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

The Federal Reserve warned in its twice-annual report on US financial stability that the government bond market could be poised for disruption and warned that financial firms operating outside outside of traditional banks can increase fragility in the system.

Investors have warned that market conditions are becoming increasingly tense in the nine months since the Fed’s fastest rate hike campaign since the 1980s. determined to promote In its bid to slow the economy as it tries to stave off rapid inflation, officials are carefully monitoring market conditions. A financial crisis will make the Fed’s job harder – 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 sync and other markets around the world – including government bond market in the UK – gives early warning signs that cracks are starting to appear.

The Financial Stability Report, released on Friday, delved into the widely discussed challenges plaguing Treasury markets and detailed less prominent vulnerabilities. Those include increased leverage at non-banking financial institutions, what is often referred to as the “shadow banking” system.

The ease of trading Treasuries, known as liquidity, has come under strain in recent months. worries analysts and investors that the market may be ready for disruption. The Fed attributed the drop in liquidity “primarily” to volatility in interest rates and uncertainty in the economy.

Continued low market depth means liquidity remains more sensitive to the actions of liquidity providers using high-frequency trading strategies to replenish their books, the report said. quick command”. That dependence could “be a source of fragility, making liquidity more likely to fall further in response to future shocks.”

The Fed also pointed out that leverage – essentially, debt used to invest – is high in the shadow banking sector and can be “difficult to gauge” because of the difficulty of timely data on the parties involved. markets such as hedge funds and other investment vehicles. pass.

“While hedge fund leverage measures are still slightly above their historical averages, these measures are only available with significant lag,” the report said. said. “These gaps increase the risk that such companies are using leveraged positions, which can increase adverse shocks, especially if they are financed with short-term funding.”

The report says that some hedge funds may have reduced their leverage more recently, based on what dealers have told the central bank in surveys.

At the same time, however, bank lending to private equity firms and other shadow banks has increased, which could deepen the interconnectedness of the financial system.

The rise has been rapid in recent years, reaching a new high of nearly $2 trillion in the second quarter of 2022, and it is “the broadest and most pronounced in the private equity portfolio, business development firms and credit unions,” the report said.

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

The overall picture emerging from the report is one of financial stability to date but there are weaknesses that could be exacerbated in times of economic stress. Researchers and market exposures surveyed as part of the report widely cited inflation and the Fed’s response to it, the war in Ukraine, and the volatility and vulnerability of market is a big risk.

“Today’s environment of rapidly synchronized monetary policy tightening globally, rising inflation, and high uncertainty associated with pandemics and wars increase the risk that a shock could lead to amplifying vulnerabilities,” Lael Brainard, Fed Vice President, said in a statement. released with the report.