FRB Reports: Financial stability risks; Supervision and regulatory priorities

Large banks mitigate financial uncertainties; the FRB denotes “work to do” to meet supervisory expectations for governance and controls

November 2022

KPMG Insight. The FRB’s reports highlight that, although the banking industry remains financially sound with strong capital levels, institutions are beginning to take steps to protect against weaker economic conditions and future uncertainties, including continued increases to loan loss reserves. Areas that may be vulnerable to evolving economic conditions and subject to heightened oversight will include exposures to crypto and digital assets and leveraged positions, changes in liquidity and capital, the stability of customer deposits, investment securities valuations, and bank and customer borrowing costs. The FRB highlights that many large financial institutions have “work to do” to meet supervisory expectations for “governance and controls” in areas such as operational resilience, information technology, third-party risk management, and BSA/AML compliance. The agency notes firms are expected to make the needed investments in systems and risk management to ensure adequate controls. 


The Federal Reserve Board (FRB) has published two semiannual reports: 1) the Financial Stability Report and 2) the Supervision & Regulation Report.

The Financial Stability Report presents FRB’s current assessment of the stability of the overall U.S. financial system, while the Supervision & Regulation Report highlights FRB’s assessment of banking system conditions, as well as regulatory and supervisory developments in 2022 and priorities for 2023.

The reports are outlined in detail below.
 

Financial Stability Report

FRB’s Financial Stability Report distinguishes between shocks to, and vulnerabilities of, the financial system, and primarily focuses on vulnerabilities across four categories, as well as several near-term risks to the financial system, each of which is highlighted below.

Overview of financial system vulnerabilities

Asset Valuations

  • Prices of risky assets generally fell amid a less favorable outlook and rising interest rates.
  • Risk premiums in equity and corporate bond markets were near their average historical distributions.
  • Real estate valuations remained very elevated despite weakened activity and price increases slowed.

Borrowing by Businesses and Households

  • Although debt of nonfinancial businesses and households grew in the first half of 2022, the ratio of debt-to-gross domestic product (GDP) remained unchanged at a moderate level.
  • Interest coverage ratios for large businesses reached historically high levels, and debt issuance by the riskiest companies slowed; the business debt-to-GDP ratio remained high.
  • Household debt was at modest levels relative to GDP and concentrated among prime-rated borrowers.

Leverage within the Financial Sector

  • Banks’ risk-based capital ratios remained in the middle of the range that has prevailed since 2010, and stress tests show the system remains resilient to a severe recession.
  • Leverage was somewhat elevated at hedge funds, and bank lending to the broader set of nonbank financial institutions continued to grow.
  • Monitoring “hidden pockets” of leverage that are tied to banking sector through private equity firms, mortgage originators, and other types of unregulated nonbank financial institutions. These pockets could amplify adverse shocks; FRB notes this could be enhanced with more comprehensive and timely data about credit and lending to these actors

Funding Risks

  • Domestic banks maintained high levels of liquid assets and stable funding.
  • Structural vulnerabilities persist at money market funds and some other mutual funds.
  • Stablecoins remained vulnerable to runs; the digital assets ecosystem could grow rapidly and increase its interconnections to the traditional financial system. Spillovers from runs on stablecoins represent the most salient financial stability risk, particularly for those stablecoins backed by traditional money market instruments (See KPMG Regulatory Alert, here).
  • Central counterparties maintain elevated margin requirements amid high market volatility, which clearing members have continued to meet.

Near-Term Risks to the Financial System

The FRB highlights possible interactions between the existing vulnerabilities and these near-term risks:

  • Persistent inflation and monetary tightening by central banks globally, energy prices, market fragilities, and geopolitical tensions – as among the most cited potential risks over the next 12 to 18 months by respondents to the “Survey of Salient Risks to Financial Stability” (conducted by the Federal Reserve Bank of New York).
  • Unexpectedly and persistently high inflation and higher interest rates.
  • Shocks caused by cyber events, especially cyberattacks, could impair the U.S. financial system
  • Climate-related financial risks. Anticipating the potential effects on the safety and soundness of financial institutions and on financial stability, the FRB is working towards developing robust climate scenario analysis with well-constructed scenarios, models, variables, and projections.
     

