Financial Stability Report, May 2023

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

May 2023

Financial Stability Report

The Federal Reserve System is the central

bank of the United States. It performs ﬁve key

functions to promote the effective operation

of the U.S. economy and, more generally, the

public interest.

The Federal Reserve

conducts the nation’s monetary policy to promote maximum employment

and stable prices in the U.S. economy;

promotes the stability of the ﬁnancial system and seeks to minimize

and contain systemic risks through active monitoring and engagement in

the U.S. and abroad;

promotes the safety and soundness of individual ﬁnancial institutions

and monitors their impact on the ﬁnancial system as a whole;

fosters payment and settlement system safety and efﬁciency through

services to the banking industry and the U.S. government that facilitate

U.S.-dollar transactions and payments; and

promotes consumer protection and community development through

consumer-focused supervision and examination, research and analysis of

emerging consumer issues and trends, community economic development

activities, and administration of consumer laws and regulations.

To learn more about us, visit www.federalreserve.gov/aboutthefed.htm.

Contents

Purpose and Framework .................................................iii

Overview ..............................................................1

1 Asset Valuations .....................................................5

Box 1.1. Update on the Transition to the Secured Overnight Financing Rate ............13

Box 1.2. Financial Institutions’ Exposure to Commercial Real Estate Debt .............16

2 Borrowing by Businesses and Households ..............................21

3 Leverage in the Financial Sector ......................................31

Box 3.1. The Bank Stresses since March 2023 ................................34

Box 3.2. Financial Stability Risks from Private Credit Funds Appear Limited ............45

4 Funding Risks .......................................................49

Box 4.1. The Federal Reserve’s Actions to Protect Bank Depositors and Support

the Flow of Credit to Households and Businesses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

5 Near-Term Risks to the Financial System ...............................59

Box 5.1. Survey of Salient Risks to Financial Stability ............................61

Box 5.2. Transmission of Stress Abroad to the U.S. Financial System ................63

Appendix: Figure Notes ................................................67

Note: This report generally reflects information that was available as of April 21, 2023.

iii

Purpose and Framework

This report presents the Federal Reserve Board’s current assessment of the stability of the U.S.

financial system. By publishing this report, the Board intends to promote public understand-

ing by increasing transparency around, and creating accountability for, the Federal Reserve’s

views on this topic. Financial stability supports the objectives assigned to the Federal Reserve,

including full employment and stable prices, a safe and sound banking system, and an efficient

paymentssystem.

A financial system is considered stable when

banks, other lenders, and financial markets

are able to provide households, communities,

and businesses with the financing they need

to invest, grow, and participate in a well-

functioning economy—and can do so even

when hit by adverse events, or “shocks.”

Consistent with this view of financial stabil-

ity, the Federal Reserve Board’s monitoring

framework distinguishes between shocks to,

and vulnerabilities of, the financial system.

Shocks are inherently difficult to predict, while

vulnerabilities, which are the aspects of the

financial system that would exacerbate stress,

can be monitored as they build up or recede

over time. As a result, the framework focuses

primarily on assessing vulnerabilities, with an

emphasis on four broad categories and how

those categories might interact to amplify

stress in the financial system.

For a review of the research literature in this area, see Tobias Adrian, Daniel Covitz, and Nellie Liang (2015), “Financial

Stability Monitoring,” Annual Review of Financial Economics, vol. 7 (December), pp. 357–95.

1. Valuation pressures arise when asset prices are high relative to economic fundamentals or

historical norms. These developments are often driven by an increased willingness of investors

to take on risk. As such, elevated valuation pressures may increase the possibility of outsized

drops in asset prices (see Section 1, Asset Valuations).

More on the Federal

Reserve’s Monitoring Efforts

See the Financial Stability section of the

Federal Reserve Board’s website for more

information on how the Federal Reserve

monitors the stability of the U.S. and world

ﬁnancial systems.

The website includes:

• a more detailed look at our monitoring

framework for assessing risk in each

category;

• more data and research on related topics;

• information on how we coordinate, cooper-

ate, and otherwise take action on ﬁnancial

system issues; and

• public education resources describing the

importance of our efforts.

iv Financial Stability Report

2. Excessive borrowing by businesses and households exposes the borrowers to distress if

their incomes decline or the assets they own fall in value. In these cases, businesses and

households with high debt burdens may need to cut back spending, affecting economic activity

and causing losses for investors (see Section 2, Borrowing by Businesses and Households).

