Research office sees monetary policy, inflation, cyberattacks as drivers of risk to financial system

Monetary policy, inflation, and cyberattacks could heighten risk to the financial system, according to the annual report issued Wednesday by the Treasury office tasked with conducting financial research.

The report also raised concerns about risks related to low bank profitability, commercial real estate performance and hedge fund strategies.

According to the Office of Financial Research (OFR) annual report to Congress, the economy has rebounded and volatility caused by the pandemic has subsided. However, the other challenges to the financial system mean the overall risks to the financial system remain in the medium range.

“This year, the report discusses how the systemic risk landscape shifted from market volatility caused by the COVID-19 pandemic towards uncertainty surrounding rising inflation, a tighter monetary policy, and the future of COVID-19,” the OFR stated. “The report also looks at the emergence of non-traditional risks, such as cybersecurity and climate change.”

The report, according to the OFR press release, highlights three key research findings related to financial system vulnerabilities:

  • Macroeconomic uncertainty remains about the continuing impact of the coronavirus and the “pattern of inflation.”
  • Cyber risk has grown from mounting economic costs inflicted by cyberattacks and the increasing expense required to guard against them.
  • The potential risk from climate change – which has introduced vulnerabilities – is still difficult to identify, assess and forecast for the financial system.

About “sector-specific” risk, the report notes that risks tied to low rates on banks’ profits should be closely monitored. “Higher interest rates on longer-term investments, such as 10-year Treasuries, did not increase net interest margins,” OFR said. “While further research is necessary, possible explanations include lower loan demand and less willingness on the part of banks to lend at longer maturities or take on more deposits.

Other specific sectors focused on in the report were commercial real estate and hedge funds. The report said that commercial real estate prices, which it said have been “buoyed” by strong industry liquidity, could see a turnaround in a shift of conditions. “Office vacancy rates have risen modestly to 18.3%, but actual office usage has declined more,” the report stated. “This decline has had limited financial impact because office rentals are usually held in multiyear leases with credit-worthy tenants, but there is considerable uncertainty about demand for office space over the long run.”

Regarding hedge funds, the report said that the debt default of the family investment fund Archegos Capital Management earlier this year “raised questions about the financial stability of the hedge fund sector.” The reason for that skepticism the report stated, is that “Archegos used strategies similar to those of hedge funds and other leveraged asset managers.”

Office of Financial Research Finds COVID Headwinds Eased, But Other Financial System Vulnerabilities Are Taking Shape