Office of Financial Research Assesses Key Threats to Financial Stability

WASHINGTON – Overall risks to U.S. financial stability remain in a medium range, the U.S. Office of Financial Research said in releasing its 2016 Annual Report to Congress and 2016 Financial Stability Report today.

The resilience of the U.S. financial system has continued to improve over the past year, according to the reports, but new threats have arisen, including from global disruptions and financial system evolution.

“We’ve identified four types of vulnerabilities in our 2016 threat assessment: Those created by global economic and financial disruptions, by continued risk-taking amid still-low long-term interest rates, by risks facing U.S. financial institutions, and by challenges in improving financial data,” said OFR Director Richard Berner.

“Our mandates position us uniquely to look across the financial system so we can weigh such vulnerabilities against financial-system resilience,” Berner said. “Likewise, those mandates require us to develop new risk-assessment tools and to help fill gaps in data and analysis.”

The 2016 Financial Stability Report focuses on assessment and monitoring, with a deep analysis of threats to financial stability. The 2016 Annual Report to Congress covers all the reporting requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010:

• Analysis of threats to U.S. financial stability
• Key findings and insights from the OFR’s research and analysis
• Status of OFR efforts in meeting its mission

Both reports cite these key threats:

• Potential spillovers from Europe — The United Kingdom’s vote to leave the European Union created long-term uncertainty, as risks increased for some large interconnected European banks whose profits are hobbled by nonperforming loans, slow growth, and low or negative interest rates.

• Credit risks in U.S. nonfinancial corporations — High levels of debt among nonfinancial companies continued to grow at a rapid rate. The ratio of debt to gross domestic product for these companies is near an all-time high, growing at a much faster rate than debt levels among financial businesses and households.

• Cybersecurity incidents — Financial institutions are vulnerable to cybersecurity threats because they are entwined in complex networks that rely on electronic transactions. Three possible risks to financial stability are lack of substitutability, or the ability of the financial system to replace lost services; loss of confidence in financial institutions; and impact on data integrity.

• Central counterparties as contagion channels — Clearing by central counterparties (CCPs) reduces the risk to each party in the transaction from the other party defaulting, but also concentrates risk in the CCP itself. CCPs are vulnerable to defaults by their clearing members, typically large and interconnected banks. The reports discuss OFR analysis of new data and stress test results that shed new light on CCPs.

• Pressure on U.S. life insurance companies — U.S. life insurers face an array of risks, including pressure on earnings from low long-term interest rates, sensitivity to stock prices, and growing exposures to some retirement products. The reports also cite life insurers’ interconnectedness with global systemically important banks.

• Systemic footprints of the largest U.S. banks — Although reforms after the financial crisis made the largest banks more resilient, the potential impact of a large bank failure remains substantial. The size, complexity, and interconnectedness of the largest banks constitutes a key threat to financial stability. Weaknesses in the banks’ resolution planning are also a concern.

• Deficiencies in data and data management — Risk managers and regulators have better data than ever before, but deficiencies in data scope, quality, and accessibility continue to prevent a full assessment of risks. To facilitate data sharing, the OFR has signed more than 50 memorandums of understanding with federal, state, and overseas regulators.

The reports also discusses the role in the financial system of shadow banking — the extension of credit by nonbank companies, or credit funded by liabilities susceptible to runs because they are payable on demand and lack a government backstop.

Credit extended by such companies amounted to about $15.1 trillion, as of the first quarter of 2016. It remains the major source of credit to U.S. businesses and households, providing 38 percent of credit, compared with 32 percent by banks at $12.8 trillion. Since 2011, this type of credit has grown more than $1.2 trillion, largely driven by mutual funds, hedge funds, and other asset managers.

The 2016 Annual Report to Congress is available here and the 2016 Financial Stability Report is available here.