3. Excessive leverage within the financial sector increases the risk that financial institutions will

not have the ability to absorb losses without disruptions to their normal business operations

when hit by adverse shocks. In those situations, institutions will be forced to cut back lending,

sell their assets, or even shut down. Such responses can impair credit access for households

and businesses, further weakening economic activity (see Section 3, Leverage in the

Financial Sector).

4. Funding risks expose the financial system to the possibility that investors will rapidly

withdraw their funds from a particular institution or sector, creating strains across markets

or institutions. Many financial institutions raise funds from the public with a commitment

to return their investors’ money on short notice, but those institutions then invest much of

those funds in assets that are hard to sell quickly or have a long maturity. This liquidity and

maturity transformation can create an incentive for investors to withdraw funds quickly in

adverse situations. Facing such withdrawals, financial institutions may need to sell assets

quickly at “fire sale” prices, thereby incurring losses and potentially becoming insolvent, as

well as causing additional price declines that can create stress across markets and at other

institutions (see Section 4, Funding Risks).

The Federal Reserve’s monitoring framework also tracks domestic and international develop-

ments to identify near-term risks—that is, plausible adverse developments or shocks that could

stress the U.S. financial system. The analysis of these risks focuses on assessing how such

potential shocks may spread through the U.S. financial system, given our current assessment of

vulnerabilities.

While this framework provides a systematic way to assess financial stability, some potential

risks may be novel or difficult to quantify and therefore are not captured by the current approach.

Given these complications, we rely on ongoing research by the Federal Reserve staff, academ-

ics, and other experts to improve our measurement of existing vulnerabilities and to keep pace

with changes in the financial system that could create new forms of vulnerabilities or add to

existingones.

Federal Reserve actions to promote the resilience of the

financialsystem

The assessment of financial vulnerabilities informs Federal Reserve actions to promote the resil-

ience of the financial system. The Federal Reserve works with other domestic agencies directly

Purpose and Framework v

and through the Financial Stability Oversight Council (FSOC) to monitor risks to financial stability

and to undertake supervisory and regulatory efforts to mitigate the risks and consequences of

financial instability.

Actions taken by the Federal Reserve to promote the resilience of the financial system include

its supervision and regulation of financial institutions. In the aftermath of the 2007–09 financial

crisis, these actions have included requirements for more and higher-quality capital, an innova-

tive stress-testing regime, and new liquidity regulations applied to the largest banks in the United

States. In addition, the Federal Reserve’s assessment of financial vulnerabilities informs deci-

sions regarding the countercyclical capital buffer (CCyB). The CCyB is designed to increase the

resilience of large banking organizations when there is an elevated risk of above-normal losses

and to promote a more sustainable supply of credit over the economic cycle.

Overview

This report reviews conditions affecting the stability of the U.S. financial system by analyzing

vulnerabilities related to valuation pressures, borrowing by businesses and households,

financial-sector leverage, and funding risks. It also highlights several near-term risks that, if

realized, could interact with these vulnerabilities.

Since the November2022 Financial Stability Report was released, Silicon Valley Bank (SVB),

Signature Bank, and First Republic Bank failed following substantial deposit outflows prompted

by concerns over poor management of interest rate risk and liquidity risk. In March, to prevent

broader spillovers in the banking system, the Federal Reserve, together with the Federal Deposit

Overview of financial system vulnerabilities

Leverage in the

ﬁnancial sector

Funding risks

Borrowing by businesses

and households

Asset valuations

• Yields on Tr easury

securities declined

across all maturities in

March amid heightened

ﬁnancial market

volatility.

• Risk premiums in equity

and corporate bond

markets continued to be

near the middle of their

historical distributions.

• Real estate valuations

remained very elevated

even though activity

weakened. Both house

prices and commercial

property prices have

shown recent declines.

• The ratio of total private

debt to gross domestic

product (GDP) edged

down but was still at a

moderate level.

• The business

debt-to-GDP ratio

remained at a high level,

but debt issuance by

the riskiest companies

slowed markedly.

Interest coverage ratios

for publicly traded ﬁrms

declined a bit from

historically high levels.

