A recent report issued by the Federal Reserve has cautioned that the apprehensions of banks regarding a deceleration in economic growth might prompt them to reduce lending activities, thereby exacerbating an impending economic downturn.

The report also emphasized the elevated level of risk associated with commercial real estate, thereby signaling a heightened level of scrutiny from bank examiners in this particular sector.

Published on Monday, the financial stability report from the United States’ central bank is the first of its kind since the collapse of four regional financial institutions.

These distressing incidents triggered a period of tumultuous trading in bank stocks and necessitated regulators to take a series of extraordinary measures, including providing support to all depositors of Silicon Valley Bank and Signature Bank.

“Concerns about the economic outlook, credit quality, and funding liquidity could lead banks and other financial institutions to further contract the supply of credit to the economy,” the Fed said in its report.

“A sharp contraction in the availability of credit would drive up the cost of funding for businesses and households, potentially resulting in a slowdown in economic activity.” 

The report, not intended as a predictive analysis, depicted bank funding as generally resilient.

However, it highlighted several liquidity vulnerabilities prevalent in various sectors of the financial markets.

“Overall, domestic banks have ample liquidity and limited reliance on short-term wholesale funding,” the report said.

“Structural vulnerabilities remained in short-term funding markets. Prime and tax-exempt money market funds, as well as other cash investment vehicles and stablecoins, remained vulnerable to runs.”

According to the report, life insurance companies are confronting heightened liquidity risks due to their amplified investments in precarious and illiquid assets.

Moreover, the report highlighted the potential consequences of the transition to remote work, suggesting a potential decline in the demand for office spaces and a subsequent devaluation of retail properties in urban areas.

“The magnitude of a correction in property values could be sizable and therefore could lead to credit losses by holders” of commercial real estate debt.

The Federal Reserve has announced an enhanced monitoring strategy in response to concerns surrounding commercial property debt, specifically by intensifying its scrutiny of commercial real estate (CRE) loan performance and expanding examination procedures for banks with substantial exposure to CRE concentration risk.

Driven by the urgency to address mounting inflation, the central bank has implemented interest rate hikes at the most rapid pace seen since the 1980s. Last year, in the midst of rising inflation, the Fed initiated a series of four 75-basis-point rate increases, resulting in the current overnight lending rate of 5% to 5.25%. In a recent development, a quarter-point increase was implemented just last week.

However, the surge in interest rates has inflicted losses on banks’ bond portfolios, thereby generating vulnerability within the banking system. This vulnerability was exemplified by the collapse of Silicon Valley Bank on March 10, which fell under the direct supervision of the Fed, following a deposit run.

The Fed’s extensive analysis of the bank’s collapse revealed that the institution failed its own liquidity stress tests, while the regulators themselves failed to recognize the presence of “critical deficiencies in the firm’s governance, liquidity, and interest rate risk management.”

Overall, the report maintained a relatively optimistic perspective on the risks faced by the banking sector as long as the economy continues to grow. It acknowledged that the credit quality of the economy remains robust, despite an increase in delinquency rates in specific segments such as automobiles and credit cards.

The report’s framework is centered around four key areas of risk, encompassing asset valuations and funding risk. Notably, property valuations continue to remain elevated.

“In residential real estate, valuations remained near all-time highs despite weakening activity and falling prices in recent months,” the report said.

“Valuations in the commercial segment also remained near historical highs even though price declines have been widespread.”

Despite business debt maintaining elevated levels, interest coverage ratios remained high, primarily due to sustained earnings growth.

The report cautioned, however, that an economic downturn could potentially undermine firms’ capacity to service their debts.

On the other hand, household debt levels were characterized as modest.

Regarding the largest banks, the Federal Reserve affirmed that they possess sufficient capital to withstand potential financial challenges.

“Notwithstanding the banking stress in March, high levels of capital and moderate interest rate risk exposures mean that a large majority of banks are resilient to potential strains from higher interest rates,” the report said.

According to the Federal Reserve, banks witnessed a significant increase in securities added to their balance sheets during the period of 2020 and 2021, amounting to nearly $2.3 trillion.

The majority of these securities consisted of fixed-rate US Treasury securities and agency-guaranteed mortgage-backed securities, primarily allocated to the available-for-sale (AFS) and held-to-maturity (HTM) portfolios.

Nevertheless, as interest rates began to rise, leading to a decline in bond prices, banks experienced reductions in fair value.

The report revealed that the AFS portfolios faced a decline of $277 billion, while the HTM portfolios suffered a decline of $341 billion.

This decline in the value of the securities portfolio poses risks for banks, especially if they are compelled to sell assets to meet deposit outflows.

However, the report reassured that domestic banks currently possess ample liquidity and have limited dependence on short-term deposits that can be withdrawn quickly.