Federal Reserve Report: Policy uncertainty becomes the number one financial stability risk, central bank independence named for the first time, focus on financial leverage

The Federal Reserve warned in its semiannual Financial Stability Report released on Friday, November 7, that policy uncertainty has become the primary risk facing the current U.S. financial system, with surveyed market participants' concerns about the system's fragility undergoing structural changes. The report noted that while the banking system remains robust overall, the high leverage of non-bank institutions such as hedge funds and elevated asset valuations still pose "significant" risks.

Notably, this month's report marks the first time since the Financial Stability Report series was first published in 2018 that the Federal Reserve explicitly identified "central bank independence" as a risk factor for the financial system. This change occurred after U.S. President Trump abruptly announced the dismissal of Federal Reserve Governor Lisa Cook and continued to publicly pressure Fed Chairman Jerome Powell to cut interest rates. The report also mentioned for the first time that "the availability of economic data" has become a risk factor, related to the record-length shutdown of the U.S. federal government that disrupted the release of official economic data.

The survey disclosed in the report indicated that policy uncertainty, including central bank independence, the availability of economic data, and trade policy, was viewed by respondents as the top financial stability risk, with geopolitical risks and rising long-term interest rates also receiving significant attention from most respondents. The report reflects the Federal Reserve's latest assessment of four categories of vulnerabilities in the financial system based on market conditions and data prior to October 23, stating that vulnerabilities related to financial leverage "cannot be ignored."

This report indicates that the risks facing the market have shifted from specific trade policy concerns to broader policy uncertainty, while the valuation risks associated with artificial intelligence (AI) assets have begun to enter the regulatory spotlight.

Over 60% of Respondents Emphasize Policy Uncertainty Risks, AI Risks Receive More Attention

According to the Financial Stability Report released this Friday, the Federal Reserve conducted a financial stability risk survey from September to October among professionals from brokerages, banks, investment funds, and consulting firms. Among them, 61% of respondents identified policy uncertainty as the primary risk to U.S. financial stability, significantly higher than the 50% who felt this way in the spring survey.

The report explains that policy uncertainty encompasses multiple dimensions, including trade policy, central bank independence, and the availability of economic data. This is the first time central bank independence has been mentioned as one of the risk factors in the Federal Reserve's financial stability risk survey. In contrast, in the April spring survey, global trade risk was the most concerning single issue, but it no longer appeared as an independent concern in the recent survey.

The survey showed a significant increase in the attention given to geopolitical risks, with 48% of respondents mentioning this risk, up from 23% in the spring survey. The report stated that respondents highlighted a range of geopolitical risks and closely monitored the potential escalation of existing tensions, while noting that "financial market indicators may currently fail to adequately reflect geopolitical risks."

Concerns about rising long-term interest rates have also significantly increased, with 43% of respondents mentioning this risk, far higher than the 9% in the spring survey. Respondents emphasized that higher long-term rates could be driven by rising term premiums, increased inflation expectations, or weak demand for U.S. Treasury bonds, and pointed out that "higher rates may increase unrealized losses in the banking sector and could force fixed-income investors to bear losses marked to market." The proportion of AI as a financial stability risk in the survey has significantly increased. This time, 30% of respondents view it as a potential shock in the next 12 to 18 months, far exceeding the 9% from the spring survey. The report states that this concern mainly focuses on how sentiment towards AI has driven recent stock market gains, and how a shift in this perspective could lead to "substantial losses" in the market, potentially resulting in broader economic impacts. Respondents pointed out that this shift could lead to massive losses in both private equity and public markets, and if the decline is significant enough, it could further slow the labor market and tighten financial conditions.

Hedge Fund Leverage Hits New Highs, Significant Leverage Risks in Financial System

The Federal Reserve specifically emphasized the vulnerabilities brought about by leverage in the financial sector in its report. The report noted:

"While the capital positions of banks and broker-dealers remain robust, the leverage of some other financial institutions is high relative to historical levels, such as hedge funds and life insurance companies. Overall, the vulnerability caused by leverage in the financial industry cannot be ignored."