• Household debt

remained at modest

levels relative to GDP

and was concentrated

among prime-rated

borrowers.

• Poor management of

interest rate risk and

liquidity risk contributed

to three sizable bank

failures since March

2023. Concerns over

broader spillovers in

the banking sector led

to ofﬁcial interventions

by the Federal Reserve,

the Federal Deposit

Insurance Corporation,

and the U.S. Department

of Treasury.

• Broker-dealer leverage

rested near historically

low levels. The limited

willingness and ability of

dealers to intermediate

during times of distress

can amplify volatility.

• Hedge fund leverage

remained elevated.

Bank lending to nonbank

ﬁnancial institutions

stabilized at high levels.

• Some banks

experienced notable

funding strains following

the failures of Silicon

Valley Bank and

Signature Bank. The

actions by the ofﬁcial

sector reduced funding

strains in the banking

system.

• Structural vulnerabilities

persisted at money

market funds, other

cash-management

vehicles, and

stablecoins. Certain

types of mutual funds

continued to be

susceptible to large

redemptions.

• Liquidity risks for life

insurers remained

elevated as the share of

illiquid and risky assets

continued to edge up.

2 Financial Stability Report

Insurance Corporation (FDIC) and the Department of the Treasury, took decisive actions to protect

bank depositors and support the continued flow of credit to households and businesses. Owing

to these actions and the resilience of the banking and financial sector, financial markets normal-

ized, and deposit flows have stabilized since March, although some banks that experienced large

deposit outflows continued to experience stress. These developments may weigh on credit condi-

tions going forward.

A summary of the developments in the four broad categories of vulnerabilities since the last report

is as follows:

1. Asset valuations. Yields on Treasury securities declined in March amid heightened financial

market volatility. Measures of equity prices relative to expected earnings were volatile over

the period but remained above their historical median, while risk premiums in corporate bond

markets stayed near the middle of their historical distributions. Valuations in residential real

estate remained elevated despite weakening activity. Similarly, commercial real estate (CRE)

valuations remained near historically high levels, even as price declines have been widespread

across CRE market segments (see Section 1, Asset Valuations).

2. Borrowing by businesses and households. On balance, vulnerabilities arising from borrowing

by nonfinancial businesses and households were little changed since the November report

and remained at moderate levels. Business debt remained elevated relative to gross domestic

product (GDP), and measures of leverage remained in the upper range of their historical

distributions, although there are indications that business debt growth began to slow toward

the end of last year. Measures of the ability of firms to service their debt stayed high.

Household debt remained at modest levels relative to GDP, and most of that debt is owed by

households with strong credit histories or considerable home equity (see Section 2, Borrowing

by Businesses and Households).

3. Leverage in the financial sector. Concerns over heavy reliance on uninsured deposits, declining

fair values of long-duration fixed-rate assets associated with higher interest rates, and poor risk

management led market participants to reassess the strength of some banks (discussed in the

box “The Bank Stresses since March2023”). Overall, the banking sector remained resilient,

with substantial loss-absorbing capacity. Broker-dealer leverage remained historically low.

Leverage at life insurance companies edged up but stayed below its pandemic peak. Hedge

fund leverage remained elevated, especially for large hedge funds (see Section 3, Leverage in

the Financial Sector).

4. Funding risks. Substantial withdrawals of uninsured deposits contributed to the failures of

SVB, Signature Bank, and First Republic Bank and led to increased funding strains for some

other banks, primarily those that relied heavily on uninsured deposits and had substantial

interest rate risk exposure. Policy interventions by the Federal Reserve and other agencies

helped mitigate these strains and limit the potential for further stress (discussed in the box

Overview 3

“The Federal Reserve’s Actions to Protect Bank Depositors and Support the Flow of Credit

to Households and Businesses”). Overall, domestic banks have ample liquidity and limited

reliance on short-term wholesale funding. Structural vulnerabilities remained in short-term

funding markets. Prime and tax-exempt money market funds (MMFs), as well as other cash-

investment vehicles and stablecoins, remained vulnerable to runs. Certain types of bond and

loan funds experienced outflows and remained susceptible to large redemptions, as they hold

securities that can become illiquid during periods of stress. Life insurers continued to have

elevated liquidity risks, as the share of risky and illiquid assets remained high (see Section 4,

Funding Risks).

