EXECUTIVE SUMMARY

The 2022 OFR Annual Report reviews financial market developments, describes potential emerging threats to U.S. financial stability, and assesses global economies, financial markets and liquidity, financial institutions, digital assets, cybersecurity risks, climate change risks, and the performance of the Office.

Overall risks to U.S. financial stability are elevated and have increased since last year’s report. This report discusses the Office’s assessment of risks associated with the U.S. financial system and identifies areas causing stress, such as the following:

  1. Weaker economic growth and monetary tightening.
  2. Elevated volatility in the Treasury and short-term funding markets.
  3. Surges in commodity pricing and hedge fund leveraging and interconnectedness.
  4. Crypto asset volatility and the depegging of the third-largest stablecoin.
  5. Increased state-sponsored cyberattacks and resulting changes in the cyber insurance market.
  6. Climate-related financial risks.

February 2022 marked the beginning of major events that would stress the financial system. Contributing factors to the financial and economic stress included Russia’s war against Ukraine, the Federal Reserve’s tightening monetary policy to reduce inflation, lingering supply disruptions as economies worked past the COVID-19 pandemic, and economic uncertainty based on the slowing of global growth.

Strong consumer demand, labor supply shortages, and supply disruptions in commodities markets were among the major triggers of global inflation. With rising interest rates, certain sectors are more susceptible to credit risks. The total reported market capitalization of all crypto assets has fallen by more than 70% from its peak of $3 trillion in November 2021. The increased frequency of cyberattacks and the growing costs to guard against them continue to pose risks. Finally, climate change introduced vulnerabilities to the financial system, yet assessing the risk is complicated by the threat’s medium- to long-term nature.

Macroeconomy

The U.S. labor markets remain tight, although real wages have fallen, and the participation rate remains below its pre-pandemic level due to shifting economic dynamics post-pandemic. The job market’s strength supports households but raises concerns about continued inflationary pressures.

Overall, macroeconomic risks to U.S. financial stability have increased since 2021. High inflation and a slowdown in growth posed risks to household balance sheets, residential and commercial real estate, and other parts of the financial system. In addition, the rising interest rate environment affected sovereign debt risk and segments of the corporate debt market. Consumer price inflation began rising in the spring of 2021. It continued to rise through the start of 2022, climbing to high levels not seen in several decades and remaining well above the Federal Reserve’s target of 2% per annum. Several factors drove higher prices, including strong aggregate demand, a post-pandemic reopening of the economy, and a material shift from services to goods.

Supply chain distortions have been larger and more persistent than markets anticipated, putting upward pressure on prices. New waves of COVID-19 infections continue to disrupt overseas supply chains (particularly in China) and the domestic services sector. As a result, domestic and global energy prices increased significantly throughout the year, affecting domestic producers and importers. The high price of energy was a key contributor to the recent record inflation, with energy as one of the fastest-rising components of several price measures. In addition, Russia’s war against Ukraine significantly disrupted European energy markets, driving up costs in the global market.

At the same time, the post-pandemic recovery in the U.S. labor market has been remarkable, and indicators show that the labor market remains tight. The unemployment rate is currently near a 50-year low. On the other hand, Russia’s war against Ukraine impacted global growth and trade. The war decreased expectations of global macroeconomic growth. The World Bank reduced its global growth forecast for 2022 to 2.9% (from 4.1%) and forecasted a contraction of 4.1% in Europe and Central Asia.

High inflation led to considerably tighter conditions in financial markets globally. Interest rates broadly increased. The Federal Reserve began hiking the federal funds’ target rate in March 2022 after maintaining a target rate of 0% - 0.25% since March 2020. As of September 2022, the target range of federal funds stood between 3.0% - 3.25% and is expected to increase. The Federal Reserve also began reversing its quantitative easing policy and is now engaging in quantitative tightening. Central banks around the world implemented similar measures. In June, the European Central Bank (ECB) announced that it raised its key policy rate for the first time in over 11 years. The ECB raised interest rates from -0.50% in July to 1.5% in October, with further increases planned. Despite inflation rising to reach the Bank of Japan’s target of 2% for the first time in years, the bank intends to maintain rates at just below zero with no expected rate increases.

