US Fed warns of vulnerabilities facing financial system

Fed Some US businesses' debt at highest level in 2 decades

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A report released by the Federal Reserve on Wednesday warned of impending risks to the USA financial system, including geopolitical uncertainty, risky trade tensions and the highest level of American business debt in more than two decades.

While household borrowing has risen roughly in line with incomes, debt owed by businesses relative to gross domestic product (GDP) is "historically high" and there are signs of "deteriorating" credit standards, the report said. The banks are considered to be so huge and interconnected that each could threaten the stability of the financial system if it collapsed. It cited the strong capital position of banks, generally tempered borrowing by households, and a system less vulnerable to the sort of run or credit crunch that almost shut down the global economy in the 2007 to 2009 financial crisis.

On the positive side, the Fed was mostly sanguine about the USA housing market, which caused the financial crisis a decade ago.

Shepherdson estimated that the Fed was still three interest rate hikes from the middle of the range for "neutral".

Yet even in areas where the Fed report indicated potential trouble, the risks were muted. For example "risky" debt held by companies, either junk bonds or leveraged loans, surged in recent months and now tops $2 trillion. But default rates remain low and the cost of debt service as a share of company earnings has been level and near a 20-year low.

The report signaled less concern about borrowing by households and by risks in the banking sector, which is regulated by the Fed, among others. Powell, in his speech, said his overall view is that "financial stability vulnerabilities are at a moderate level".

But giving financial stability a marquee publication of its own shows the importance the issue has taken on as Fed officials strive to avoid the mistakes that led to the 2007 financial crisis.

Financial stability has remained a central focus at the Fed because of the easy-money policies employed to nurse the economy back to health in the years following the crisis.

"After 10 years of concentrated effort in the public and private sectors, the system is now much stronger, with greater capacity to function effectively in stressful times", Powell said.

Investors will be closely watching US Federal Reserve chairman Jerome Powell's speech on Wednesday, amid speculation that the path of rate hikes will slow next year, even if the Fed goes ahead with a planned increase this month.

On Wednesday, Powell may reveal more about his thinking when he speaks to the Economic Club of NY.

Should the economy turn, money managers who've been chasing returns might be in for a rude awakening, with prices for leveraged loans and junk bonds potentially causing some of the steepest losses, the USA central bank warned.

United States central bankers are trying to keep the world's largest economy on an even keel and inflation near their 2 per cent target amid a strong labour market that has driven unemployment to the lowest level since 1969.

When triggered, it forces lenders to set aside additional capital - up to 2.5 percent of risk-weighted assets - when times are good.

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