Federal Reserve Report: Policy uncertainty is the number one financial stability risk, central bank independence is mentioned for the first time, and attention is focused on financial leverage.

The Federal Reserve warned in its semi-annual financial stability report released on Friday, November 7th that policy uncertainty has become the primary risk facing the U.S. financial system. Concerns among market participants about the fragility of the financial system are undergoing structural changes. The report states that while the banking system overall remains stable, the high leverage of non-bank entities such as hedge funds and elevated asset valuations still pose "significant" risks. Of note is that, for the first time since the financial stability report was first released in 2018, the Federal Reserve specifically mentioned "central bank independence" as a risk factor for the financial system. This change comes after U.S. President Trump suddenly announced the dismissal of Fed Board Member Lisa Cook and continued to publicly pressure Fed Chair Powell to lower interest rates. The report also for the first time mentioned "accessibility of economic data" as a risk factor, which is related to the record time the U.S. federal government shutdown led to the interruption of official economic data releases. The Fed survey disclosed in the report showed that policy uncertainty, including central bank independence, accessibility of economic data, and trade policies, are considered the top financial stability risks by respondents. Geopolitical risks and rising long-term interest rates are also concerns for the majority of respondents. The report, based on market conditions and data as of October 23rd, reflects the Fed's latest assessment of the four major categories of vulnerabilities in the financial system, deeming the vulnerability related to financial leverage as "not to be ignored." The report indicates that the risks facing the market have shifted from specific trade policy concerns to more broad policy uncertainties, while valuation risks related to artificial intelligence (AI) assets are beginning to come into regulatory focus. Over sixty percent of respondents are concerned about policy uncertainty, with a noticeable increase in AI-related risks. According to the financial stability report released on Friday, the Federal Reserve conducted a financial stability risk survey of professionals in the securities, banking, investment funds, and consulting companies from September to October. Sixty-one percent of respondents listed policy uncertainty as the top risk to U.S. financial stability, significantly higher than the fifty percent of respondents who thought so in the spring survey earlier this year. The report explains that policy uncertainty covers multiple dimensions such as trade policy, central bank independence, and the accessibility of economic data. This is the first time central bank independence has been mentioned as one of the risk factors in the Fed's financial stability risk survey. In contrast, in the spring survey in April, global trade risks were the most prominent single issue of concern, but in the recent survey, it no longer appeared as a standalone worry. The survey shows a significant increase in the focus on geopolitical risks, with forty-eight percent of respondents mentioning this risk, higher than the twenty-three percent of respondents in the spring survey. The report states that respondents mentioned a series of geopolitical risks and closely follow the possibility of existing tensions escalating, while also pointing out that "financial market indicators may not fully reflect geopolitical risks at present." Concerns about rising long-term interest rates have also significantly increased, with forty-three percent of respondents mentioning this risk, much higher than the nine percent in the spring survey. Respondents emphasized that higher long-term rates could be driven by increased term premiums, higher inflation expectations, or limited demand for U.S. Treasuries, and noted that "higher rates could increase unrealized losses in the banking sector and potentially force fixed-income investors to bear losses based on market value." The mention of AI as a financial stability risk in the survey has significantly increased. Thirty percent of respondents viewed it as a potential impact in the next twelve to eighteen months, far exceeding the nine percent in the spring survey. The report states that this concern primarily focuses on how emotions regarding AI are driving recent stock market gains, and the shift in this sentiment could lead to "significant losses" in the market and potentially have broader economic impacts. Respondents noted that this shift could result in significant losses for hedge funds and public markets, and if the decline is significant enough, it could further slow down the labor market and tighten financial conditions. High hedge fund leverage rates pose significant risks to financial system leverage. The Federal Reserve particularly emphasized the vulnerability brought about by leverage in the financial sector in its report, stating: "While the capital positions of banks and broker-dealers remain robust, leverage ratios of some other financial institutions are relatively high compared to historical levels, such as hedge funds and life insurance companies. Overall, the vulnerability caused by leverage in the financial industry cannot be ignored." The report points out that the leverage ratio of hedge funds has risen to the highest level since regulatory agencies began tracking the data in its current