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    FED Publishes Financial Stability Report in November 2020

    FED published the financial stability report, which presents an assessment of the resilience of the financial system in U.S. The report examines vulnerabilities related to valuation pressures, borrowing by businesses and households, financial leverage, and funding risk. It also highlighted several near-term risks, which, if realized, could interact with such vulnerabilities. FED also published a Federal Register notice to make corrections to information collections published with a proposal dated October 07, 2020. The proposal updates the capital planning requirements to reflect the new framework that sorts large banks into different categories based on their risks, with rules that are tailored to the risks of each category. This correction adds the OMB control number for the reporting form FR LL and provides a corrected burden estimate, as the previously published document incorrectly listed the estimated recordkeeping burden associated with the FR YY information collection.

    The financial stability report highlights that FED is evaluating and investing in ways to deepen its understanding of the full scope of implications of climate change for markets, financial exposures, and interconnections between markets and financial institutions. The assessment found that business and household earnings have fallen while business borrowing has risen, thus leaving households and firms more vulnerable to future shocks. Banks absorbed large losses related to the pandemic but remained well-capitalized; moreover, capital ratios have since generally recovered to the pre-pandemic levels. However, the COVID-19 shock highlighted how vulnerabilities related to leverage and funding risk at nonbank financial institutions could amplify shocks in the financial system during times of stress. The key findings of the report include the following:

    • Asset valuations. The elevated levels of asset prices in various markets likely reflect the low level of Treasury yields while measures of the compensation for risk appear roughly aligned with historical norms. Given the high level of uncertainty associated with the pandemic, assessing valuation pressures is particularly challenging, and asset prices remain vulnerable to significant declines should investor risk sentiment fall or the economic recovery weaken.
    • Borrowing by businesses and households. Debt owed by businesses, which was already historically high before the pandemic, has risen sharply, as businesses increased borrowing to weather the period of weak earnings. The general decline in revenues associated with the severe reduction in economic activity has weakened the ability of businesses to service these obligations. So far, strains in the business and household sectors have been mitigated by significant government lending and relief programs and by low interest rates. 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.
    • Leverage in the financial sector. The pandemic stressed the resilience of banks, which remain well-capitalized. Leverage at broker-dealers also remains low. In contrast, measures of leverage at life insurance companies are at post-2008 highs and remain elevated at hedge funds relative to the past five years. Some nonbank financial institutions experienced significant strains amid the acute period of extreme market volatility, declining asset prices, and worsening market liquidity earlier this year. Pressures eased as a result of policy actions, including FED asset purchases and repurchase agreement (repo) operations, regulatory relief for dealers affiliated with bank holding companies, and support from the emergency lending facilities.
    • Funding risk. Bank funding risk remains low, as banks rely only modestly on short-term wholesale funding and maintain large amount of high-quality liquid assets, which has helped banks to manage heightened liquidity pressures. Banks also benefited from a surge in deposit inflows through the second quarter of 2020. In contrast, large redemptions from money funds and fixed-income mutual funds, along with the need for extraordinary support from emergency lending facilities, highlighted vulnerabilities in these sectors. While in place, those facilities substantially mitigate these vulnerabilities.

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    Keywords: Americas, US, Banking, Insurance, Securities, Financial Stability Report, CCyB, Stress Testing, Credit Risk, Climate Change Risk, ESG, Regulatory Capital, Reporting, Regulation YY, FED

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