Fed cautions about debt, liquidity issues, but says system is otherwise stable

Key Points
  • Financial conditions remain stable the and the system "resilient," according to the Federal Reserve's latest financial stability report.
  • The central bank cautioned about rising levels of corporate debt as well as bouts of volatility and illiquidity.
  • Student debt also is discussed, saying that levels have remained fairly stable but still posing challenges to households.
A pedestrian walks past the Federal Reserve building on Constitution Avenue in Washington on March 19, 2019.
Leah Millis | Reuters

Stock market prices remain high compared to earnings, and corporations, including those at the bottom end of the credit spectrum, continue to run up debt. But financial stability overall remains solid, according to a report Friday from the Federal Reserve.

The central bank's biannual financial stability report also indicated that prices are high for commercial real estate and farmland. It also noted a few incidents where market liquidity deteriorated.

In all, though, there are no areas identified as posing a threat to the larger stability of U.S. financial markets and the economy. In fact, the report found that the biggest threats come from abroad, through Brexit and other geopolitical risks.

"The core of the financial sector appears resilient, with leverage low and funding risk limited relative to the levels of recent decades," the report said. "Overall, the level of vulnerabilities in the financial system has moved little since" the last report in May.

The market liquidity issue gets some detailed attention in the report — Fed officials found that liquidity, or the willingness of participants to trade, deteriorated in May and August and has shown in recent times to decline in times of high volatility, which historically has not been the case. So-called flash events, where prices spike and drop quickly, could become more common, the report said, adding that the issues have been more prevalent in equity than bond markets.

More recently, the Fed faced rate spikes in the repo market, where banks get their overnight funding.

Market participants told the Fed that reasons for the trend include decreased willingness of principal trading firms to provide liquidity as well as a higher concentration in the firms that generally provide liquidity.

On debt, the report notes that for much of the recovery household borrowing grew roughly in line with GDP. However, that has not been the case for business debt, which is now "historically high" compared with economic growth. Debt to assets is around a 20-year high, the Fed reported.

In addition, growth has happened in particular at the lowest end of the credit spectrum, posing a potential threat in the event of a downturn where that debt could face downgrades.

By contrast, household debt has expanded primarily among those with better credit.

The report does note that student debt is growing but said default levels have been around historical averages.

"Although the risks posed to the broader financial system appear limited, as the majority of student loans were issued through government programs, the elevated student loan balances and delinquency rates highlight the challenges associated with debt payments some households continue to face," the report said.

In the banking sector, the report said institutions remain well capitalized but face declining profitability. Hedge funds leverage is around historic highs but is at lows for broker-dealers.