Reports > 2021 Annual Report to Congress
Key Findings from the OFR's 2021 Annual Report to Congress
Overall risks to U.S. financial stability remain in the medium range. The Office of Financial Research reached this assessment after weighing the resilience of the nation’s financial system against its vulnerabilities.
The financial system is far more resilient than it was when the COVID-19 pandemic began in early 2020. Government support for households and businesses hurt financially by the pandemic led to a period of growth following last year’s recession. The recovery in the first half of 2021 was robust, but its momentum has slowed in the second half. Uncertainty remains due to various existing and emerging vulnerabilities, including rising inflation, the future impact of COVID-19, and a tighter monetary policy.
Macroeconomic uncertainty remains regarding the continuing impact of the virus and the pattern of inflation.
- COVID-19 variants may continue to emerge, potentially threatening to derail the ongoing recovery.
- If the global increase in prices persists for longer than currently anticipated, it could lead to a faster-than-expected rise in interest rates and, potentially, a repricing of risky assets.
- Rising inflation increases the risk of an economic slowdown, though financial conditions remain stable.
Credit risk is a concern due to high debt burdens in some sectors that could worsen.
- Nonfinancial corporate debt levels, already high before the pandemic, hit new records after the virus outbreak in the U.S. due to extraordinary monetary and fiscal stimulus and were fueled by investor demand for higher yields.
- There are elevated risks in certain commercial real estate sectors, driven by a divergence in demand, rents, and market values, depending on the real estate sector and geographic region.
- Residential real estate market risk is low due to strong home prices and the forbearance relief and eviction bans put in place, as the pandemic took hold. However, the expiration of these consumer assistance programs could burden some homeowners and renters.
Near-term market risks appear contained by the supportive nature of fiscal and monetary policies, solid corporate earnings, and risk-free rates at historically low levels.
- Equity market valuations were at record levels and market sentiment was positive at the time of this report. Share prices in certain areas reached euphoric levels in 2021.
- Bond yields are historically low and favor borrowers but adversely affect investors like retirees and pension funds as well as other institutional fixed-income investors.
- The rising value and growing types of digital assets and the advent of cryptocurrencies into mainstream investment products make them a potential source of instability.
In the Treasury cash market, actions in 2020 by the Federal Reserve improved liquidity and reduced volatility, but structural vulnerabilities still exist.
- Liquidity has greatly improved since the start of the pandemic last year. Improvements in liquidity were concentrated in longer-dated and off-the-run Treasury securities.
- U.S. and foreign regulatory agencies are exploring reforms to address vulnerabilities in the Treasury and short-term funding markets, which contributed to the need for intervention by the Federal Reserve in 2020.
- The underlying causes of Treasury market stress in 2020 — the limited ability of dealers to make markets during flights to liquidity — remain unaddressed. This highlights the importance of dealer intermediation and nonbank participants in critical markets.
The level of contagion risk for banks has reverted to more normal levels. However, vulnerabilities persist in connection with the central clearing process, resulting in potential sources of contagion risk.
- As measured by OFR’s Contagion Index in our Bank Systemic Risk Monitor, some banks showed higher levels of contagion risk after the outbreak of COVID-19. But these values have since fallen back to pre-pandemic levels, decreasing the potential for contagion risk emanating from banks.
- The Contagion Index’s higher scores for banks reflected the actions of non-depository financial institutions, such as insurers and mortgage lenders, to increase the sizes of the deposits they hold at banks.
- Market volatility in March 2020 led to an increase in estimated default risk for CCPs. The sudden demand for additional margin by CCPs among other standard practices may impose significant stress and create the potential for contagion.
- Another vulnerability is that relatively few CCPs hold material positions in the central clearing process, which increases the risk that problems at one CCP could spread quickly to others.
While the low-interest rate environment supported the economic expansion, it also increased leverage levels, which remain high for some financial institutions.
- A decline in lending, combined with compressed net interest margins, makes it more difficult for banks to profit from traditional-deposit taking and lending activities. As a result, the biggest banks 15 have offset the decline in lending with gains from other business lines, such as trading, investment banking, and asset management.
- As large investors in fixed-income securities, insurers continue to face investment challenges in the current low interest-rate environment; certain minimum investment returns must be met to fund their obligations.
- Although the hedge fund industry is still weary of the losses it experienced during the pandemic, some hedge funds have been taking on more risk by increasing their balance sheet leverage and exposure to riskier asset classes.
Cyber risk has grown due to the mounting economic costs inflicted by cyberattacks and the increasing expense required to guard against them.
- The price paid to address a cyberattack has gone up. In 2021, the U.S. led the world in the average cost of data breaches at $9.05 million, up 5% year-over-year. That is more than double the $4.24 million global average cost.
- One factor driving up the cost of data breaches is the increasing downtime companies experience following successful cyberattacks. For example, victims face an average of 23 days of downtime following a successful ransomware attack.
Although climate change has introduced vulnerabilities to the financial system, its potential risk to the financial system is still difficult to identify, assess, and forecast.
- Assessing the risk to financial stability posed by climate change is complicated by the medium- to long-term nature of the threat. At the same time, markets tend to focus on more immediate-to-intermediate threats.
- Climate change is expected to have a large and diffuse impact on various regions of the country, but at this point, it is difficult to assess how climate change will ripple through the economy and, in turn, the financial system.
- Climate models provide an expectation of long-term climate changes, but data gaps between climate and economic models impede a full understanding of how climate change is expected to translate into deeper levels of financial risks.