WASHINGTON Excessive risk-taking amid low interest rates and the migration of financial transactions away from the heavily regulated banking sector have combined to make the system even riskier in 2014 than a year ago, according to a report released Tuesday by the Office of Financial Research.
In its annual report to Congress, the data research agency said the system is generally stable and more resilient than before the 2008 financial crisis. But new threats have emerged and others have grown, the agency said.
"Threats to financial stability are moderate, our tools for spotting them are better, and the financial system in many ways is more resilient compared with just before the financial crisis," said Richard Berner, director of the OFR, in a briefing with reporters. "But as the financial system evolves and innovates, we must be especially watchful for important new vulnerabilities that are emerging in dynamic financial companies and markets."
The report specifically noted that corporate credit risk and certain kinds of market risk appear to have increased in the past year, spurred by the Federal Reserve's longstanding accommodative interest rate policy. That policy is meant to encourage lenders to take on riskier loans, the report said, but "there may be a point at which it could also increase the vulnerability of the financial system to a future shock."
OFR said the market anticipates the Fed will increase interest rates eventually, but a sudden or drastic increase in rates beyond what the market is prepared for could devalue long-dated investments and drive many bank depositors toward higher-yielding investments.
The report also said that the ongoing migration of certain financial activities away from banks to lightly regulated nonbanking sectors so called shadow banks is another growing threat to financial stability. The trend of banks selling mortgage servicing rights to nonbanks to avoid new capital restrictions and the securitization of single-family rental properties by investment firms are two examples of services previously managed by banks that have migrated to unregulated areas.
"If the regulatory playing field is not level across the financial system, the shift of certain activities to more lightly regulated sectors could increase risk-taking and reduce transparency in market practices," the OFR report said.
The report also noted that illiquidity in certain markets has persisted and poses a threat to the functionality of the financial system. A number of factors are at play, OFR said, including the increased capital requirements imposed on banks since the financial crisis and the general unwillingness of broker-dealers to put capital at risk. The illiquidity is noticeable in lower broker-dealer inventories, lower trading volumes in emerging market sovereign and U.S. corporate bonds, and lower average trade sizes.
The report's conclusions will likely bolster efforts by the Financial Stability Oversight Council which oversees the OFR and other regulators to combat shadow banking. The FSOC has attempted to examine whether asset managers should be considered systemically important financial institutions, and therefore subject to greater scrutiny by the Fed. The Securities and Exchange Commission, as well as lawmakers from both parties and the asset managers themselves have balked at the idea, however, and the council has made little headway since.
In September the FSOC preliminarily designated MetLife as a systemically significant financial institution, spurring a formal protest from the insurer. The council has since said it will review its designation process and has been engaged in talks with various stakeholders on those issues.
The Fed, for its part, has indicated its intention to issue new capital rules on short-term wholesale funding for banks and indicated that the rules would ideally be extended to other entities as well. That initiative has also remained stalled, with Fed chair Janet Yellen saying in June that there was no "detailed timetable" on when the Fed may issue a rule.