For release on delivery
5:15 a.m. EST (10:15 a.m. local time)
November 8, 2023
Financial Stability: Resilience, Challenges, and Global Connections
Remarks by
Lisa D. Cook
Member
Board of Governors of the Federal Reserve System
at the
Central Bank of Ireland
Dublin, Ireland
November 8, 2023
Thank you for the invitation to speak at the Central Bank of Ireland. I am happy
to be with you today to discuss financial stability.1
My own work as an academic has frequently reinforced the importance of
financial stability in the United States and abroad. Early in my career, I examined the
impact of underdevelopment in the Russian banking system on growth in post-Soviet
Russia and the instability that can occur in a poorly regulated financial system. Years
later, as an economist on the Council of Economic Advisers, I saw how weaknesses in
the financial system contributed to instability in the euro area. These formative
experiences shaped my view that the Federal Reserve's work on financial stability is
critical to the well-being of households, businesses, and the broader economy. This is
one reason I particularly value the opportunity to serve on the Board's Committee on
Financial Stability.
I will focus my remarks on my assessment of financial stability risks, based on the
Federal Reserve's framework for monitoring vulnerabilities in the financial system. In
my view, our financial system is substantially more resilient than it was in the mid-2000s,
reflecting progress by regulators and the private sector in boosting resilience. That said,
we cannot be complacent, and I see some important risks.
Achieving the Federal Reserve's dual mandate of maximum employment and
stable prices depends on a stable financial system.2 We all saw how the Global Financial
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Crisis triggered the Great Recession and brought misery to countless millions who lost
their jobs, homes, or investments.
A stable financial system provides households, communities, and businesses with
the financing they need to invest, grow, and participate in a well-functioning economy-
even when hit by adverse events or "shocks." Consistent with this view of financial
stability, our framework for how we think about this goal-as laid out in our Financial
Stability Report (FSR), which was just released in October-distinguishes between
shocks to, and vulnerabilities of, the financial system.3 Importantly, and as we
economists know, we cannot predict exogenous shocks, which are, by definition, the
surprise events that will hit the financial system and economy. By contrast,
vulnerabilities-the aspects of the financial system that would exacerbate stress-tend to
build up over time and can be identified, assessed, and monitored. In the example of the
Global Financial Crisis, although it was widely recognized that housing valuations were
high, the magnitude of the ensuing price drop was unexpected, or a shock. That shock
was amplified by vulnerabilities that had built up within the financial system over time,
including weak bank capital, excessive household debt, lax lending standards, and fragile
short-term wholesale funding. One hard-learned lesson of the crisis is that the Fed and
other regulators must watch closely for vulnerabilities that may build up within the
financial system.
Based on this experience, other historical episodes, and academic research, we
focus, in the Board's FSR and other work, on assessing vulnerabilities across four broad
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categories related to asset valuations, borrowing by businesses and households, financial-
sector leverage, and funding risks. We also consider, through contacts with market
participants and experts, near-term risks that, if they were to come to pass, could interact
with these vulnerabilities.
Asset Valuations
One key set of vulnerabilities stems from valuation pressures. The willingness of
investors to take on risks is closely related to the economic and financial cycle. When
their risk appetite drives prices higher relative to economic fundamentals, there may be a
greater risk of outsized drops in prices that can be destabilizing.4 The Fed looks at a
broad range of asset markets, including equities, Treasury securities, corporate bonds,
loans, and real estate. This table from our FSR shows the sizes of the asset markets
discussed in this section as of Q2, the most recent data available. The largest asset
markets are those for residential real estate, equities, Treasury securities, and commercial
real estate (CRE).5
This year, asset valuations have generally risen notably above their historical
levels. In particular, prices of residential and commercial properties remain above levels
historically associated with fundamentals. House prices, relative to rents, are near all-
time highs. Further, prices have started increasing again in recent months after falling for
more than a year. Commercial property prices also remain high relative to rental income.
