Federal Reserve warns of potential ‘strains’ on US banks

US banks risk losses from the coronavirus crisis that could strain their finances even though they entered the tumult with strong balance sheets, the Federal Reserve warned in its semi-annual review of America’s financial system.

Banks have set aside tens of billions of dollars for potential loan losses since the pandemic began and said that they were so strong going into the shutdown that they will be able to continue to pay dividends.

The Fed warned, however, that lenders could face “material losses” from lending to struggling borrowers who are unable to get back on track after the crisis. 

“The strains on household and business balance sheets from the economic and financial shocks since March will likely create fragilities that last for some time,” the Fed wrote. “Financial institutions — including the banking sector, which had large capital and liquidity buffers before the shock — may experience strains as a result.” 

Lael Brainard, a Fed governor, added: “Forceful early interventions have been effective in resolving liquidity stresses, but we will be monitoring closely for solvency stresses among highly leveraged business borrowers, which could increase the longer the Covid pandemic persists.”

In its report, the Fed laid out the risk of another decline in asset valuations, despite a rebound from their lows at the end of March and beginning of April. 

“Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse, or financial system strains re-emerge,” the Fed said.

The Fed pointed out that the debt levels of businesses had already been high at the beginning of 2020, and the decline in their revenues had brought about a “widespread repricing of credit risk” and a slower pace of issuance of high-yield corporate bonds and origination of leveraged loans.

In the November edition of the same report, supervisors had zeroed in on “historically high” business borrowing as a key risk, noting that debt was growing faster for “the riskiest firms amid weak credit standards”.

But even for household debt, which had been moderate before the coronavirus shock, the Fed warned on Friday that a “deterioration in the ability of some households to repay obligations may result in material losses to lenders”.

Banks are hoping that individual borrowers will move quickly to pay their loans after government-directed 90-day “holidays” that allow them to delay payments to see out the crisis. 

The Fed also noted that leverage levels at hedge funds had already been high before the pandemic, and “at least some” of them had been “severely affected” by the volatility and asset price declines that hit markets at the outset of the crisis, contributing to the “dislocations”. 

“All told, the prospect for losses at financial institutions to create pressures over the medium term appears elevated,” the central bank said.

The Fed specifically said that defaults on leveraged loans were “likely to continue to increase, with the specific contour highly dependent on the path of overall economic activity. Such developments would weaken the balance sheets of lenders, including [collateralised loan obligations] that hold leveraged loans, and amplify the economic effects of Covid-19,” it said. 

The Fed has often noted the differences between the coronavirus shock to an otherwise healthy financial system and the 2008-09 crisis, which originated within the financial system. It has also stressed that while healthy banks could not prevent financial damage from the pandemic, they could prevent additional stress from being layered on top of it.

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