The central bank said the financial system came under severe pressure in March as the pandemic shut down much of the economy and sent the markets plummeting. The Fed said its quick action helped alleviate many of the stresses but it cautioned that prices for stocks, bonds and other assets could fall further, depending on the course of the virus.
“Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse or financial system strains re-emerge,” the Fed said.
The Fed’s assessment of the virus’ impact on the financial system came in a twice-a-year “Financial Stability Report” that the central bank issues to assess vulnerabilities in the financial system. The report also noted that corporate debt had risen to historically high levels even before the coronavirus hit the United States. The sharp economic contraction will make it harder for businesses and individuals to meet their loan obligations.
While household debt is not as elevated as business debt, the loss of millions of jobs will mean that banks could face “material losses” if borrowers can't repay mortgages, auto loans and other consumer debt.
The report said that stresses seen in March in various financial markets, such as short-term business loans known as commercial paper, had eased with the help of a number of emergency credit facilities the Fed created to deal with specific problems, similar to the help the central bank provided during the 2008 financial crisis.
The Fed’s concern is that, while the billions of dollars it is supplying to keep credit, or liquidity, from drying up, the financial system could be hit by a wave of corporate or individual bankruptcies that could raise solvency concerns.
The coronavirus crisis sent the country's unemployment rate surging to 14.7% in April, the highest level since the Great Depression of the 1930s. It has also triggered a sharp contraction in economic growth with analysts forecasting the economy could shrink at a record annual rate of 40% in the current quarter.
The Trump administration is predicting a sharp rebound in the second half of the year but private forecasters are concerned that the country could struggle to emerge from the current downturn until a vaccine is widely available.
The report said that reforms to the financial system adopted after the 2008 crisis had made banks and other institutions much better prepared to handle the current crisis, but risks still remained. “Financial sector vulnerabilities are likely to be significant in the near term,” the report said. “The strains on household and business balance sheets from the economic and financial shocks since March will likely create fragilities that last for some time.”
Federal Reserve Chairman Jerome Powell warned in a speech Wednesday that the U.S. economy would become stuck in a lengthy recession if Congress and the White House did not provide more aid to address the economy fallout.
As part of the market turmoil earlier this year cited by the Fed, the report said that at least some hedge funds appeared to have been “severely affected” by the large drop in asset prices and increased volatility in February and March. The report said these problems appeared to be contributing factors to market dislocations.
“All told, the prospect for losses at financial institutions to create pressures over the medium term appears elevated,” the report said. In a related development, the Fed and other federal bank regulators announced Friday they were temporarily modifying their regulation on how much leverage big banks with more than $250 billion in assets need to hold against the loans they make.
The modifications, which will go into effect once the rule change is published in the Federal Register, will allow large banks to make more loans available to credit-worthy borrowers. The Fed said the looser requirements would remain in effect through March 31 of next year.