I am watching closely the extent to which post-pandemic supply and demand patterns
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normalize. Demand in the office sector has remained weak, particularly in central
business districts and coastal cities, with vacancy rates increasing further and rent growth
declining. Finally, average delinquency rates for commercial mortgage-backed securities
have moved up recently, as office and retail loan performance has deteriorated. If
delinquency rates generate selling pressure or increase notably further and result in forced
sales of properties, then CRE prices could decline sharply.
Another notable market development has been the significant increase in longer-
term bond yields since June. Decompositions between changes in expected rates and
term premiums depend on the specific models and assumptions used, but I would say that
an expectation of higher near-term policy rates does not appear to be causing the increase
in longer-term rates.
Business and Household Borrowings
Valuation pressures are especially concerning if they are associated with
excessive borrowing. If households or businesses borrow too much, they may be unable
to service debt or could find themselves underwater if assets decline in value. Such
stresses can propagate through the financial system, causing funding shortages that curtail
credit and hamper economic activity. Of course, it's very difficult to tell in real time
whether households and businesses are, in fact, borrowing "too much," so we rely on a
range of benchmarks.
Currently, business debt is at historically high levels relative to such benchmarks
as gross domestic product (GDP) or business assets, although those ratios are
significantly lower than the record highs reached at the onset of the pandemic. However,
measures of the ability of firms to service their debt remain strong overall, supported by
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resilient corporate profits and limited effects to date from higher interest rates. The pass-
through of higher interest rates into debt-servicing costs appears to be muted by the large
share of long-term, fixed-rate liabilities. However, I note that for risky borrowers or
those with high-yield or unrated debt, the ability to service their debt burdens has started
to show signs of weakness, as would be expected in a rising interest rate environment,
and could become further strained if corporate earnings fall due to a sharper-than-
expected slowdown in economic activity.
The household sector, taken as a whole, looks quite resilient. Household debt,
including home mortgages, auto and student loans, and credit cards, remains at modest
levels relative to GDP, and most of that debt is owed by households with strong credit
histories or considerable home equity. Of course, we are seeing emerging signs of stress
for households with lower credit scores, and individual borrowers may struggle with debt
burdens in the face of economic hardships.
Financial-Sector Leverage
Now to financial-sector leverage. As I mentioned earlier, we pay careful attention
to our financial system's ability to support the activities of businesses and households.
When financial institutions are overly indebted, adverse shocks can cause them to
retrench more than they otherwise would, resulting in greater declines in economic
activity. In extreme circumstances, such effects can lead to credit crunches and
widespread economic dislocations. Similarly, some institutions may be forced to rapidly
deleverage, stressing markets and forcing other institutions to also pull back.
The United States has a large and vibrant financial system, so it is important to
assess leverage across the broad array of nonbanks and banks of all sizes that provide
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credit to our economy. Starting with banks: The banking sector remains sound and
resilient overall. Most banks continue to report solid capital levels well above regulatory
requirements.
The rise in interest rates over the past two years has contributed to robust bank
profitability, as banks earned higher interest income on floating-rate loans while interest
expense on many deposits remained well below market rates. At the same time, higher
long-term interest rates also substantially affected the fair value of banks' holdings of
fixed-rate assets. As we saw earlier this year, fair value losses on bank balance sheets,
when combined with poor liquidity and interest rate risk management, can leave banks
exposed to additional risk. While acute stresses have abated, I continue to monitor this
situation closely.
Some nonbanks can be quite leveraged. For example, available data suggest that
hedge fund leverage remains elevated, especially for the largest hedge funds. It is
important to better understand how their leveraged activities could impact the functioning
of underlying markets.
Funding Risks
Looking at funding, many financial institutions raise funds from the public with a
commitment to return their money on short notice. But those institutions then invest
much of those funds in assets that are hard to sell quickly or have a long maturity. This
liquidity and maturity transformation can create strains across markets or institutions,
particularly in the absence of a lender of last resort such as the Fed's discount window for
commercial banks.
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In the banking industry, the deposit volatility that we saw earlier this year has
abated. That said, some banks have had to turn to higher-cost funding sources to make
up for lost deposits and face reduced market values for investment securities.
