Wednesday, December 17, 2014

OFR Annual Report Warns of Lingering Threats to Financial Stability

In its most recent Annual Report, the Office of Financial Research (OFR) warns that despite the strengthening global financial system, threats to financial stability still remain, and it is no time for complacency.  Formed in 2010 as a part of the Treasury Department under a mandate in the Dodd-Frank Act, the OFR is charged with improving the quality of financial data available to policymakers and to facilitate more robust and sophisticated analysis of the financial system.  As part of its mission, in an annual report to Congress, the OFR analyzes potential threats to U.S. financial stability, documents significant progress in meeting the mission of the Office, and reports on key research findings.  This year’s document reports that, though the financial system has continued to recover and strengthen, and threats to financial stability are presently moderate, several financial stability risks have increased.  The three most important are excessive risktaking in some markets, vulnerabilities associated with declining market liquidity, and the migration of financial activities toward opaque and less resilient corners of the financial system.

Market Risk -   One particular concern is market risk, which is the vulnerability of investor portfolios to large losses because of unanticipated adverse movements in interest rates, exchange rates, and other asset prices. OFR analysis also reveals elevated risks among nonfinancial corporations in the United States because of relaxed lending standards, lower credit quality, higher debt levels in relation to total assets, and thinner cushions to counteract shocks.

Liquidity - OFR analysis finds that market liquidity risks have also increased, in part reflecting structural changes in the way liquidity is provided.  OFR also remains concerned about structural vulnerabilities related to short-term wholesale funding markets because incentives still exist for fire sales of assets during periods of stress. Short-term funding markets are instrumental in providing liquidity to keep the global financial system operating

Shadow Banking - Regulators have sought to strengthen banks’ ability to weather stress by increasing capital and liquidity standards. However, OFR analysis suggests that these new regulations may have unintended effects on financial stability. OFR warns that the new capital and liquidity standards could reduce banks’ ability to lend. Large banks’ loan growth has been slow relative to the growth in gross domestic product in recent years. That could (1) interfere with the credit channel and efforts by the central bank to stimulate economic activity, and (2) shift lending activity from banks to capital markets and other forms of nonbank financing that do not have a federal government backstop and generally are subject to less prudential oversight.