Supervision and Regulation Report

FRB’s Supervision and Regulation Report outlines its current assessment of banking system conditions, and highlights regulatory and supervisory developments over the year along with priorities for 2023. Each are briefly outlined below.

Banking System Conditions

  • Banking system remains financially sound amid changing economic conditions, however bank market indicators have weakened since the start of 2022.
  • Loan balances continue to increase, and banks continue to report low delinquency and net charge-off rates in major loan categories.
  • Bank financial performance remains stable; capital and liquidity positions remain adequate, while securities depreciation is significant at some banks.

Regulatory Developments

  • Crypto-related activities: In August 2022, FRB issued supervisory letter SR 22-6 “Engagement in Crypto-Asset Related Activities by Federal Reserve-Supervised Banking Organizations,” that outlines the steps FRB-supervised banks should take prior to engaging in crypto-asset activities, including assessment of whether the activities are legally permissible or regulatory filings are required and notification to, and approval from, FRB of intended activities, which includes review of systems and controls.
  • LIBOR: Proactive transition of legacy products and reduction in exposures.
  • Climate Risk:
    • FRB is working with OCC and FDIC to propose guidance on identification, measurement, monitoring, and management of climate-related financial risks.
    • Pilot climate scenario analysis exercise for the largest banks designed to enhance both supervisors’ and firms’ capabilities for measuring and managing climate-related financial risks (see KPMG Regulatory Alert, here).
  • Resolution: FRB and FDIC jointly issued an ANPR on potential changes to the resolution-related rules and guidance applicable to large banking organizations (LBOs) that are not global systemically important banking organizations (GSIBs), as well as their insured depository institution subsidiaries (IDIs) (see KPMG Regulatory Alert, here).
  • Other. In addition to the topics above, the report outlined priorities from Vice Chair Barr’s September speech including capital, bank merger policy review, stablecoins, the Community Reinvestment Act, and innovation, access, and consumer protections (see KPMG Regulatory Alert, here).

Supervisory Developments

  • Supervisors have been focusing on remediation of outstanding supervisory findings and evolving risks, which increased at large financial institutions in the first half of 2022.
  • Large financial institutions are generally meeting supervisory expectations for capital, but some weaknesses were noted.

2023 Supervisory Priorities

  • Large Financial Institutions
    • Capital
      • Financial risks impacted by economic changes, including interest rate (IR) risk, market and counterparty credit risk, and consumer and commercial credit risk.
      • Risk management practices in credit, market, and IR risk.
      • Implementation of regulatory phase-ins (e.g., counterparty rules).
      • LIBOR transition.
    • Liquidity
      • Intraday liquidity risk management.
      • Changes in deposits and the effect on funding mix asset.
      • Asset/liability management and stress testing.
    • Governance and controls
      • Operational resilience, including cybersecurity and information technology risks.
      • Third-party risk management (TPRM).
      • Compliance, internal loan review, and audit.
      • Firm remediation efforts on previously identified MRAs.
    • Recovery and resolution planning
      • Recovery planning and preparedness.
  • CBOs and RBOs (where Community Banking Organizations (CBOs) have less than $10 billion in total assets and Regional Banking Organizations (RBOs) have between $10 billion and $100 billion in total assets)
    • Credit Risk
      • High-risk loan portfolios and debt service coverage capacity in changing rate environment.
      • Credit concentrations, particularly in commercial real estate.
      • Implementation of CECL with CBOs in 2023.
    • Other financial risks
      • Interest rate risk.
      • Securities risk.
    • Operational risk
      • Information technology and cybersecurity.
      • Fintech and crypto-related activities.

Please refer to:

—   Statement (Brainard): Financial Stability Report


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Amy S. Matsuo

Amy S. Matsuo

Regulatory and ESG Insights Leader, KPMG US

+1 919-664-7100