Outside of banking, we also monitor a wide range of nonbank financial
institutions (NBFIs) such as money market funds, open-end funds, insurers, central
counterparties, and digital assets. Many of their activities give rise to a liquidity
mismatch that could amplify market stress. They have daily or frequent redemption
possibilities on the liability side, while holding less-liquid assets. I think the Securities
and Exchange Commission's recent reform on money market funds and proposal for
open-end funds are encouraging steps toward mitigating funding risks arising from
nonbanks.
Salient Near-Term Risks
Let me illustrate how these vulnerabilities factor into my views on the resilience
of the financial system. I will walk through how potential near-term risks could interact
with current conditions in the United States. I will cover both domestic and international
risks in a way that is closely aligned with the discussion in the FSR.6 In recent outreach,
as summarized in this figure from the FSR, contacts were particularly focused on the
persistent inflationary pressures leading to further monetary tightening, the potential for
significant losses on CRE and residential real estate, the reemergence of banking-sector
stress, and market liquidity strains and volatility.
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As I said earlier, the banking sector has stabilized since the period of acute stress
earlier this year, and the system as a whole has ample capital and liquidity to withstand
shocks. I continue to monitor the system for signs of renewed stresses. I also support
seeking public comment on federal banking agencies' Basel III endgame proposal on
bank capital requirements.
In addition, NBFIs have become an integral part of the financial system and are
increasingly interconnected with the banking sector. It is crucial for relevant authorities
to implement stronger oversight and appropriate prudential requirements for nonbanks.
This is especially important amid concerns that proposed higher capital requirements for
large banks could cause some bank activities to migrate to the more lightly regulated
NBFIs. It would be the most effective and balanced way to enhance the stability of the
entire financial system.
Internationally, inflationary pressures persist in advanced foreign economies and
could pose risks to the global financial system. Energy prices have increased notably in
recent months, potentially forcing businesses to pass on renewed cost pressures to
customers. An unexpected increase in policy rates abroad could lead to heightened
volatility in financial markets, strains in market liquidity, and an adjustment in asset
prices. Higher interest rates, particularly if they persisted, could be a binding constraint
on the debt-servicing capacity of foreign households, businesses, and governments.
Collectively, these factors could lead to pronounced losses among global financial
intermediaries and a consequent reduction in the credit supply.
In China, a further slowdown in economic growth could worsen financial stresses.
Many Chinese firms, especially in the property sector, are struggling to service very high
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debt burdens. Local governments are also facing increasing fiscal strains. Stresses
originating in China could spill over to other emerging market economies (EMEs),
particularly those highly dependent on trade with China or on credit provided by Chinese
entities. The spillovers could trigger significant capital outflows from EMEs, which may
already be more susceptible to external shocks given generally heightened debt levels.
Given the size of its economy and financial system, financial stress in China could be
propagated to global markets more broadly through disruptions to economic activity,
deterioration of risk sentiment, and a sharp appreciation of the dollar.
Last but not least, a worsening of global geopolitical tensions, including those
involving Russia, the Middle East, and China, could lead to broad negative spillovers to
global markets. Russia's ongoing war against Ukraine continues to weigh on many
economies in a variety of ways, including sustained disruptions to regional trade in food,
energy, and other commodities. The conflict in the Middle East could generate further
risks to energy and financial markets, as well as a worsening of global humanitarian and
migration challenges. More broadly, escalation of geopolitical tensions could lead to
lower economic activity and increased fragmentation of global trade flows and financial
intermediation, raising financing and production costs and contributing to more sustained
supply chain challenges and inflationary pressures. The global financial system could be
affected by a pullback from risk-taking, declines in asset prices, and losses for exposed
businesses and investors.
I will conclude by saying that we must remain vigilant to potential shocks that
could exacerbate vulnerabilities in the global financial system. Thank you for inviting
me to speak here. I look forward to participating on the panel.
Financial Stability: Resilience and Challenges
Lisa D. Cook
Member
Board of Governors of the Federal Reserve System
Central Bank of Ireland
November 8, 2023
The views expressed here are my own and do not reflect those of the Board of
Governors or the Federal Open Market Committee