a) Valuation Pressures as measured by asset prices relative to economic fundamentals. This highlights the possibility of price crashes.
b) Borrowings by businesses and households measures how much these units are vulnerable to distress if the assets fall in value.
c) Leverage of the financial sector looks at the potent systemic risk that financial institutions may not be able to handle adverse price and liquidity shocks.
d) Funding risks explores the risk that a run on funds may expose the financial system to liquidity-driven bankruptcy
Observations on Asset valuations
The Fed has observed that the prices of most risky assets had increased sharply since the May 2021 report. In many specific asset classes like equity and real estate, asset prices were not exactly compatible with expected cash flows. For example, house prices had outstripped rent growth and equity prices had outdone earnings growth consistently.
On the positive side, the Fed was of the view that despite rising housing prices, there was no evidence of deteriorating credit standards or a surfeit of leveraged investment activity in the housing market. Fed noted that housing and equity asset prices remained vulnerable to significant declines if the economic recovery stalled or if investors became risk-averse.
Observations on borrowings by micro units
Fed has observed that the key analytical metrics like the debt/GDP ratio, interest coverage ratio and debt service coverage ratio had returned to pre-pandemic levels. The Fed also noted that most businesses had benefited from sustained earnings growth, low interest rates and almost limitless government support.
However, the one risk factor has been the uneven nature of the recovery. For example, smaller businesses have taken longer to recover from the Delta Variant impact. Similarly, household debt had also benefited from the borrower relief programs, federal stimulus and boost to aggregate personal savings rates. However, the risk is that once the government support programs were withdrawn, the vulnerability could be exposed.
Observations on financial sector leverage
On the positive side, the Fed has underlined that profitability of banks was much stronger and capital ratios had exceeded statutory requirements. However, the Fed also noted that the net interest margins or NIMs of banks had been under pressure due to loans to vulnerable sectors. Also, insurance companies and hedge funds were still substantially leveraged at well above the pre-pandemic levels.
Observations on funding risks
Fed noted that funding risk would not pose a challenge as most local banks relied only modestly on short-term wholesale funding. Also, their holdings of high-quality liquid assets or HQLA was sizable and did not pose any systemic risk. There were some structural weaknesses in money market funds and other cash management vehicles, but they were not large enough to create systemic risk.
Key takeaways for India from the Fed Financial Stability Report
India has tried to align its liquidity levers and monetary policy largely with the thrust of the US Fed. Here is what this FSR means for India.
- It is gratifying that risks to the US financial system had eased over the last one year and that should keep flows steady. Strong corporate balance sheets of corporate America, as pointed out by the Fed also implies that the huge export demand generated by US companies should continue in the foreseeable future.
- Fed has cited that they were worried about asset price risk, both in the equity and the housing market. That underlines the intent of the US Fed to move aggressively with taper and also front-end rate hikes to cool the US economy; especially asset prices to the extent they were out of sync with fundamentals.
- The good news for emerging markets like India is that the US Fed still does not see any deterioration in housing credit quality. That means, any major crisis of the magnitude of sub-prime was unlikely. The risk would be more at the periphery than deep-rooted like in the case of 2008, before the implosion of Lehman.
- The Fed FSR reports have pointed to the market instability caused by meme stocks as well as the sudden surge in retail participation. Fed also observed that stock markets were quite often being distorted due to the influence of social media. That is a problem that SEBI has also been grappling with and any signal from the Fed could see similar tightening measures in India also.
- Fed also observed that the combination of social media and the existence of low-cost Robinhood type brokers was resulting in a sharp rise in the ability of retail to collectively influence stocks. These are early days in India but it is surely going to direct the thought process of the regulators on those lines.