Reading the financial press can make you feel like we are either at the beginning of an economic boom or that disaster is just around the corner. It can give the impression of an unstable U.S. economy. Headlines may be overblown, but it is fair to ask: Just how stable is the U.S. financial system, and what methods do we use to measure the stability?
The Office of Financial Research (OFR), an independent agency within the Treasury Department, has taken on the task of answering these questions. OFR was created as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act in order to support the Financial Stability Oversight Council. Therefore, assessing financial stability is squarely within their scope.
OFR released their first annual report on financial stability in December 2015. Their conclusion: over the past year, the threats to U.S. financial stability have increased, but currently the risk is rated as moderate. Six areas of concern were highlighted by OFR.
1. Credit Risks – Credit risks are high and continue to rise for non-financial businesses in the U.S. as well as within emerging markets. Compared to gross domestic product (GDP), non-financial business debt has reached a historically high level. The threat of a "credit bubble" is tangible.
2. Low Interest Rates – Low interest rates are welcomed in some aspects, but rates that are continuously low (as they have been for the last seven years) contribute to risky behavior by reducing risk premiums that would naturally suppress excessive market risk.
3. Inconsistency – Financial stability is certainly better than it was during the 2008 financial crisis, however, the progress has been uneven. Some vulnerabilities stubbornly remain despite remediation efforts, while new vulnerabilities in the financial system have surfaced. Some risks remain beyond regulatory control. Meanwhile, the interconnectivity of financial systems is evolving in ways that are not fully understood.
4. Central Clearing of Derivatives – Derivatives now have a central clearinghouse that helps risk management in some ways, but it concentrates the risk in central counterparties (CCPs) and this could evolve into new stressors in the market.
5. Derivative Data Repositories – Data on derivatives that is being reported to registered swap data repositories could use improvement. Data quality is not sufficient to produce a truly reliable analysis. More work is needed on standardizing and validating the incoming data streams.
6. New Bank Requirements – Dodd-Frank established new capital and leverage requirements to keep banks from becoming overextended, but new risks have emerged as a result. OFR has found that in some ways, the new requirement increases risk-taking incentives for larger banks as they are now by definition holding more cash.
OFR realizes that this measurement is still in its infancy and will continue to refine the process over time. They list three primary goals for the future: continuing to build on their existing initiatives to "improve the scope, quality, and accessibility of financial data," refining financial stability research abilities along with correspondingly better monitoring to highlight vulnerabilities in the system, and evaluating the results of policies designed to improve financial stability.
If you are interested, the entire 137-page report can be accessed here. As the Fed embarks on the path to normalizing interest rates, the risks to the economy are likely to rise, so the OFR may take on greater importance in its next report.