The Federal Reserve's report mentioned that hedge fund leverage has risen to the highest level since regulators began tracking this data in its current form over a decade ago. The report shows that hedge fund leverage has steadily increased across a wide range of strategies in recent years, including those involving government bonds, interest rate derivatives, and equities. The Federal Reserve specifically pointed out that the largest hedge funds often have the highest leverage, and this increased leverage supports large positions in key markets.

The leverage of life insurance companies is also at the highest quartile of historical distribution. However, the report also noted that the proportion of life insurance companies using non-traditional liabilities remains relatively small, accounting for a limited share of general account assets.

In contrast, the banking system continues to maintain stability and resilience, with regulatory capital ratios at historical highs, and most banks reporting capital levels well above regulatory requirements. However, the Federal Reserve warned that while the fair value losses on fixed-rate assets have decreased, they remain quite significant for some banks and continue to be sensitive to changes in long-term interest rates. The leverage of broker-dealers remains near historical lows, but intermediary activities have reached historical highs in a range of markets, including the government bond market.

Asset Valuations Are Elevated

The Federal Reserve pointed out that asset valuations are high. The report states that since market volatility calmed in early April, the price-to-earnings ratio of stocks has returned to near the high end of its historical range. The estimated equity premium—i.e., the risk compensation of the stock market—remains well below average levels. The spread between corporate bond yields and government bond yields of the same maturity has also returned to levels seen before April, remaining low compared to long-term history.

In the real estate market, while the rate of increase in housing prices has slowed, the ratio of housing prices to rents continues to approach historical highs. The inflation-adjusted commercial real estate transaction price index shows some signs of stabilization after a significant decline, but vulnerabilities remain due to upcoming refinancing needs. According to Reuters, a large amount of commercial real estate debt will mature in the next year, and if borrowers are forced to sell assets, it could increase market volatility

Corporate and Household Debt Risks Moderate, Consumer Default Rates Remain High

The report assesses the vulnerabilities posed by corporate and household debt as being at a moderate level. The total amount of corporate and household debt as a percentage of GDP continues to decline slightly, reaching the lowest level in the past two decades. The leverage ratio of listed companies remains slightly above the median of its historical distribution, while debt held by privately-owned companies continues to grow. Although the overall debt repayment capacity of listed companies remains robust, the repayment capacity of small businesses and high-risk privately-held companies has declined in recent years.

The ratio of household debt to GDP has remained low in recent history. Most household debt is held by borrowers with good credit histories. Due to ample home equity buffers and strict underwriting standards, mortgage default rates remain low. However, default rates on credit cards and auto loans are still higher than pre-pandemic levels.

According to Reuters, consumer default rates remain high by historical standards, with a significant increase in student loan default rates expected after the government resumes student loan repayments in the first half of 2025. These data indicate that while overall debt levels are manageable, certain consumer groups still face repayment pressures.

Financing Risks Remain Moderate, Growth of Money Market Funds Concentrated in Government Products

Financing risks remain at a moderate level. The assets of cash management tools continue to grow, primarily driven by government money market funds, which have historically been the least likely category to experience large-scale investor redemptions. Measured as a percentage of GDP, the asset size of more vulnerable investment instruments remains close to the median of its historical distribution.

Banks' reliance on uninsured deposits is an important component of their financing risk, currently far below the peaks seen in 2022 and early 2023. Most domestic banks maintain high levels of liquid assets and stable funding sources. The non-traditional liabilities of life insurance companies have further increased but account for only a small portion of general account assets.

The commercial real estate market shows signs of stabilization. While market prices indicate signs of stability, the Federal Reserve points out that a significant amount of commercial real estate debt will mature in the coming year, which could increase volatility if borrowers are forced to sell assets. Vacancy rates and rent growth in the office property sector also appear to be stabilizing.

The Federal Reserve emphasized in the report that while this framework provides a systematic approach to assessing financial stability, certain potential risks may be novel or difficult to quantify, and therefore may not be captured by current methods. The Federal Reserve stated that it will rely on ongoing research to improve the measurement of existing vulnerabilities and keep pace with changes that may give rise to new forms of vulnerabilities in the financial system or exacerbate existing ones