Federal Reserve warns of potential ‘strains’ on US banks

US banks risk losses from the coronavirus crisis that could strain their finances, the Federal Reserve warned on Friday, as it laid out a litany of vulnerabilities and risks to the financial system including high corporate debt levels and excessive concentration among hedge funds.

The message from the Fed, delivered in its semi-annual report on financial stability, included a warning that asset valuations could fall again, despite a recent rally which was partly driven by the US central bank’s efforts to shore up financial markets.

“Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse, or financial system strains re-emerge,” the Fed said.

US banks entered the tumult with strong balance sheets, setting aside tens of billions of dollars for potential loan losses since the pandemic began and insisting they were so resilient that they would be able to continue to pay dividends.

The Fed warned, however, that lenders could face “material losses” from lending to struggling borrowers who are unable to get back on track after the crisis. 

“The strains on household and business balance sheets from the economic and financial shocks since March will probably create fragilities that last for some time,” the Fed wrote.

“Financial institutions — including the banking sector, which had large capital and liquidity buffers before the shock — may experience strains as a result.” 

Lael Brainard, a Fed governor, added: “Forceful early interventions have been effective in resolving liquidity stresses, but we will be monitoring closely for solvency stresses among highly leveraged business borrowers, which could increase the longer the Covid pandemic persists.”

The Fed pointed out that the debt levels of businesses had already been high at the beginning of 2020. The decline in their revenues had brought about a “widespread repricing of credit risk” and a slower pace of issuance of high-yield corporate bonds and origination of leveraged loans.

In the November edition of the same report, supervisors had zeroed in on “historically high” business borrowing as a key risk, then noting that debt was growing faster for “the riskiest firms amid weak credit standards”.

Even for household debt, which had been moderate before the coronavirus shock, the Fed warned on Friday that a “deterioration in the ability of some households to repay obligations may result in material losses to lenders”.

Banks are hoping that individual borrowers will move quickly to pay their loans after government-mandated 90-day “holidays” that allow them to delay payments to see out the crisis. 

The Fed also flagged leverage levels at hedge funds, already high before the pandemic. “At least some” of these funds had been “severely affected” by the volatility and asset price declines that hit markets at the outset of the crisis, contributing to the “dislocations”. 

“All told, the prospect for losses at financial institutions to create pressures over the medium term appears elevated,” the central bank said.

The Fed also noted the “concentration” of hedge funds as a source of trouble. The top 25 hedge funds accounted for half of the industry’s borrowing as of the second quarter of last year, it said, despite accounting for less than 14 per cent of its net assets.

“Market participants have raised concerns over this concentration because distress at a few large hedge funds with disproportionately high leverage can have outsized effects, as they may have to sell large amounts of assets to meet margin calls or reduce portfolio risk during periods of market stress,” the Fed wrote. “Such deleveraging may have contributed to the poor liquidity conditions in financial markets in March.”

The Fed specifically said that defaults on leveraged loans were “likely to continue to increase, with the specific contour highly dependent on the path of overall economic activity.”

“Such developments would weaken the balance sheets of lenders, including [collateralised loan obligations] that hold leveraged loans, and amplify the economic effects of Covid-19,” it said.

The Fed has often noted the differences between the coronavirus shock to an otherwise healthy financial system and the 2008-2009 crisis, which originated within the financial system. It has also stressed that while healthy banks could not prevent financial damage from the pandemic, they could prevent additional stress from being layered on top of it.

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