Financial sector vulnerabilities are “likely to be significant in the near term,” as the coronavirus pandemic continues to take a severe toll on economic activity in the U.S., the Federal Reserve said in its latest financial stability report released today. “The strains on household and business balance sheets from the economic and financial shocks since March will likely create fragilities that last for some time,” the report said. “Financial institutions—including the banking sector, which had large capital and liquidity buffers before the shock—may experience strain as a result.”
The Fed flagged rising household and business debt and a deterioration of borrowers’ ability to repay as the economy continues to contract sharply. Prior to the pandemic, business and household debt expanded at a pace similar to the U.S. GDP, but that ratio is expected to rise “dramatically” as 2020, with a significant decrease in GDP expected. In addition, the Fed noticed that the business sector was highly leveraged going into the crisis.
While banks entered the pandemic well-capitalized and have thus far been able to meet the credit demands of their customers while simultaneously strengthening their loan loss reserves, the Fed cautioned that the prospect for losses over the medium term “appears elevated.” The Fed also observed volatile asset prices across many markets and noted that they remain vulnerable to significant price declines if the current downward economic trajectory continues for a protracted period. Additionally, heightened funding risks that emerged early in the pandemic prompted the Fed to respond quickly by establishing several new liquidity facilities.
Looking ahead, the Fed warned that banks may continue to face operational risk associated with the pandemic, though the reported noted that “banks’ relative success thus far demonstrates the benefits of both having [business continuity plans]and actively testing them.” Additionally, stresses in global markets could also spill over and further strain U.S. markets, the Fed said. Read the report.