WASHINGTON — The Federal Reserve is tracking the ongoing conflict in Ukraine as the biggest threat to the U.S. financial system in 2022.
When Russia invaded its sovereign neighbor in February, it shocked commodity markets and put stress on the banks and broker-dealers that facilitate such investments by extending lines of credit, the Fed noted in its latest financial stability report, released Monday afternoon.
“Russia’s unprovoked war in Ukraine has sparked large price movements and margin calls in commodities markets and highlighted a potential channel through which large financial institutions could be exposed to contagion,” Fed Vice Chair Lael Brainard said in a statement.
The potential ripple effects from the war in Ukraine aside, the semiannual report, which examines potential risks and vulnerabilities, painted a largely favorable picture of the U.S. financial system.
Asset valuation, borrowing by households and businesses, financial system leverage and fund risks, the four areas the Fed probes for weaknesses, were all on relatively firm footing, the central bank said. Borrowing levels have nearly returned to their prepandemic levels and banks have moderate leverage as well as ample liquidity, all signs of improvement from November when the last stability report was issued, Brainard noted.
“Among other findings, it is noteworthy that households and businesses have decreased their borrowing as a percentage of gross domestic product, and currently appear to have resources to cover debt burdens, which is an important aspect of resilience in an environment of rising interest rates,” she said.
Some issues remain unresolved. Despite falling significantly since last year, asset prices remain elevated, with stocks, commercial real estate, homes and farmland all being priced at premiums. Likewise, funding risks, especially for emerging assets such as cryptocurrencies and stablecoins, are on the rise.
On the commodity side, the traders most affected by the conflict — those dealing in energy and wheat futures — have been able to service their hedging costs and avoid default, the report noted. Yet, higher costs of hedging against potential losses are already driving up consumer prices, contributing to another top risk highlighted by the Fed: increased inflation.
“The Federal Reserve is working with domestic and international regulators to better understand the exposures of commodity market participants and their linkages with the core financial system,” Brainard said.
The report noted several other external factors that could jeopardize the U.S. economy, including potential spillover from a real estate crisis in China and possible foreign divestment from Treasuries and other U.S. assets. Domestically, the top stability threats were runaway inflation and the sudden collapse in asset prices, which have been volatile.
Overall, the Fed assessed the U.S. financial system to be resilient, but noted that the most adverse economic conditions tend to arise in ways that regulators don't expect.
"Shocks, such as sudden changes to financial or economic conditions, are typically surprises and are inherently difficult to predict," the report said.