The global economy is experiencing high inflation driven by strong demand following the COVID-19 pandemic and disruptions in the supply of energy and other commodities:

  • U.S. economic growth has slowed as financial conditions have tightened, partly due to interest rate hikes and quantitative tightening. The U.S. labor market remains strong, but the labor force participation rate and the employment-to-population ratio are below pre-pandemic levels.
  • Higher inflation in the post-pandemic global economy and a dramatic rise in commodity prices following Russia’s war against Ukraine have hampered global growth prospects. European economies are particularly vulnerable to rising energy costs that affect labor productivity and consumption. As a result, many European economies entered into a recession in 2022.
  • Central banks are raising interest rates to fight inflation but must balance this against the risk of overtightening. European central banks are facing the prospect of stagflation as the U.S. dollar continues to strengthen and the war in Ukraine drags on. Moreover, increasing yields in peripheral eurozone countries have given rise to fragmentation concerns and a potential return of the European debt crisis of the 2010s.
  • In emerging markets, food and energy prices remain high, hampering economic growth and raising social tensions. In addition, increasingly tight financial conditions may push some debt burdens to unsustainable levels.

Credit Risk from Tighter Financial Conditions

Corporate leverage remains elevated, but it has declined from the peak. Credit risk premiums, the difference in yield between a corporate bond and a Treasury bond of the same maturity, increased sharply in 2022 and are above historical medians. As the U.S. economy transitions from an era of unprecedented quantitative easing and zero interest rates to one with quantitative tightening and higher rates, the outlook for the corporate credit cycle is more uncertain. As a result, corporate sector vulnerabilities could amplify stress in the economy and financial markets.

The 2007-09 financial crisis illuminated financial-stability channels related to the household sector and how systemic shocks to the financial system can originate from household balance sheet issues. The net worth of U.S. households declined to $143.8 trillion in Q2 2022 from its peak of $149.8 trillion in 2021, based on the Federal Reserve’s Financial Accounts data. Adjusting for inflation and expressed in real terms, household net worth remains slightly higher today compared to pre-pandemic levels, or $123.8 trillion compared to $116.4 trillion in Q4 2019. Household debt increased over the past year to levels not seen since 2007. The year-over-year aggregate growth in household debt is 7.0% in September 2022, or $15.6 trillion.

A depressed commercial real estate (CRE) market can cause and has caused past financial stability issues, such as during the 1990-91 recession, when depository failures were primarily due to CRE lending-related losses. However, we have seen limited CRE market stress in recent years as the CRE market has performed well with strong occupancy rates, rising rents, and property values. However, offices in dense central business districts such as New York and San Francisco had physical office occupancy rates well below their pre-pandemic usage, due to the work-from-home (WFH) phenomenon.

Tighter financial conditions expose credit risk vulnerabilities:

  1. Nonfinancial firms with floating-rate debt or near-term maturities face larger financing burdens. This headwind is amplified by weaker fundamental trends.
  2. The CRE market’s performance is softening after exceptional performance in recent years. Unlike previous market downturns, credit losses on CRE loans are not expected to pose a significant risk to financial stability. The longer-run performance of the office sector is unclear, especially in dense central business districts where WFH appears to be a permanent development.
  3. Household leverage remains at historically low levels because low interest rates and COVID-19 pandemic-related support programs aided households in decreasing debt obligations. Household financial conditions have deteriorated for some, due to inflationary pressures. Delinquency rates have increased more rapidly for renters compared to homeowners among the most vulnerable households.
  4. Rapidly rising mortgage rates dampened home price appreciation, though the risks to the economy are lower than they were in the period leading up to the 2007-09 financial crisis.

Financial Markets and Liquidity

Short-term funding markets support core functions of the financial system, providing liquidity to borrowers and allowing corporations, financial firms, and other investors to meet immediate and near-term cash needs. Funding markets are relatively stable, but market liquidity remains fragile. In addition, market volatility and the impact of Federal Reserve interest rate increases are magnified in short-term markets.

