In delivering remarks about the current state of financial stability, Lisa Cook, member of the Board of Governors of the Federal Reserve System, discussed financial leverage and funding risk.
In assessing these vulnerabilities, the Fed tends to place a lot of weight on the capital adequacy and liquidity of the largest and most interconnected financial firms. Currently, these firms appear well positioned to absorb a shock.
For the largest banks, the ratio of common equity tier 1 capital to risk-weighted assets stands at multidecade highs. The largest banks also have strong funding profiles, owing in part to the strength of the regulatory regime for these banks.
Despite the overall resilience of the banking sector, some regional banks experienced large deposit outflows amid the failures of three banks last spring. Conditions have improved considerably since then: bank profitability remains solid, and deposit flows have stabilized. In addition most institutions have lowered their reliance on uninsured deposits since the beginning of 2023. Supervisors are working closely with the set of banks that have experienced outsized fair-value losses from higher interest rates and with banks that have high concentrations of commercial real estate loans.
When it comes to other kinds of financial intermediaries, there are varying levels of visibility into leverage and funding vulnerabilities. While there are some areas of apparent vulnerability, there is also evidence of resilience. Hedge fund leverage is hard to measure, but available data suggest that these funds’ leverage is near the high end of its range. Large insurers are well capitalized, but they have been increasing their use of liabilities subject to rollover risk at the same time as they have raised the portion of their assets invested in riskier corporate debt instruments.
Money funds have inherent funding vulnerabilities that regulators have been taking steps to address. Reforms adopted by the US Securities and Exchange Commission (SEC) and coming into force this year will improve funds’ liquidity positions and address the structural first-mover advantages among money fund investors that contributed to some of the runs we have seen in this sector over the years.