The Fed’s Financial Stability Report (FSR) is a document published two times a year by the Federal Reserve to provide color on the state of the American financial sector. The goal is to promote transparency on key issues in the financial system and their impact on inflation and employment. In this article, we will look at what the report is and why it is important to traders and investors.
Fed’s dual mandate
To understand what the FSR is, we need to understand the role of the Federal Reserve. The Fed has a dual mandate of ensuring the stability of prices and full employment. The bank does this by observing the overall economic situation and tweaking monetary policy through low interest rates and quantitative easing.
In a period of economic challenges, the Fed tends to lower interest rates. Doing this incentivizes consumer spending by making it easy and cheaper to borrow by businesses and individuals.
In times of significant strains, such as during the 2008 financial crisis and the 2020 pandemic, the bank implemented a quantitative easing plan. This is a situation where the bank buys billions worth of government bonds and mortgage-backed securities. This then lowers the cost of government borrowing and makes money flow in the economy.
The Fed starts to tighten monetary policy when the economy starts to do well. Doing so helps the bank prevent the economy from overheating. It also gives the Fed tools that are needed in case of another major crisis.
Therefore, the Financial Stability Report is a document that the Fed uses to provide an assessment of the current state of the financial system. This is important since there is a close correlation between the health of the financial sector, employment, and asset prices.
Parts of the Financial Stability Report
The Financial Stability Report generally looks at four key aspects: assets valuation, borrowing by businesses and households, leverage in the financial sector, and funding risks.
Asset valuation
Asset valuation refers to the estimated worth of assets in the financial industry like cryptocurrencies and stocks. In stocks, valuation refers to the ideal worth of the company. There are several methods used to conduct these valuations. For example, in stocks, some investors use the discounted cash flow (DCF) to estimate the value of a company.
Others use multiple comparisons, where they compare metrics like price-to-earnings (PE), price-to-sales (PS), and enterprise value to EBITDA (EV to EBITDA) to estimate the value.
In the United States, the valuations of many companies have been growing over the years. For example, the ratio of the total market value of all public companies in the US compared to the GDP has grown to more than 200. Indeed, the five biggest companies in the country have a market cap of more than $8.13 trillion, which is about 38% of the total GDP of the economy.
At the same time, the price-to-earnings ratio of the S&P 500 has jumped to 44.49, signaling that companies are getting expensive.
S&P 500 PE ratio
Other financial assets have gotten more expensive. For example, the total market cap of all cryptocurrencies tracked by CoinMarketCap has surged to more than $2 trillion.
The Fed talks about valuations in its Financial Stability Report because it could impact the labor market and inflation.
For example, the country’s unemployment rate rose in 2008 and 2009 when the bubble in the housing market burst. Also, Fed’s policies tend to have an impact on these valuations. An extended period of low interest rates leads to expensive valuations since investors move from low-yielding bonds to risky assets like stocks and cryptocurrencies.
Borrowing by businesses and individuals
The Fed’s Financial Stability Report looks at the trends in borrowing by businesses and individuals. Low-interest rates tend to incentivize people and businesses to increase their borrowing. For example, the total outstanding corporate debt has kept rising over the years. Similarly, the outstanding mortgage in the United States has risen sharply because of low interest rates.
Increased borrowing has its benefits and disadvantages in the economy. The most significant advantage is that borrowing leads to more consumer and business spending. Since consumer spending is the biggest constituent of the American economy, borrowing is a major contributor to growth.
However, borrowing has its risks to the economy, as it did in the 2008/9 financial crisis. When defaults rise, it tends to affect companies that provide this financing, like banks. Since banks hold customer deposits, defaults pose a systemic risk to the economy. The FSR provides more insights into the level of borrowing in the economy and the ongoing trends.
Leverage in the financial sector
The Financial Stability Report looks at leverage in the financial sector. Leverage refers to the number of loans that financial institutions and banks have. For example, if you have $10,000, you can buy 1,000 shares of a company whose stock is trading at $10. With 5x leverage, you can buy 5,000 shares. This leverage is a good way in which banks and hedge funds make money.
However, when things go wrong, it can lead to systematic failures and risks to the economy. There are two popular examples. Two decades ago, Long-Term Capital Management (LTCM), a hedge fund, almost sank the US financial sector because of its leverage.
In 2021, a family office known as Archegos cost banks like Nomura and Credit Suisse more than $10 billion when it imploded. Therefore, this section looks at how leveraged the financial market is because they can impact the labor market and inflation if they fail.
Funding risk
Funding risk is the final section of the Fed’s Financial Stability Report. This section looks at the overall liabilities that are in the economy. It looks at the amount of debt that is vulnerable in banks, insurance companies, and money market funds (MMF). This is important because of the size of these funds.
In its 2021 report, the bank identified more than $17.7 trillion of funds in banks and nonbanks that were vulnerable to runs. Having a good picture of these funds can help investors and the general public have a good understanding of the state of the economy.
Summary
The Financial Stability Report is a relatively new document that updates investors and the public about the state of the economy and the potential risks. It is a good document that has the latest data since the Fed has access to data from all financial institutions in the United States.