In Treasury markets, the persistent specialness in certain securities may have resulted from the repositioning around Federal Reserve tightening combined with one-sided positioning and limited supply. As tightening continues, there is a possibility that liquidity challenges may persist if high levels of uncertainty remain about the future path of policy. In the market for short-term Treasury securities, substantial increases in investors’ cash balances have led to demand outpacing the supply of new Treasury bills.

While market risk, or volatility in asset prices, is not the same as financial-stability risk, market risk may interact with and reinforce other vulnerabilities where the combination amplifies financial-stability risk. For example, negative nominal and real yields distorted asset prices and encouraged borrowers to maintain high leverage levels. The normalization of yields reduces these effects and provides a more robust set of investment opportunities for fixed-income investors, reducing incentives to reach for yield.

The overall health of the municipal market was strong after municipalities received support during the onset of the COVID-19 pandemic. In addition, states entered the monetary-tightening cycle in a strong position due to the 2021 economic expansion, which increased tax receipts and saw a decline in fuel and energy costs. Infrastructure spending continued to be a significant issue because municipal issuers invested in repairing or replacing failing bridges, dams, utilities, and other projects. Since the 1960s, the proportion of U.S. infrastructure spending to GDP has declined by 47%. This lack of expenditures has placed municipalities and states at risk of catastrophic infrastructure failures. The economic impact of infrastructure failures is significant and can impact communities for decades through higher taxes, reduced productivity, and higher costs.

Fixed income and equity investors experienced large losses from a sharp increase in risk-free rates and may face more declines if market sentiment deteriorates:

  • Treasury market volatility is elevated, and liquidity remains tight amid monetary policy uncertainty. More generally, bond market stress measures are showing levels comparable to March 2020 and the early days of the 2007-09 financial crisis.
  • Short-term funding market conditions have tightened as investors become more risk averse amid economic and monetary policy uncertainty. Structural vulnerabilities remain in some segments of the short-term funding market, such as money market funds and other cash management vehicles.
  • Asset prices have fallen sharply, but many valuation metrics are either elevated or near historical averages. Further price declines are possible if economic conditions weaken materially or if another shock emerges.
  • State and local governments emerged from the COVID-19 pandemic with strong balance sheets but face increasing cost pressures from energy and wage inflation, which siphon resources from needed infrastructure spending.

Financial Institutions

After enjoying a relatively benign economic and financial climate in 2021, buoyed by strong profitability and limited credit losses, U.S. banks entered a period of heightened uncertainty. Higher inflation and interest rates, a greater risk of recession, and enhanced global risks due to Russia’s war against Ukraine lowered the sector’s outlook. Nevertheless, despite headwinds, in aggregate, the U.S. banking sector remained well capitalized and maintained risk-based capital ratios well above regulatory minimums.

While the insurance industry was not immune to the stresses of 2022, it is unlikely to meaningfully affect the U.S. financial system’s near-term stability. Yet, there remain important issues impacting the insurance industry, including the following:

  1. Changes in insurers’ investment policies as interest rates rise and fall.
  2. Rising claim costs due to inflation.
  3. Increased life sector involvement by private equity–affiliated insurers.
  4. The increasing stress on the ability of the private insurance industry to cover large and growing risks.

Since the market downturn in March 2020, hedge fund leverage and asset class exposures have grown significantly, although these increases have moderated in the past year. Hedge funds engaged in various trading strategies to maximize risk-adjusted returns. While many hedge funds sought to mitigate the sensitivity of their performance to adverse market movements, certain fund classes were not able to mitigate with the rise of inflation.

In February and March 2022, the surge in commodity prices following Russia’s war against Ukraine forced several commodity-focused central counterparty (CCP) clearinghouses to raise initial margins on various commodity contracts. The increases were most significant in Europe, where margins nearly doubled compared to the prior year’s average. In the U.S., the initial margin increase at commodity CCPs was 20%-30%. The sudden increase in volatility would have led to even larger increases were it not for the residual effects of market volatility in early 2020, which led CCPs to maintain high resource levels in the U.S. due to the lengthy lookback period of their risk models. Although increased margin demands have put a temporary strain on the liquidity of some members, the resulting elevated levels of posted collateral can aid in easing concerns about potential CCP defaults going forward.