form over a decade ago. The report shows that over the past few years, hedge fund leverage rates have steadily increased in a wide range of strategies, including strategies involving government bonds, interest rate derivatives, and equities. The Federal Reserve specifically mentioned that the largest hedge funds often have the highest leverage ratios, and these increased leverages support significant positions in key markets. The leverage ratio of life insurance companies is also at the highest one-fourth level in historical distribution. However, the report also points out that the proportion of non-traditional liabilities used by life insurance companies remains relatively small and limited to a portion of their general account assets. In comparison, the banking system continues to maintain resilience and stability, with regulatory capital ratios at historical highs, and most banks reporting capital levels well above regulatory requirements. However, the Federal Reserve warned that while the fair value losses on fixed-rate assets have decreased, they are still significant for some banks and continue to be sensitive to changes in long-term interest rates. Broker-dealers' leverage ratios remain near historical lows, but their intermediation activities have reached historically high levels in a range of markets, including the government bond market. Asset valuations are high. The Federal Reserve pointed out that asset valuations are at high levels. The report states that since the settling of market volatility earlier in April, stock prices relative to earnings have returned to the higher end of their historical range. The estimated equity risk premium - the risk compensation in the stock market - remains far below average levels. The spread between corporate bond yields and yields on the same-term government bonds has also fallen to pre-April levels and is at historically low levels compared to long-term history. In the real estate market, the rate of house price growth has slowed down, but the ratio of house prices to rents continues to near historically high levels. The commercial real estate transaction price index, adjusted for inflation, shows some signs of stabilization after a sharp decline, but vulnerability persists due to upcoming refinancing needs. According to Reuters, a large amount of commercial real estate debt is due in the next year, which could increase market volatility if borrowers are forced to sell assets. Corporate and household debt risks moderate, consumer default rates remain high. The report assesses the vulnerability brought about by corporate and household debt at a moderate level. The total corporate and household debt as a percentage of GDP continues to decline slightly, reaching the lowest levels in the past twenty years. The leverage measure for publicly traded companies remains slightly above the median of its historical distribution, while the debt of privately held companies continues to grow. While the overall debt servicing capacity of publicly traded companies remains robust, the debt servicing capacity of small businesses and high-risk private companies has decreased in recent years. Household debt as a percentage of GDP has remained low in recent history. Most household debts are held by borrowers with good credit records. Due to sufficient housing net worth buffers and strict underwriting standards, mortgage delinquency rates remain low. However, default rates on credit cards and auto loans are still higher than pre-pandemic levels. According to Reuters, consumer default rates are still high by historical standards, and after the government resumed student loan repayments in the first half of 2025, student loan default rates saw a significant increase. These data indicate that while overall debt levels are manageable, certain consumer groups still face repayment pressures. Financing risks remain moderate, with money market fund growth concentrated in government products. The financing risks remain at a moderate level. Assets in cash management tools continue to grow, mainly driven by government money market funds, which historically have been the least likely category to experience significant investor redemptions. The size of assets in more vulnerable investment instruments, measured as a percentage of GDP, remains close to the median of historical distribution. Banks' reliance on uninsured deposits is a significant component of their financing risks, currently far below the peak levels in 2022 and early 2023. Most domestic banks maintain high levels of liquid assets and stable sources of funding. The growth of non-traditional liabilities in life insurance companies further increases, but it only accounts for a small portion of general account assets. The commercial real estate market shows signs of stabilization. While market prices are exhibiting signs of stability, the Federal Reserve points out that a large amount of commercial real estate debt will mature in the next year, which could increase volatility if borrowers are forced to sell assets. Vacancy rates and rental growth in the office property sector also seem to be stabilizing. The Federal Reserve emphasizes in the report that while the framework provides a systematic approach to evaluate financial stability, some potential risks may be novel or difficult to quantify, thus not captured by current methods. The Fed states that it will rely on ongoing research to improve the measurement of existing vulnerabilities and keep pace with new forms of vulnerability that may emerge in the financial system or exacerbate existing vulnerabilities.