Fed Frets About Shadow Banks and Eyes Treasury Liquidity in New Report

The Federal Reserve warned in its twice-annual report on America’s financial stability that the government bond market could be primed for disruption, and cautioned that financial firms that operate outside of traditional banks could increase fragility in the system.

Investors have been warning that market conditions are becoming increasingly fraught nine months into the Fed’s fastest rate-increase campaign since the 1980s. While the central bank is determined to push ahead with its effort to slow the economy as it tries to choke off rapid inflation, officials are keeping a careful eye on market conditions. A financial meltdown would make the Fed’s job more difficult — potentially even forcing it to deviate from some of its tightening efforts.

Financial stability issues are in focus as central banks around the world raise interest rates in synchrony and other markets around the world — including the government bond market in Britain — offer early warning signs that cracks are beginning to emerge.

The Financial Stability Report, released on Friday, delved into widely discussed challenges that have been plaguing Treasury markets and detailed less prominent vulnerabilities. Those included elevated leverage at financial institutions beyond banks, what is often referred to as the “shadow banking” system.

The ease of trading Treasury securities, called liquidity, has been strained in recent months, which is making analysts and investors nervous that the market could be primed for disruption. The Fed attributed the decline in liquidity “primarily” to volatility in interest rates and economic uncertainty.

“The continued low level of market depth means that liquidity remains more sensitive to the actions of liquidity providers that use high-frequency trading strategies to replenish the order book rapidly,” the report said. That dependence could “be a source of fragility, making it more likely that liquidity could further deteriorate sharply in response to future shocks.”

The Fed also pointed out that leverage — essentially, debt that is used to invest — was high in parts of the shadow banking sector and could “be difficult to assess” because timely data on market participants like hedge funds and other investment vehicles was difficult to come by.

“While comprehensive measures of hedge fund leverage remained somewhat above their historical averages, these measures are only available with a considerable lag,” the report said. “These gaps raise the risk that such firms are using leveraged positions, which could amplify adverse shocks, especially if they are financed with short-term funding.”

The report said that some hedge funds might have decreased their leverage more recently, based on what dealers were telling the central bank in surveys.

But, at the same time, bank lending to private equity firms and other shadow banks has ramped up, which could deepen the interconnectedness of the financial system.

The increase has been rapid in recent years, reaching a new high of almost $2 trillion in the second quarter of 2022, and it “was broad-based and most pronounced in the category of private equity, business development companies and credit funds,” the report said.

Those shadow bank borrowers may have other funding sources that dry up in times of crisis, which “could contribute to increased vulnerabilities in the financial sector.”

The overall picture that emerged from the report is one of a financial system that is stable for now but that has weak spots that could be exacerbated by a strained economic moment. Researchers and market contacts surveyed as a part of the report widely cited inflation and the Fed’s response to it, the war in Ukraine and market volatility and vulnerability as major risks.

“Today’s environment of rapid synchronous global monetary policy tightening, elevated inflation and high uncertainty associated with the pandemic and the war raises the risk that a shock could lead to the amplification of vulnerabilities,” Lael Brainard, the Fed’s vice chair, said in a statement released with the report.

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