Financial institutions face uncertainty and unique challenges due to higher interest rates and inflation, slower economic growth, and geopolitical risks:

  • In aggregate, the U.S. banking sector remains well capitalized and has maintained risk-based capital ratios well above regulatory minimums.
  • Insurers have increased the risk profile in their investment portfolios in response to low interest rates in recent years, thereby making them more exposed to investment losses during an economic downturn. Inflation continues to negatively affect property and casualty insurers as claim costs rise, especially for homeowners and automobile insurance.
  • Bond fund flows are sensitive to interest rate increases. Significant outflows may strain fixed-income markets. During historical periods of rising interest rates, the size of bond funds was much smaller, and dealer capacity to intermediate was much greater.
  • The hedge fund industry has experienced negative returns but has been able to outpace broad market indices during this high inflationary period in 2022. The industry’s asset exposures and leverage moderated in 2022 after rebounding from the 2020 downturn. Despite declines in aggregate industry leverage, some funds are highly leveraged and may pose a threat to financial stability.
  • The surge in commodity prices in March and September 2022 triggered large increases in initial margins at some CCPs. Several commodity-centric CCPs faced significant stress, although no CCP member defaulted. The size and concentration of member positions in commodity markets have raised questions about the transparency of exposures across CCPs, making it difficult to set effective margins.

Digital Assets

Risks in the digital-assets markets were highlighted when several crypto asset lenders suspended customer withdrawals following the decline in crypto asset prices in June 2022. Central banks can issue central bank digital currencies (CBDCs), which are digital liabilities of the central bank. As discussed in the 2021 OFR Annual Report, CBDCs should be immune to the run risk of stablecoins but may increase flight-to-safety concerns. U.S. regulators are currently exploring CBDCs. The Federal Reserve issued a CBDC consultation paper in January 2022 and is continuing its independent research into and experimentation with CBDCs. Globally, around 90% of central banks now report studying or working on developing a CBDC. Four central banks issued CBDCs (the Bahamas, the Eastern Caribbean Currency Union, Jamaica, and Nigeria), and over 30 CBDCs are in development or pilot phases.

Digital assets experienced a volatile 2022, with the total market capitalization falling from over $2.2 trillion in January 2022 to under $1 trillion in August 2022. Losses to date appear largely contained within the digital-asset sector, although the risk of contagion looms.

  • Many prominent crypto asset trading and lending platforms suspended customer withdrawals. Some also filed for bankruptcy.
  • The third largest stablecoin at the time depegged in May 2022. During that month, the $18.5 billion loss in value highlighted risks associated with stablecoins and spillover risks in the digital-assets space.

Cybersecurity Risk

Russia’s war against Ukraine heightened the prospect of state-sponsored cyberattacks and the importance of vigilance and planning in technology infrastructure. Prior events—such as the 2012 coordinated denial-of-service cyberattack, where several major U.S. financial institutions suffered simultaneous outages—were believed to be in response to the U.S.-imposed economic sanctions on Iran. Furthermore, beyond attacks directly targeting U.S. financial services institutions, there were concerns of unintended spillovers from cyberattacks stemming from state-sponsored actions, as demonstrated by the NotPetya malware incident in 2017. This alleged Russian attack infected software used by Ukrainian organizations and then spread to companies worldwide, leading to billions of dollars in U.S. corporate losses.

Organizations are continually working to mitigate the consequences of attacks in response to these various actors’ threats to the financial system. Otherwise, there is the potential that a successful attack will cause significant harm not only to the organization but to the financial systems in which they operate. Three mechanisms can be used to prepare for potential cyber incidents:

  1. Mechanism 1 - technology security, resiliency, and recovery. This consists of preventing attacks by minimizing vulnerabilities that adversaries could exploit, such as active cyber defense, cybersecurity hygiene, and insider threat management.
  2. Mechanism 2 - coordination and information sharing. Cybersecurity discussions tend to focus on reducing risk for the individual through means such as multifactor authentication and zero-trust architecture, coordination, and communication across firms and government agencies, such as the Cybersecurity and Infrastructure Security Agency (CISA), the Office of Cybersecurity and Critical Infrastructure Protection (OCCIP), and the Financial Services Information Sharing and Analysis Center (FS-ISAC).
  3. Mechanism 3 - cyber insurance. This can offer vital financial support and recovery assistance to an entity suffering from a cyberattack. Increased numbers of written policies and premiums per policy have driven rapid growth in this sector. As a result, annual policy premiums grew at a double-digit rate or (in some cases) a triple-digit rate, depending upon the risk-and-loss profile of the insured.

The increasing frequency of cyberattacks and the growing cost to guard against them pose risks to the financial system:

  • Russia’s war against Ukraine has substantially increased the perceived risk of state-sponsored cyberattacks in the U.S. financial services sector, although the majority of attacks have been focused on theft. The cyber posture of the sector has responded through increased information sharing and focused readiness exercises.
  • Firms can implement cyber-defense mechanisms that reduce financial stability risk. These include undertaking internal/individual security measures, such as the application of the zero-trust framework; information sharing and coordination among firms and the government; and cyber insurance.
  • As the cyber insurance market matures and adapts to new threats, substantial changes are emerging.
  • The number of policies written continues to grow as the need for cyber risk insurance becomes increasingly evident and cyber risk coverages are excluded from general insurance policies.
  • Obtaining cyber insurance has become more challenging because insurers have tightened their underwriting standards and insurance premiums for cyber policies have risen substantially.

Climate-related Financial Risk

Climate-related financial risk is the risk of financial losses due to rising global temperatures and accompanying environmental shifts, such as rising sea levels and more severe weather events. Climate-related financial risk poses physical and transition risks to the financial system. Physical risks describe the potential destruction or damage of physical assets, the impact on economic activity, and other losses from extreme weather events. Transition risk, created by technological advances, policy changes, and preferences shifts, can be more challenging to quantify economically. Governments face financial risks related to climate change. An increase in climate-related events is likely to cause firms and households to increasingly rely on the insurance and banking sectors. At the same time, local municipalities and state governments are likely to rely on the federal government for financial support. Some households and businesses might be left without insurance as private insurers may become increasingly unwilling or unable to insure against climate-related physical risks. Climate-related damages in the U.S. have grown to about $133 billion per year, with the federal government often stepping in with emergency relief and acting as an insurer of last resort.

Climate change impacts numerous aspects of the financial markets, often in unanticipated ways. In addition to transition risks, a myriad of physical risks can affect the financial markets. Climate risks are being priced into financial assets, but the extent varies depending upon the market, and not all risks are priced for the market. For example, the potential risk of mispricing lies in the mortgage industry. Lenders may be indirectly encouraged to underwrite mortgages without accounting for flood risks and then pass these loans to government sponsored mortgage companies (GSMC) to securitize into mortgage pools. This may indirectly encourage households to locate or, after disaster strikes, rebuild in areas prone to risks such as flood, hurricane, and wildfire. Recent evidence suggests this hasn’t been the case, but it could be a source of future risk.

Climate-related financial risk has introduced vulnerabilities into the financial system, although assessing the risk to financial stability is complicated by the medium- to long-term nature of the threat.

  • Physical and transition risks have already affected the broader economy.
    • Assessing and forecasting these risks to financial stability can be challenging.
    • Emerging areas of research highlight how interactions and networks in financial markets might amplify these risks.
  • The costs of climate change related to damages and mitigation may be transferred to third parties.
    • Firms and households affected by climate disasters are increasingly relying on the insurance and banking sectors to finance repairs and fund mitigation efforts.
    • State and local governments are likely to rely on federal support for recovery efforts, disaster relief, and insurance programs.
  • Climate-related risks could affect financial institutions and GSMCs through securitization, especially in flood-prone areas.
  • To facilitate the dissemination of data, the OFR, in collaboration with the Federal Reserve, piloted an OFR-hosted Climate Data and Analytics Hub that provided staff from the Federal Reserve Board and Federal Reserve Bank of New York access to public climate and financial data, high-performance computing tools, and analytical and visualization software.