This report also discusses potential near-term risks based in part on the most frequently cited

risks to U.S. financial stability as gathered from outreach to a wide range of researchers, academ-

ics, and market contacts conducted from February to April (discussed in the box “Survey of Salient

Risks to Financial Stability”). Frequently cited topics in this survey included persistent inflation and

tighter monetary policy, banking-sector stress, commercial and residential real estate, and geopo-

litical tensions. The box “Transmission of Stress Abroad to the U.S. Financial System” describes

how financial stresses abroad can spill over to the U.S. financial system.

Finally, the report contains additional boxes that analyze salient topics related to financial

stability: “Update on the Transition to the Secured Overnight Financing Rate,” “Financial

Institutions’ Exposure to Commercial Real Estate Debt,” and “Financial Stability Risks from

Private Credit Funds Appear Limited.”

Survey of salient risks to the U.S. financial system

Survey respondents cited several risks to the U.S. financial system. For more information, see the box “Survey of Salient

Risks to Financial Stability.”

November

2022

May

2023

62%

of contacts

surveyed

56%

of contacts

surveyed

Persistent inﬂation;

monetary tightening

56%

of contacts

surveyed

U.S.–China

tensions

42%

of contacts

surveyed

62%

of contacts

surveyed

52%

of contacts

surveyed

Russia–Ukraine

war

12%

of contacts

surveyed

52%

of contacts

surveyed

Commercial and

residential real estate

56%

of contacts

surveyed

Banking-sector

stress

12%

of contacts

surveyed

Asset Valuations

Asset valuation pressures remained moderate despite notable

fluctuations in financial markets

Since the November report, significant strains in the banking sector, along with increased uncer-

tainty about the economic outlook and the path of monetary policy, led to notable fluctuations in

financial asset prices. Yields on Treasury securities declined across all maturities. Broad equity

indexes were volatile but have increased, on net, since the previous report. Corporate credit

spreads were moderately lower, on net, and near their historical averages.

Liquidity in short-term Treasury markets experienced notable strains associated with the high vola-

tility and elevated uncertainty that roiled financial markets in the middle of March, while equity and

corporate bond markets also saw liquidity deteriorate during that period. Despite these worsened

liquidity conditions, market functioning proved largely resilient.

As has been the case for some time now, valuation pressures remained elevated in property

markets. In residential real estate, valuations remained near all-time highs despite weakening

activity and falling prices in recent months. Valuations in the commercial segment also remained

near historical highs even though price declines have been widespread. In addition, fundamentals

have weakened, particularly for the office segment. Farmland prices were also historically elevated

relative to rents, reflecting higher crop prices and limited inventories of land.

Table 1.1 shows the sizes of the asset markets discussed in this section. The largest asset mar-

kets are those for residential real estate, equities, Treasury securities, and CRE.

Treasury yields declined sharply following the Silicon Valley Bank

and Signature Bank failures, particularly for shorter-maturity

securities

On net, yields on Treasury securities moved lower since the November report (figure1.1). How-

ever, the monthly averages plotted in the figure obscure some important daily movements during

the month of March. Throughout February and into early March, the yields on Treasury securities

moved notably higher following stronger-than-expected economic data but abruptly reversed course

following the failures of SVB and Signature Bank. These failures raised uncertainty about the eco-

nomic outlook and future path of interest rates, prompting investors to reallocate portfolios toward

safer assets. The market for two-year Treasury securities was most acutely affected, with the two-

year yield falling by more than 60 basis points on March13, the single largest daily decline since

1987. Yields on longer-term Treasury securities also declined in March, but by a smaller amount.

6 Financial Stability Report

Table 1.1. Size of selected asset markets

Item

Outstanding

(billions of dollars)

Growth,

2021:Q4–2022:Q4

(percent)

Average annual growth,

1997–2022:Q4

(percent)

Residential real estate 55,670 10.4 6.4

Equities 46,819 −21.0 8.7

Treasury securities 23,845 5.7 8.1

Commercial real estate 23,796 −1.4 6.8

Investment-grade corporate bonds 7,116 4.8 8.1

Farmland 3,188 10.1 5.7

High-yield and unrated corporate bonds 1,677 −6.6 6.6

Leveraged loans* 1,424 6.2 13.9

Price growth (real)

Commercial real estate** −1.9 3.1

Residential real estate*** .3 2.5

Note: The data extend through 2022:Q4. Growth rates are measured from Q4 of the year immediately preceding the period through Q4 of the

final year of the period. Equities, real estate, and farmland are at nominal market value; bonds and loans are at nominal book value.

