By Howard Schneider and Pete Schroeder
WASHINGTON (Reuters) - The U.S. Federal Reserve on Friday flagged high levels of corporate debt, the impact of an extended period of low global interest rates, and emerging "stablecoin" cryptocurrency proposals as potential risks to the financial system.
In its latest twice-yearly review of financial stability, the Fed said that overall financial stability conditions had changed little since its last report in May, and that "the core of the financial sector appears resilient."
Some asset values are high, the Fed noted, pointing in particular to commercial real estate values. But "risk appetite" was felt to be in line with "historical norms," household debt "at a modest level relative to income," leverage levels low among the largest banks, and the use of potentially volatile short-term funding posing only a modest risk to financial institutions.
But the report highlighted the Fed's ongoing concern with record high levels of corporate debt, which some Fed officials worry could go bad if business slows and worsen any economic downturn. In addition, the Fed said low global borrowing costs could over time erode bank, insurance company, and pension fund returns, prompting them to take more risks.
"The current combination of very low credit spreads and high levels of indebtedness among risky nonfinancial corporates, including through leveraged loans, merits heightened vigilance," Fed Governor Lael Brainard said in a prepared statement. "Over the medium term, the low-for-long environment and the associated incentives to reach for yield and take on additional debt could increase financial vulnerabilities."
STABLECOINS AND STABILITY
But the most pointed commentary was directed at "stablecoins," an effort, most prominently by Facebook through its proposed "Libra" initiative, to remove volatility from crypto currencies by tying them to an underlying basket of assets.
The Fed devoted a section of the report to the idea, warning that while that and other innovative, technology-driven financial products could serve as a new medium of exchange, the financial system could face “potentially severe consequences” if a broad-based stablecoin is poorly designed or regulated.
"The possibility for a stablecoin payment network to quickly achieve global scale introduces important challenges and risks related to financial stability, monetary policy, safeguards against money laundering and terrorist financing, and consumer and investor protection," the report concluded.
Shortly after Facebook announced plans to use its massive platform to help establish a global stablecoin, the Fed said it raised a host of regulatory, anti-money laundering, and consumer protection challenges that must be addressed before any product launch.
The financial stability report was inaugurated a year ago, part of a growing effort by the central ban to better understand the risks posed by financial markets to the broader economy. The last two U.S. recessions emanated from the financial sector - the collapse of the dot-com stock bubble at the start of the century, and the meltdown of the subprime housing market ahead of the 2007 to 2009 slowdown - and policymakers see the report as a way to identify problems before they become acute.
The last few months have been volatile ones for stock and bond markets, with tensions heightened due to the U.S.-China trade war, a slowing global economy, and a list of geopolitical risks.
Central banks globally have cut interest rates as a result, with three Fed rate cuts in particular easing tensions in bond markets and recently boosting activity in housing and other credit-sensitive sectors.
In a Fed survey of investors and government contacts, however, "trade frictions" were cited as the chief economic risk, followed by concerns that looser monetary policy could lead to "excessive risk-taking."
The "historically high" level of corporate debt is part of that, and a risk that Fed Chair Jerome Powell has repeatedly cited since taking over as head of the central bank.
Business credit has continued to grow faster than the economy, the Fed noted, debt is high relative to both the size of the U.S. economy and the size of corporate balance sheets, and the fastest increases have been in "debt extended to firms with poorer credit profiles."
So far, however, low borrowing costs have made that debt sustainable.
"Broader corporate credit performance remains favourable amid a strong economy, and, with interest rates low by historical standards, debt service costs are at the lower ends of their historical ranges, particularly for risky firms," the Fed concluded.
(Reporting by Howard Schneider; Editing by Andrea Ricci)