chapter 2 provides deeper analysis of the seven key threats to financial stability that we have identified. We chose the vulnerabilities that can lead to threats based on four criteria: their potential impact; the probability of their occurring and leading to threats; their proximity or immediacy; and the preparedness of policymakers, regulators, and market participants to mitigate them. We review why these vulnerabilities pose potential risks to financial stability. We then suggest steps policymakers could take to mitigate the risks. In particular, we note ways to increase visibility into now-opaque parts of the financial system. We also concentrate on the need for regulators to actively monitor and stress test financial exposures, and evaluate potential indirect channels for spillovers to the U.S. financial system and real economy. Four themes are woven through this Financial Stability Report: the potential for disruptions in the global economy to affect U.S. financial stability; risk-taking amid low long-term interest rates; risks facing U.S. financial institutions; and challenges to improving financial data. The issues embedded in these themes have been central to our monitoring efforts over the past 12 months. Figure 1 illustrates how the seven vulnerabilities in Chapter 2 fit in these themes and how they relate to the five core risk categories described in Chapter 1. For example, deficiencies in data can impede analysis across risk categories. Figure 1. Key Financial Stability Themes in 2016 Risk Categories (Chapter 1) Themes Disruptions in the global economy Vulnerabilities (Chapter 2) Potential spillovers from Europe Macro Market Credit Funding/ liquidity Contagion W W W W Risk-taking amid low longterm interest rates Risks facing U.S. financial institutions Risks in U.S. nonfinancial corporate credit W W W Cybersecurity incidents affecting financial firms W W Central counterparties as contagion channels W W W W Pressure on U.S. life insurance companies W W W Systemic footprints of largest U.S. banks W W W W Challenges to improving data Deficiencies in data and data management W W W W W 2 2016 | OFR Financial Stability Report
1. Disruptions in the Global Economy The United Kingdom (U.K.) vote to exit the European Union (EU) has raised uncertainty about the U.K.’s future relationship with the EU and London’s future role as a financial capital. That uncertainty may prompt businesses to postpone investment, leading to slower growth and higher inflation in the U.K. over the next few years. The vote highlights existing vulnerabilities, such as weaknesses in EU banks. Shocks could expose those vulnerabilities, and could spill over to U.S. institutions and markets and thus the economy. Any shock could also aggravate risks to U.S. financial firms from low long-term interest rates and exacerbate reach-for-yield behavior. Section 2.1 of this report discusses potential spillovers from Europe in greater detail. We conclude that U.S. regulators should continue to expand the scope of their monitoring and stress testing of exposures by including an evaluation of potential indirect channels through which spillovers to the U.S. financial system and economy could arise. 2. Risk-Taking Amid Low Long-Term Interest Rates We remain concerned about the effects of persistently low long-term interest rates on risk-taking. While long-term rates have risen since mid-2016, they remain near historic lows. Low long-term rates have supported the economic expansion. They have also promoted greater risk-taking by investors, borrowers, and financial institutions. The continuing demand for risky assets is reflected in elevated prices for equities and commercial real estate. Low long-term interest rates also strain earnings of banks and life insurance companies and their ability to generate capital internally. While markets have been resilient to recent market shocks, investors’ willingness to take credit, duration, and liquidity risks could expose them to large losses in the face of a bigger shock. Low borrowing costs have also promoted the high level and rapid growth of U.S. nonfinancial corporate debt, including loans and securities (see Section 2.2). A severe downturn in this $8 trillion market could threaten financial stability if the exposed counterparties cannot manage the losses and associated erosion of confidence. Banks are the most exposed institutions, but nonbanks now own more than a quarter of U.S. corporate debt, primarily through bond holdings. Insurance companies and pension funds are traditional buyers of corporate bonds, and mutual funds have rapidly increased their holdings over the past decade. We conclude that exposed financial firms should undergo stress tests for severe corporate defaults. Stress scenarios should also include the possibility Low long-term rates have supported the economic expansion. They have also promoted greater risktaking by investors, borrowers, and financial institutions. Executive Summary 3
Page 1: OFFICE OF FINANCIAL RESEARCH 2016 F
Page 5: Contents Executive Summary ........
Page 10 and 11: of sharp decreases in U.S. equity a
Page 13 and 14: 1 Financial Stability Assessment Ov
Page 15 and 16: Figure 3. Real GDP Growth (year-ove
Page 17 and 18: Figure 8. Ten-Year U.S. Treasury Yi
Page 19 and 20: Monitoring Shadow Banking Risks The
Page 21 and 22: An earlier OFR paper proposed an ac
Page 23 and 24: Figure 17. Size, Liquidity, and Con
Page 25: Figure 19. Top Systemic Risk Scores
Page 28 and 29: The analysis pointed to seven key t
Page 30 and 31: could. In early 2016, investor conc
Page 32 and 33: earnings or share issuance. But red
Page 34 and 35: Fund Monitor, the OFR assessed expo
Page 36 and 37: 2.2 Risks in U.S. Nonfinancial Corp
Page 38 and 39: Figure 31. U.S. Nonfinancial Corpor
Page 40 and 41: Figure 36. U.S. Corporate Bond Defa
Page 42 and 43: Commercial Real Estate Prices Have
Page 44 and 45: 2.3 Cybersecurity Incidents Affecti
Page 46 and 47: Hackers Breach Bangladesh’s Centr
Page 48 and 49: Figure 42. Banks that Include an Op
Page 50 and 51: The industry is working with the pu
Page 52 and 53: Figure 46. U.S. Financial Regulator
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Page 56 and 57: eleased the results of an unprecede
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Figure 49. CCP Default Waterfall ($
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Figure 50: CCP Ratios and Amounts f
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cause more-prudent CCPs to appear m
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2.5 Pressure on U.S. Life Insurance
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The experience of Japan’s life in
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2015). These benefits are effective
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Figure 55. Life Insurance Securitie
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Drivers of Insurers’ Systemic Ris
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2.6 Systemic Footprints of Largest
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Interest Rates and Derivatives Expo
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Figure 63. Components of U.S. G-SIB
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Figure 66. Five-Year Changes to G-S
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2.7 Deficiencies in Data and Data M
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Figure 68. Examples of Key Post-Cri
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Broader Adoption of Data Standards
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Better Regulatory Sharing Needed Th
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The U.S. Census Bureau surveys publ
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The group will also consider how th
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and contracts would be crucial. The
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Figure 72. Scaling of Data Validati
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Glossary 10-Year, 10-Year Forward R
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Conditional Value-at-Risk (CoVaR) C
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Fire Sale Form N-MFP Form PF Fundin
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Liquidity Risk Liquidity Transforma
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Pension Funded Ratio Pension Risk T
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Stress Test Supplemental Leverage R
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Bibliography Adrian, Tobias, and Ma
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Board of Governors of the Federal R
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www.richmondfed.org/~/media/richmon
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Her Majesty’s Government and Mars
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Paul, Ruma. “Bangladesh hopes to
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Zetter, Kim. “That Insane, 18M Ba
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