Even though the initial market volatility has subsided, the U.S. financial system faces risks from the possibility that the United Kingdom’s exit from the European Union might go badly, government researchers warned Monday.
The Office of Financial Research, the new Treasury Department agency tasked with studying possible sources of financial instability, said Monday that the to-be-determined fallout from the June “Brexit” vote is one of the factors pushing up the overall level of risk to the financial system, which is medium currently.
The U.S. is also vulnerable to the high level of business debt and from the possibility that the historically low interest rate environment could spur investors to make increasingly risky bets, the office reported.
Of those major risks, however, the possibility that Britain’s divorce from Europe, the terms of which have yet to be negotiated, could harm the U.S. is the only one that is new this year.
Richard Berner, the director of the Office of Financial Research, told reporters Monday that the Brexit fallout “introduces months or years of uncertainty about the rules governing the U.K.’s investment, financing and trade relations with Europe and the rest of the world.”
If Britain or Europe were to tip into recession, it could hurt the U.S. by slowing trade, hurting U.S. assets overseas, or simply through a self-fulfilling collapse of confidence or increase in uncertainty, the agency reported.
The initial reaction to the June 23 referendum vote sent the dollar spiking and financial markets into turmoil, effects that worried federal regulators, including those at the Federal Reserve.
Investors overreacted to the vote results initially, according to the agency, but then may have gone too far in the other direction, toward complacency, in the subsequent weeks as markets recovered.
Meanwhile, the low interest rates that have prevailed in the U.S. for years, partly because of the Fed’s monetary policies, have created incentives for investors to take speculative and risky positions to get profits, Berner warned.
“We’ve continued to seek a reach for yield and risk-taking behavior,” he said, adding that such risks tend to accumulate over time and then become exposed by some shock.
Also, the agency flagged the growth in business indebtedness, which is higher than it was in 2007, before the financial crisis. While households and financial companies have been deleveraging, non-financial businesses have been adding more debt, raising concerns about what would happen to banks and other financial firms if many businesses began defaulting.
