Risks on Wall Street and in the finance sector are rising, researchers for the federal government warned Tuesday.
Among the problem areas are increasingly risky corporate bonds and unintended consequences of new regulations imposed on banks, according to a new report on financial markets by the Office of Financial Research.
“Overall, threats to U.S. financial stability remain moderate, in other words, in a medium range, but they edged higher within that range over the past year,” Office of Financial Research Director Richard Berner said in announcing the report.
The report is the first of its kind but will be published annually by the office, which was created within the Treasury by the 2010 Dodd-Frank financial reform law to keep regulators apprised of developments in banking and finance.
The top risk identified by the report is in corporate credit. The report suggests that the U.S. is in the late stages of the corporate credit cycle, with corporate debt at a record high and nearing the levels it reached before the financial crisis as a share of economic output. Credit risk outside banks, the report says, is “elevated and rising.”
The report also noted that bond market liquidity “appears to have been fragile” in recent years, partially validating concerns voiced by top bankers and investors in recent months. The fear is that safe assets such as Treasury securities might not be available anywhere near prevailing prices in a panic, partly because Dodd-Frank and other new rules have required that banks hold so many bond on their books, rather than trade them.
The report suggests that the new rules might be playing such a role in moments of apparent fragility, such as the 2010 “flash crash” and the stock market sell-off on Aug. 24.
It also assigns blame, however, to changes in the market, the rise of high-frequency and automated trading systems that can magnify changes in the markets, and low interest rates.
The possibility that low interest rates could be pushing investors to “reach for yield” — that is, buy riskier assets to get a return — is one of the factors identified by the report that weighs in favor of the Federal Reserve raising interest rates at its monetary policy committee meeting ending Wednesday. Although Fed Chairwoman Janet Yellen has said she doesn’t see any flashing red lights, other members of the committee have warned that they have seen the first signs of over-optimistic prices in markets.
