Fed Report Says COVID-19 Biggest Risk to Economy, Financial System, Says Public Health Measures to Contain Coronavirus Crucial
May 18, 2020
The future course of the COVID-19 pandemic – and the size and duration of its economic fallout – are the most significant risks to the U.S economy and financial system, the Board of Governors of the Federal Reserve system says in its new Financial Stability Report.
Whether the risks they pose become realities will depend largely on the success of public health measures and other government actions to contain the spread of COVID 19, according to the Fed. Steps households and business take to resume economic activity, supported by government efforts and policy actions, “may ameliorate the most adverse potential outcomes.”
Because the financial system has “amplified” negative economic impacts associated with COVID-19, the report says “financial sector vulnerabilities are likely to be significant in the near term. 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. Financial institutions – including the banking sector, which had large capital and liquidity buffers before the shock – may experience strains as a result.”
The report looks at financial stability through the following framework:
Elevated Valuation Pressures. The Board notes that asset valuations have been volatile and remain vulnerable “should the pandemic take an unexpected course, the economic fallout prove more adverse, or financial system strains reemerge.” The report states that “since their lows in late March and early April, risky asset prices have risen and spreads have narrowed in key markets.” The report also points to an increasing reliance by hedge funds on model-driven trading strategies, which has increased the potential for “crowding” in strategies, i.e., leading to many hedge funds needing to buy and sell the same types of securities at the same time, negatively affecting liquidity.
Excessive Borrowing. The report observes that the severe reduction in economic activity due to the pandemic has weakened the ability of businesses and households to repay their debt obligations. This has impacted credit risk and slowed the origination of leveraged loans.
Excessive Leverage. The Board identifies elevated pressure on “at least some hedge funds that appear to have been severely affected by the large asset price declines and increased volatility in February and March, reportedly contributing to market dislocations.”
Funding Risk. In the face of COVID-19, significant strains on the funding markets, including through large-scale redemptions, have emerged, and emergency Federal Reserve actions have been required to stabilize short-term funding markets.
See Related Story – Fed Survey Identifies COVID-19, Global Response as Biggest Threats for Next 12-18 Months
Vulnerabilities identified in the report could grow if the current coronavirus outbreak persists or if there is a second wave of the pandemic, further amplifying negative shocks to the economy, the Fed says.
Noting that investor risk appetite and asset prices have declined, the report says risk aversion could increase further with a protracted pandemic.
“Given the generally high level of leverage in the nonfinancial business sectors, financial stress and defaults could become more widespread in a more sustained economic downturn,” the report warns. “In addition, a prolonged slowdown could further deteriorate the finances of even high-credit-score households, which could lead to defaults and place financial pressure on banks and other lenders. Broader solvency issues could impair the ability of some financial institutions to lend or induce more selling of assets and redemptions of withdrawable liabilities.”
TAGS: Federal Reserve Board, Financial Stability, Coronavirus, COVID-19