WASHINGTON — Uncertainty about the coronavirus pandemic and the economic recovery is leading to heightened risk in the financial system, the Financial Stability Oversight Council said Thursday.
The annual report issued by the interagency council is its first during a period of economic stress. The panel highlighted vulnerabilities in commercial real estate, business debt and short-term wholesale funding markets, saying regulators should monitor those areas in particular.
The council, which is chaired by Treasury Secretary Steven Mnuchin and includes the heads of the financial regulators, met to approve the report during a meeting Thursday.
One of the strongest recommendations the FSOC made in its report was that bank regulators should take action, if warranted, to mitigate structural vulnerabilities in short-term wholesale funding markets, including money market funds, which the council said were exposed in March and April when the markets contracted in reaction to the onset of the pandemic in the U.S.
The FSOC noted that nonbanks like hedge funds and mortgage real estate investment trusts may have contributed to the market shock, due to “the complexity of their interactions,” and that their role in the overnight repurchase market should be reviewed.
“The council recommends that agencies continue to monitor levels of nonfinancial business leverage, trends in asset valuations and potential implications for the entities they regulate, in order to assess and reinforce the ability of the financial sector to manage severe, simultaneous losses,” the report said.
The council also said corporate credit quality deteriorated in the spring due to COVID-19 fallout, exposing a sector that the council has
A number of companies drew upon existing lines of credit with banks because of the uncertainty about the economic outlook, which exposed banks to losses in the first half of the year.
Although many firms were helped by the fiscal stimulus provided in the Coronavirus Aid, Relief and Economic Security Act, “considerable credit risk remains given the uncertain economic outlook,” the report said.
Still, the default rates on corporate bonds and leveraged loans remain below the levels reached during the 2008 financial crisis.
However, the same cannot be said for outstanding commercial real estate loans. The outstanding amount of CRE loans in the second quarter of this year totaled $4.7 trillion, and is similar to the peak in the second quarter of 2009, according to the FSOC.
About half of outstanding CRE loans are on bank balance sheets, which could expose the financial sector to substantial losses should a wave of defaults occur. And if lenders take significant losses on CRE loans, they could tighten their underwriting standards, which could potentially hold back economic growth, the report said.
Community banks would be more vulnerable to losses in commercial real estate than larger banks. CRE loans comprise about 40% of the average loan portfolio of banks that have less than $10 billion of assets.
“These smaller banks are also an important source of credit to small business and retail borrowers,” the FSOC report said. “Sharp losses on CRE-backed loans at small and mid-sized banks could drive a broad contraction in credit, particularly in the sectors of the economy that rely on local sources of financing.”
The council recommended that the banking regulators urge banks to set aside loan-loss reserves to bolster their capital and liquidity buffers to account for the concentration of CRE loans on their respective balance sheets.
