2017 Financial Stability Report

This post is based on the executive summary of the 2017 Financial Stability Report prepared by the Office of Financial Research.

The OFR’s Financial Stability Report presents our annual assessment of U.S. financial stability. The financial system is now far more resilient than it was at the dawn of the financial crisis 10 years ago. But new vulnerabilities have emerged.

Chapter 1 of the complete publication (available here) highlights three potential threats to financial stability: vulnerability to cybersecurity incidents, resolution risks at systemically important financial institutions, and evolving market structure. Chapter 2 concludes that overall financial stability risks remain in a medium range, although market risks are elevated.

In developing our financial stability assessment this year, we kept in mind that the United States has begun a two-year period of 10-year anniversaries of key events from the 2007-09 global financial crisis. Anniversaries encourage reflection on the events of the past, the reactions to those events, and the lessons learned. Anniversaries of massively disruptive events such as the crisis lead to hard questions: How does today differ? Are we better positioned to withstand the next crisis?

From this perspective, we can see that the crisis was a turning point. In response, both financial regulation and industry practices changed substantially. These changes have brought us closer to a resilient system, one where we are better able to see problems and absorb shocks. But as we explain in this report, there are vulnerabilities that require attention. Some of those vulnerabilities have emerged in reaction to post-crisis innovations in technology, regulation, and business models.

The complete Financial Stability Report (available here) highlights key threats to financial stability. In Chapter 1, we discuss three vulnerabilities that have been building and are of most concern today. First, cybersecurity incidents have become a greater concern for the financial system since the crisis. Second, the disorderly resolution of a failing systemically important financial institution remains a risk. Third, financial market structures are evolving, sometimes lowering costs and promoting efficiency, but also raising potential new concerns.

Cybersecurity incidents rank near the top of our threat assessment because of the potential for disruption of networks and the damage such disruptions could cause to financial stability and the economy. Sound risk management—specifically, cyber hygiene—can protect firms in most cases from the many malicious actors seeking to infiltrate or otherwise disrupt their operations. But some of these malicious efforts will succeed. We discuss how cyber incidents can affect financial stability if a firm’s defenses fail. We describe some examples of factors that increase the probability of cyber incidents for all companies, including financial ones: the open structure of the Internet, the emergence of cryptocurrencies, and the legal liability of software developers. We then discuss ways to mitigate the risks that an attempt will succeed and an incident will lead to financial instability.

New tools have been developed to make the orderly resolution of a failing systemically important financial institution more likely. Still, the failure of a large financial firm could amplify and transmit distress and possibly trigger a financial crisis. The resolution process under either U.S. bankruptcy law or a special resolution authority has potential weaknesses for handling global systemically important bank (G-SIB) failures. The treatment of derivatives obligations of a failing financial firm presents a conundrum for policymakers seeking to balance contagion and run risks against moral hazard concerns. Also, tools for the orderly resolution of systemic nonbank financial firms, such as central counter-parties (CCPs) or insurance companies, are not as well developed.

Third, financial market structures continue to evolve in response to competitive forces, innovation, regulatory changes, and financial disruptions, among other factors. This report discusses three potential vulnerabilities of market structure that bear monitoring. They could make the financial system vulnerable to shocks that threaten liquidity and price discovery. First, growing concentration in the provision of some financial services means that sufficient substitutes may not exist if a dominant firm can’t perform. Second, the increasing fragmentation of trading across multiple venues and products may limit liquidity in times of stress. Third, officials and market participants are well aware of the need to achieve a timely and smooth transition to a new reference rate to replace the U.S. dollar London Interbank Offered Rate (LIBOR), which is now unsustainable. However, a disorderly transition could impair market functioning. This Financial Stability Report also provides our overall assessment of U.S. financial stability. In our assessment, risks are medium overall, based on our Financial System Vulnerabilities Monitor heat map and related analysis. As described in Chapter 2, our assessment covers the six key risks in the heat map: (1) macroeconomic, (2) market, (3) credit, (4) solvency and leverage, (5) funding and liquidity, and (6) contagion. Vulnerabilities in these areas can originate, amplify, or transmit shocks and stress. These vulnerabilities have been central in many financial crises, not just the recent one. At the same time, our Financial Stress Index—a real-time measure of stress—has been falling in 2017 and is near its lows since the financial crisis. That low reading reflects not only current subdued levels of market volatility, but also, perhaps, complacency about the future.

Market risk is of most concern now. Some valuations have approached historic highs. We know that markets work in cycles. Booms end; corrections happen. Market valuations tend to return to long-term trends over time. By itself, even a significant market correction is unlikely to cause financial instability. The severity of the global financial crisis that started 10 years ago was caused by a combustible confluence of factors. Those factors included highly leveraged financial institutions, risky and poorly understood linkages across firms and markets, households reliant on rising home prices to cover their debts, and poor oversight by official supervisors and internal risk managers.

Today, the mix is different. Consumer debt is again rising. However, the growth is in auto loans and student loans. Those loans are not tied to potentially bubbly asset prices, unlike the mortgages that fed the crisis were.

Improved transparency, regulatory policies, and risk-management practices have also made the system more robust against shocks. Regulators and risk managers now have a greater focus on stress tests and a better understanding of risks. Compared to the precrisis period, banks are more resilient, with more capital and better liquidity risk management. At the same time, a handful of complex institutions with a range of nonbank activities increasingly dominate the banking industry. As described in Chapter 1, whether a large, failing financial firm with material derivatives positions could be resolved today, without serious systemic effects, remains an open question.

The complete publication is available here.

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