The OFR’s Performance

FY 2022 was a significant year for the OFR, highlighted by the launch of two major pilot programs: the Non-centrally Cleared Bilateral Repo Pilot Project and the Climate Data and Analytics Hub pilot.

While the OFR’s centrally cleared repo collection has been an asset in allowing regulators greater visibility into this market, non-centrally cleared bilateral repo has remained largely opaque and regarded as a potentially significant liability for regulators. This led to the creation of a pilot data collection project in which nine firms volunteered to participate. The project shed light on several market practices, including the composition of collateral, the identity of counterparties, and the terms of repo agreements. Notably, it was determined that most non-centrally cleared bilateral repos are collateralized by U.S. Treasuries, despite the eligibility of much of the collateral for bilateral central clearing. The OFR has initiated the rulemaking process to establish a permanent data collection, and the pilot data collection and subsequent analysis are expected to lead to a proposed rule governing these repo transactions.

The OFR’s Climate Data and Analytics Hub pilot was intended to allow regulators to assess climate risks to financial stability. The project met the Federal Reserve’s request for reliable climate data and tools, and it allows the OFR to potentially provide additional capabilities or enhanced services to the Council and its member agencies. Pilot participants included researchers, analysts, and support staff of the OFR; the Federal Reserve; and the Federal Reserve Bank of New York. After the conclusion of the pilot, a review will be conducted to document lessons learned, assess scalability, and document future requirements.


Regulatory Oversight Committee (ROC)

The OFR assumed the role of ROC Secretariat, a key role in the organization, and is providing administrative services to the global body of authorities for multiple International Organization for Standardization (ISO) standards and data. The ROC is composed of more than 50 countries and is responsible for overseeing the governance of multiple globally used financial data standards, including the Legal Entity Identifier (LEI), the Unique Product Identifier (UPI), the Unique Transaction Identifier (UTI), and Critical Data Elements (CDE) for over-the-counter derivatives transaction reporting.


Data Center

The enhancement of the Financial Instrument Reference Database (FIRD) was a notable achievement. It included the addition of new data elements of the Financial Information eXchange (FIX) Protocol, and it brought in ideas for future functionality from the X9 Industry Forum for Financial Terms Harmonization, which analyzes and maps the terms and definitions across multiple industry standards. The Office also made significant gains toward fulfilling its mission to promote financial stability by delivering high-quality financial data standards, including improving the quality and utility of financial data in a way that facilitates data aggregation, integration, sharing, access, interoperability, and exchange.


Research and Analysis Center

Throughout the year, the OFR published numerous working papers on timely topics of high importance to financial regulators, including hedge funds, central bank digital currencies, and Treasury market stress. Other noteworthy content included financial stability monitors, research and evaluation of financial stability policies, and briefings for the FSOC and other stakeholders. In addition, the Office assisted the Defense Advanced Research Projects Agency (DARPA) EcoSystemic program to address disruptions to distributed financial ledgers.


Integrated Planning

Significant progress was achieved this year on the OFR’s Workforce Plan 2020–2024 by addressing gaps related to staff retention, workforce development, training, and recruitment. Of particular note were the development of an OFR-wide competency model and the completion of a competency assessment for all staff and leaders. In addition, the OFR expanded its team by 14%, enabling the closure of key gaps in subject matter expertise. The OFR filled multiple critical leadership positions, including Associate Director of Financial Institutions and a supervisory information technology specialist. In addition, the Office added considerable expertise and bench strength to its research, analysis, information technology, operations, and public affairs teams.


Technology

The Office implemented new layers of security focused on infrastructure and data. This included the creation of a new security operations facility that enabled significant advances toward a zero-trust architecture, in line with the federal mandate that all agencies should be compliant with zero trust by 2024. The OFR also completed the four-year migration from Treasury-hosted services, hardware, and equipment to a 100% cloud-based environment. Finally, the Office initiated hybrid workplace flexibilities, including telework and remote work, following temporary workplace provisions that began during the COVID-19 pandemic.


Back to 2022 Annual Report