Fed's financial stability report - beware shadow banks & private equity

The Federal Reserve has issued its November 2022 financial stability report. This report is 60 pages long, including Appendices.

[begin quote]
The Federal Reserve Board’s monitoring
framework distinguishes between shocks to,
and vulnerabilities of, the financial system
Shocks are inherently difficult to predict, while
vulnerabilities, which are the aspects of the
financial system that would exacerbate stress,
can be monitored as they build up or recede
over time As a result, the framework focuses
primarily on assessing vulnerabilities, with an
emphasis on four broad categories and how
those categories might interact to amplify
stress in the financial system.

  1. Valuation pressures arise when asset prices are high relative to economic fundamentals or historical norms. These developments are often driven by an increased willingness of investors to take on risk [This describes the asset bubbles in stocks, junk bonds, property, cryptocurrencies, etc. The impact of ultra-low interest rates, TINA and FOMO. -W] …

  2. Excessive borrowing by businesses and households exposes the borrowers to distress if their incomes decline or the assets they own fall in value In these cases, businesses and households with high debt burdens may need to cut back spending, affecting economic activity and causing losses for investors…

  3. Excessive leverage within the financial sector increases the risk that financial institutions will not have the ability to absorb losses without disruptions to their normal business operations when hit by adverse shocks In those situations, institutions will be forced to cut back lending, sell their assets, or even shut down … [Zombie companies. – W]

4 Funding risks expose the financial system to the possibility that investors will rapidly
withdraw their funds from a particular institution or sector, creating strains across markets or institutions. Many financial institutions raise funds from the public with a commitment to return their investors’ 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 an incentive for investors to withdraw funds quickly in adverse situations. Facing such withdrawals, financial institutions may need to sell assets quickly at “fire sale” prices, thereby incurring losses and potentially becoming insolvent, as well as causing additional price declines that can create stress across markets and at other institutions …[Classic run on the bank, stock market crash when margin calls force investors to sell the good to finance the bad, etc. – W] [end quote]

This is a very long report with a lot of detail. Many areas of potential risk are pretty calm and safe. But there are pockets of potential risk.

The Fed is primarily responsible for maintaining the stability and liquidity of the banks and entire financial system. They don’t care much about asset prices (e.g. the stock market falling) though they note what is happening. They really do care about hidden problems that could cause the flow of money to “lock up,” causing a financial crisis like 2008.

The most dangerous situation is a fiduciary (e.g. money market fund, shadow bank, etc.) that borrows short but invests long. If short-term debt matures and lenders aren’t willing to roll over the debt, or if money market depositors withdraw their deposits, the fiduciary could be bankrupted. With the shadow banking system so interconnected and private equity so deep in hock the Fed is uneasy because they aren’t getting timely updates on the situation. This vulnerability could blindside them with a financial crisis as it did in 2008.

Fed Frets About Shadow Banks and Eyes Treasury Liquidity in New Report

The Federal Reserve is watching the government bond market and investment funds as rate increases ricochet through finance.
Joe Rennison

By Jeanna Smialek and Joe Rennison, The New York Times, Nov. 4, 2022

The Federal Reserve warned in its twice-annual report on America’s financial stability that the government bond market could be primed for disruption, and cautioned that financial firms that operate outside of traditional banks could increase fragility in the system…

The ease of trading Treasury securities, called liquidity, has been strained in recent months, which is making analysts and investors nervous that the market could be primed for disruption. The Fed attributed the decline in liquidity “primarily” to volatility in interest rates and economic uncertainty…

The Fed also pointed out that leverage — essentially, debt that is used to invest — was high in parts of the shadow banking sector and could “be difficult to assess” because timely data on market participants like hedge funds and other investment vehicles was difficult to come by…

But, at the same time, bank lending to private equity firms and other shadow banks has ramped up, which could deepen the interconnectedness of the financial system.

The increase has been rapid in recent years, reaching a new high of almost $2 trillion in the second quarter of 2022, and it “was broad-based and most pronounced in the category of private equity, business development companies and credit funds…” [end quote]

As your loyal METAR weather reporter, I will continue to watch the financial stress indexes. These are computed from various interest rates. If the market becomes less liquid and lenders require higher interest rates to lend, these will reflect it.

Right now, things are calm. But there are hidden vulnerabilities.




The post is timely. The other shoe dropping is expected by all of us.

The asset prices and inflation play a larger over arching reality.

China was exporting manufacturing deflationary forces. That has ended. The US must assume the role of exporter of manufacturing deflationary forces globally. If the UK gets its head of its rear she will join us.