Nonbank sector needs reform to combat risk to financial stability: Fed

WASHINGTON — Temporary policy responses from Congress and the Federal Reserve have mitigated financial stability risks resulting from the pandemic, but permanent fixes may be needed in some areas to counter potential long-term shocks, the Fed said Monday.

In its semiannual Financial Stability Report, the Fed said that short-term funding markets have stabilized considerably since March when the reality of the pandemic first set in for investors. But that stability has much to do with the central bank’s emergency lending facilities, most of which are set to sunset at the end of this year, the report said.

“Emergency measures undertaken by the Federal Reserve with the support of the Treasury have temporarily lowered the risk of adverse events associated with vulnerabilities in the nonbank sector in the near term, but remaining vulnerabilities call for structural fixes in the longer term,” the Fed’s report said.

The Fed and the Treasury Department have not yet said if they plan to extend their loan facilities created under section 13(3) of the Federal Reserve Act past Dec. 31.

Fed Gov. Lael Brainard, who chairs the Fed’s committee on financial stability, agreed in a statement that the coronavirus pandemic has made clearer the need for more permanent reforms, including in the “critically important” Treasury market, she said.

“The resurgence of fragility and funding stress in the same nonbank financial sectors in the COVID-19 crisis and the Global Financial Crisis highlights the importance of a renewed commitment to financial reform,” said Brainard in a statement.

The leverage at nonbanks, including hedge funds and life insurance companies, remains high and could lead to more acute problems in the event of either funding shortages or sharp drops in asset prices, the Fed added. Money market funds and mutual funds are particularly vulnerable to funding strains.

“While government support has lowered the risk of adverse events associated with vulnerabilities in the nonbank sector, this sector would be vulnerable to funding risk should the government support be withdrawn,” the Fed said.

However, unlike nonbanks, bank funding risk remains low, the Fed’s report said, given that financial institutions have benefited from a surge in deposits in 2020 and that banks are holding on to large amounts of high-quality liquid assets.

Additionally, in the third quarter, the common equity tier 1 capital at banks slightly rose above pre-pandemic levels, the Fed said, based on preliminary earnings data, giving the Fed greater confidence about the resilience of U.S. banks.

But the Fed warned that loan delinquencies could worsen as the pandemic continues.

“As many households continue to struggle, loan defaults may rise, leading to material losses,” the Fed said. “So far, strains in the business and household sectors have been mitigated by significant government lending and relief programs and by low interest rates. That said, some households and businesses have been substantially more affected to date than others, suggesting that the sources of vulnerability in these sectors are unevenly distributed.”

For the first time, the Fed identified climate change as a potential risk to financial stability in its report, which the agency said could lead to the mispricing of assets and the risk of downward price shocks.

“Levered financial institutions may be exposed to losses from disasters made more likely by climate change that are not accurately reflected in current financial models,” the Fed’s report said.

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