FOMC minutes: U.S. financial system faces ‘notable’ financial vulnerabilities; leverage in banking sector noted

Financial vulnerabilities of the U.S. financial system were described as “notable” by Federal Reserve staff participating in the July meeting of the Federal Open Market Committee (FOMC), the Fed’s monetary policy-setting arm.

Leverage in the banking sector was also described as “notable” in staff’s updated assessment of financial system stability, according to the July 25-26 FOMC meeting minutes released Wednesday.

“In the banking sector, regulatory risk-based capital ratios showed the system remained well capitalized. However, while the overall banking system retained ample loss-bearing capacity, some banks experienced sizable declines in the fair value of their assets as a consequence of rising interest rates,” the minutes state. “Vulnerabilities associated with funding risks were also characterized as notable.”

The Fed staff also said that while a small number of banks saw notable outflows of deposits late in the first quarter and early in the second quarter, deposit flows later stabilized, the minutes show.

Meanwhile, asset valuation pressures were also characterized as notable. “In particular, measures of valuations in both residential and commercial property markets remained high relative to fundamentals. House prices, while having cooled earlier this year, started to rise again, and price-to-rent ratios remained at elevated levels and near those seen in the mid-2000s,” the minutes state. “Al­though commercial property prices moved down, developments in the CRE sector following the pandemic may have produced a permanent shift away from traditional working patterns. If so, fundamentals in the sector could decline notably and contribute to a deterioration in credit quality.”

Vulnerabilities associated with household and nonfinancial business leverage remained moderate overall, according to the reported assessment.

Minutes of the Federal Open Market Committee July 25-26, 2023