* The amount outstanding shows institutional leveraged loans and generally excludes loan commitments held by banks. For example, lines of

credit are generally excluded from this measure. Average annual growth of leveraged loans is from 2000 to 2022:Q4, as this market was fairly

small before then.

** One-year growth of commercial real estate prices is from December2021 to December2022, and average annual growth is from 1998:Q4

to 2022:Q4. Both growth rates are calculated from equal-weighted nominal prices deflated using the consumer price index (CPI).

*** One-year growth of residential real estate prices is from December2021 to December2022, and average annual growth is from 1997:Q4

to 2022:Q4. Nominal prices are deflated using the CPI.

Source: For leveraged loans, PitchBook Data, Leveraged Commentary & Data; for corporate bonds, Mergent, Inc., Fixed Income Securities

Database; for farmland, Department of Agriculture; for residential real estate price growth, CoreLogic, Inc.; for commercial real estate price

growth, CoStar Group, Inc., CoStar Commercial Repeat Sale Indices; for all other items, Federal Reserve Board, Statistical Release Z.1, “Financial

Accounts of the United States.”

Figure 1.1. Nominal Treasury yields fell in March and April

2-year

10-year

1998 2003 2008 2013 2018 2023

Apr.

Monthly

Percent, annual rate

Source: Federal Reserve Board, Statistical Release H.15, “Selected Interest Rates.”

Asset Valuations 7

A model-based estimate of the nominal Treasury term premium—a measure of the compensation

that investors require to hold longer-term Treasury securities rather than shorter-term ones—

remained low relative to its long-run history (figure1.2). Treasury market volumes, particularly in

the on-the-run segment, increased dramatically in March as well. Interest rate volatility implied by

options remained well above its historical median (figure1.3).

Equity market valuation pressures increased modestly

Equity prices in the banking sector fell following the SVB and Signature Bank failures to levels well

below those that prevailed at the time of the November report. Broad equity indexes experienced

considerable volatility but, smoothing through

the ups and downs, were up a bit from the

previous report. All told, equity market val-

uation pressures increased modestly since

the November report as equity price growth

outpaced growth in earnings forecasts, push-

ing the forward price-to-earnings ratio higher

to a level notably above its historical average

(figure1.4).

An estimate of the expected equity premium—

one measure of the additional return that

investors require for holding stocks relative

to risk-free bonds—declined since the

November report to somewhat below its

Figure 1.2. An estimate of the nominal

Treasury term premium remained low

1998 2003 2008 2013 2018 2023

−1.5

−1.0

−0.5

0.0

0.5

1.0

1.5

2.0

2.5

Apr.

Monthly

Percentage points

Source: Department of the Treasury; Wolters Kluwer,

Blue Chip Financial Forecasts; Federal Reserve Bank

of New York; Federal Reserve Board staff estimates.

Figure 1.3. Interest rate volatility remained

above its long-term median

2005 2008 2011 2014 2017 2020 2023

100

150

200

250

Apr.

Monthly

Basis points

Median

Source: For data through July13, 2022, Barclays

Trading and IHS Markit; for data from July14, 2022,

onward, ICAP, Swaptions and Interest Rate Caps and

Floors Data.

Figure 1.4. The price-to-earnings ratio of

S&P500 firms continued to be above its

historical median

1991 1995 1999 2003 2007 2011 2015 2019 2023

Mar.

Monthly

Ratio

Median

Source: Federal Reserve Board staff calculations

using Refinitiv, Institutional Brokers’ Estimate System.

8 Financial Stability Report

historical median (figure1.5).

Equity market volatility remained elevated during the first quarter of

2023, reflecting strains in the banking system and continued uncertainty around monetary policy

and future economic conditions, but fell to near its historical median in April (figure1.6).

Market liquidity worsened in key markets amid heightened

uncertainty

Market liquidity refers to the ease and cost of buying and selling an asset. Low liquidity can

amplify the volatility of asset prices and result in larger price moves in response to shocks. In

extreme cases, low liquidity can threaten market functioning, leading to a situation in which partici-

pants are unable to trade without incurring a significant cost.

