Office of Financial Research Finds COVID Headwinds Eased, But Other Financial System Vulnerabilities Are Taking Shape

WASHINGTON, D.C. – The Office of Financial Research (OFR) published its 2021 Annual Report to Congress today, which concluded that while the economy rebounded, and volatility caused by the pandemic subsided, monetary policy, inflation, and cyber-attacks could heighten systemic risk.

“This year’s economic recovery cannot lead to complacency,” said Dino Falaschetti, Director of the Office of Financial Research. “Macroeconomic uncertainty will test the staying power of the economic rebound, and risks that have not traditionally been examined in terms of threats to financial stability are beginning to take shape.”

The OFR’s 2021 Annual Report to Congress report finds overall risks to U.S. financial stability remain in the medium range. This year, the report discusses how the systemic risk landscape shifted from market volatility caused by the COVID-19 pandemic towards uncertainty surrounding rising inflation, a tighter monetary policy, and the future of COVID-19. The report also looks at the emergence of non-traditional risks, such as cybersecurity and climate change.

In the 2021 Annual Report to Congress, the OFR highlights these key research findings:

Macroeconomic uncertainty remains about the continuing impact of the virus and the pattern of inflation. While the U.S. economy rebounded strongly in 2021, momentum has slowed. Though financial conditions remain stable, rising inflation increases the risk of an economic slowdown. COVID-19 variants may continue to emerge, potentially threatening to derail the ongoing recovery.

Cyber risk has grown due to the mounting economic costs inflicted by cyberattacks and the increasing expense required to guard against them. In 2021, the U.S. led the world in the average cost of data breaches. The average cost of a U.S. data breach is more than double the global average cost. One factor driving up the cost is the increasing downtime companies experience following successful cyberattacks.

Although climate change has introduced vulnerabilities to the financial system, its potential risk is still difficult to identify, assess, and forecast. 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. Additionally, risk to financial stability posed by climate change is a medium- to long-term threat, whereas financial markets tend to focus on more immediate-to-inter¬mediate threats.

In addition, the report discusses how sector-specific risk may affect financial stability. For example:

• Commercial Real Estate: While commercial real estate prices have been buoyed by strong industry liquidity, this could change amid a shift in conditions. Office vacancy rates have risen modestly to 18.3 percent, but actual office usage has declined more. This decline has had limited financial impact because office rentals are usually held in multiyear leases with credit-worthy tenants, but there is considerable uncertainty about demand for office space over the long run.
• Banking: Risks tied to the effect of low rates on banks’ profits should be closely monitored. For example, higher interest rates on longer-term investments, such as 10-year Treasuries, did not increase net interest margins. While further research is necessary, possible explanations include lower loan demand and less willingness on the part of banks to lend at longer maturities or take on more deposits.
• Hedge Funds: Hedge funds continued to perform strongly in 2021. However, the default of family investment firm Archegos on its debt earlier this year raised questions about the financial stability of the hedge fund sector. The reason is that Archegos used strategies similar to those of hedge funds and other leveraged asset managers.

“As I enter my fourth year as Director of the OFR, I am incredibly proud of how the OFR has helped the FSOC to address vulnerabilities in the financial system, both in the wake of a material threat to financial stability and during a remarkable economic recovery,” Falaschetti said. “A stable, resilient financial system is pivotal to long-term economic growth, and, ultimately, economic opportunities for American households and businesses”

The report can be found here.

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The OFR helps promote financial stability by looking across the financial system to measure and analyze risks, perform essential research, and collect and standardize financial data principally to support the Financial Stability Oversight Council and its members. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires the OFR to analyze threats to the financial stability of the United States each year and provide Congress with its key findings. For more information, visit us at https://www.financialresearch.gov/.