Fed financial stability report highlights ongoing concerns about COVID-19 pandemic, including pressures on small banks

Significant near-term economic and financial impacts of a sustained or second-wave COVID-19 (coronavirus) pandemic, including concerns about bank asset quality, are outlined in a financial stability report released Friday by the Federal Reserve.

In its report, the Fed said most forecasters expect a sharp contraction in economic output in the United States, for at least the first half of 2020, as well as a global recession. “The expected slowdown could affect the financial system by further weakening the balance sheets of businesses and households, especially those that are already vulnerable,” the report states. “Furthermore, monetary and fiscal policy tools have limited ability to moderate some dimensions of what is fundamentally a public health shock.”

From Fed’s May 2020 Financial Stability Report

As part of its market intelligence gathering, Fed staff collected views from a wide range of contacts – at banks, investment firms, academic institutions, and political consultancies – on risk to U.S. financial stability from early February to mid-April. Concerns evolved throughout this period, but those related to the pandemic’s financial and economic effects “featured prominently” throughout, the report states.

Those concerns are synthesized in a section titled “Salient Shocks to Financial Stability Cited in Market Outreach.” Among the specific responses noted:

  • Contacts were highly focused on the effect of the COVID-19 pandemic and lockdown efforts on the economy and financial system. With regard to the virus itself, respondents early in the outreach cited the potential spread of the virus from China to Europe and the United States. As the virus spread globally, the focus shifted toward the risk of a longer, deeper pandemic, with contacts highlighting the prospect that a premature easing of restrictions could prolong the outbreak and that effective vaccines or therapies might not be developed in time to attenuate possible second waves.
  • Respondents also highlighted a range of operational, financial, and policy risks related to the outbreak. Respondents noted that lockdowns were likely to amplify operational vulnerabilities at firms; they cited the potential for remote or home-based trading activity to weaken market functioning and for financial institutions’ offshore back-office operations to be disrupted.
  • Many contacts expressed concern that a U.S. recession brought about by the pandemic could expose highly leveraged sectors of the economy. Contacts noted that corporate default rates were likely to increase sharply, with acute stress in the energy sector. Even before the outbreak spread to the United States, concerns related to nonfinancial corporate debt were cited frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds. More recently, surveyed respondents noted that a period of renewed outflows from credit-oriented mutual funds could lead to limits on redemptions and that stressed global insurers could become large sellers of U.S. corporate bonds.
  • A number of contacts also raised concerns over household balance sheets, especially in low-income segments, highlighting increases in credit card, student loan, and auto loan delinquencies as well as concerns over spillovers from nonpayments of rent and mortgages. Against the backdrop of corporate, consumer, and real estate stress, several respondents noted that bank asset quality could come under severe pressure. Smaller banks with high concentrations of lower-rated consumers, small and medium-sized businesses, and commercial real estate (CRE) were viewed as especially vulnerable.
  • Several policy-related risks were also identified, including the risk that funding designated to support small businesses would be either insufficient to address the scale of the need or not timely enough to avert a wave of layoffs and bankruptcies.
  • A few contacts noted the prospect that state and local governments would face large budgetary gaps, with spillovers to the municipal bond market and local economies.