This estimate is constructed based on expected corporate earnings for 12 months ahead. Alternative measures of the

equity premium that incorporate longer-term earnings forecasts suggest more elevated equity valuation pressures.

Figure 1.5. An estimate of the equity premium fell below its historical median

1991 1995 1999 2003 2007 2011 2015 2019 2023

−2

Mar.

Monthly

Percentage points

Median

Source: Federal Reserve Board staff calculations using Refinitiv (formerly Thomson Reuters), Institutional Brokers’

Estimate System; Department of the Treasury; Federal Reserve Bank of Philadelphia, Survey of Professional

Forecasters.

Figure 1.6. Volatility in equity markets remained elevated

Option-implied volatility

Realized volatility

1998 2003 2008 2013 2018 2023

Apr.

Monthly

Percent

Source: Refinitiv, DataScope Tick History; Federal Reserve Board staff estimates.

Asset Valuations 9

Liquidity conditions in the market for Treasury securities are particularly important due to the key

role those securities play in the financial system. Throughout much of last year and into early

2023, various measures of liquidity—the average size of bid and ask orders posted on electronic

platforms at the best prices (“market depth”) and bid-ask spreads—indicated that liquidity in the

Treasury market was lower and less resilient than is typical.

Market liquidity conditions came

under even greater strain as a result of distress in the banking sector. Market depth in on-the-run

Treasury securities, normally the most liquid segment, fell substantially in mid-March (figures 1.7

and 1.8), and bid-ask spreads rose marketwide, with particularly notable increases for shorter-

maturity notes. Further, the intraday volatility of bid-ask spreads on short-maturity securities rose

to levels last seen in March2020.

These additional liquidity strains in March2023 appeared to

The bid-ask spread is the difference between the best “bid” quote to buy an asset and the best “ask” quote to sell that

asset; smaller bid-ask spreads indicate lower trading costs and, hence, more liquid markets.

For further discussions about the liquidity risks posed by volatile bid-ask spreads, see Dobrislav Dobrev and Andrew

Meldrum (2020), “What Do Quoted Spreads Tell Us about Machine Trading at Times of Market Stress? Evidence from

Treasury and FX Markets during the COVID-19-Related Market Turmoil in March2020,” FEDS Notes (Washington: Board

of Governors of the Federal Reserve System, September25), https://doi.org/10.17016/2380-7172.2748.

Figure 1.7. Treasury market depth remained below historical norms

5-year (right scale)

10-year (right scale)

30-year (left scale)

Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr.

100

150

200

250

300

350

Apr.

5-day moving average

Millions of dollarsMillions of dollars

2019 2020 2021 2022 2023

Source: Inter Dealer Broker Community.

Figure 1.8. On-the-run market depth worsened in March then recovered

2-year OTR market depth (right scale)

10-year OTR market depth (left scale)

Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr.

100

200

300

Apr.

5-day moving average

Millions of dollarsMillions of dollars

2019 2020 2021 2022 2023

Source: BrokerTec; Federal Reserve Board staff calculations.

10 Financial Stability Report

be a consequence of the elevated interest rate volatility that followed the heightened uncertainty

around the future economic outlook and path of monetary policy. Despite these strains, Treasury

markets continued to function throughout the episode without severe dislocations or reports of

investors being unable to transact. By early April, the most acute strains had dissipated, and

liquidity conditions in Treasury markets returned to the levels that prevailed for much of the

pastyear.

Liquidity deteriorated in a range of other markets in March as well. Bid-ask spreads on corpo-

rate bonds widened, particularly for investment-grade financial bonds, although these spreads

remained well below pandemic levels. In equity markets, depth in the S&P 500 futures markets

declined before stabilizing at below-average levels (figure1.9). Equity and corporate bond market

functioning remained largely smooth despite the rising transaction costs associated with lower

liquidity, and liquidity conditions normalized by early April.

Corporate debt market valuations remained near their historical

averages

Yields on corporate bonds fell since the November report and by more than yields on

comparable-maturity Treasury securities (figure1.10). Consequently, corporate bond spreads,

measured as the difference in yields between corporate bonds and comparable-maturity

Treasury securities, were moderately lower since November and near their historical average levels

(figure1.11). The excess bond premium—a measure that captures the gap between corporate

bond spreads and expected credit losses—has remained near its historical average (figure1.12).

Valuation pressures in leveraged loan markets were little changed from the November report.

The average spread on leveraged loans above their benchmark rates in the secondary market

declined moderately and was near its average over the past decade (figure1.13). The excess loan

Figure 1.9. A measure of liquidity in equity markets fell sharply in March

Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr.

100

200

300

Apr.

5-day moving average

Market depth (number of contracts)

2019 2020 2021 2022 2023

Source: Refinitiv, DataScope Tick History; Federal Reserve Board staff calculations.

Asset Valuations 11

Figure 1.10. Corporate bond yields fell to near their historical averages

Triple-B

High-yield

1998 2003 2008 2013 2018 2023

Apr.

Monthly

Percent

Source: ICE Data Indices, LLC, used with permission.

Figure 1.13. Spreads in the leveraged loan market fell modestly

1998 2003 2008 2013 2018 2023

Apr.

Percentage points

Source: PitchBook Data, Leveraged Commentary & Data.

Figure 1.11. Spreads to similar-maturity

Treasury securities edged down

Triple-B

(left scale)

High-yield

(right scale)

1998 2003 2008 2013 2018 2023

Apr.

Monthly

Percentage pointsPercentage points

Source: ICE Data Indices, LLC, used with permission.

Figure 1.12. The excess bond premium stayed

near its historical average

1998 2003 2008 2013 2018 2023

−2

−1

Mar.

Monthly

Percentage points

Source: Federal Reserve Board staff calculations

based on Lehman Brothers Fixed Income Database

(Warga); Intercontinental Exchange, Inc., ICE Data

Services; Center for Research in Security Prices,

CRSP/Compustat Merged Database, Wharton

Research Data Services; S&P Global, Compustat.

12 Financial Stability Report

premium, a measure of the risk premium in leveraged loans, increased notably during March and

remained at an elevated level, indicating subdued investor risk appetite. The trailing 12-month

loan default rate increased moderately but remained somewhat below its historical median, while

the year-ahead expected default rate rose moderately, suggesting a mild deterioration of the credit

quality of leveraged loan borrowers and a worsening outlook.

The transition away from LIBOR as the benchmark rate in the leveraged loan market was nearly

complete, with almost all new leveraged loan activity being conducted using the Secured Over-

night Financing Rate (SOFR) (see the box “Update on the Transition to the Secured Overnight

FinancingRate”).

Commercial real estate prices declined, but valuations

remainedhigh

Valuation pressures in the CRE sector have eased slightly since the November report but

remained at high levels. Aggregate CRE prices measured in inflation-adjusted terms have declined

(figure1.14). These prices are based on repeat sales and may mask growing weaknesses, as

more distressed properties are generally less likely to trade. Capitalization rates at the time of

property purchase, which measure the annual income of commercial properties relative to their

prices, have turned up modestly from their historically low levels (figure1.15). While price declines

were widespread across all property types, fundamentals in the office sector were particularly

weak for offices in central business districts, with vacancy rates increasing further and rent growth

declining since the November report. In the January2023 Senior Loan Officer Opinion Survey

(SLOOS), banks reported weaker demand and tighter standards for all CRE loan categories over

Figure 1.14. Commercial real estate prices,

adjusted for inflation, declined

1998 2003 2008 2013 2018 2023

100

120

140

160

180

200

Feb.

Monthly

Jan. 2001 = 100

Source: CoStar Group, Inc., CoStar Commercial

Repeat Sale Indices; consumer price index, Bureau of

Labor Statistics via Haver Analytics.

Figure 1.15. Income of commercial properties

relative to prices turned up but remained near

historically low levels

2003 2007 2011 2015 2019 2023

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

Mar.

Monthly

Percent

Source: Real Capital Analytics; Andrew C. Florance,

Norm G. Miller, Ruijue Peng, and Jay Spivey (2010),

“Slicing, Dicing, and Scoping the Size of the U.S.

Commercial Real Estate Market,” Journal of Real

Estate Portfolio Management, vol. 16 (May–August),

pp.101–18.

Asset Valuations 13

Box 1.1. Update on the Transition to the Secured Overnight

Financing Rate

The banks contributing to the U.S. dollar (USD) LIBOR rates are due to end their submissions after

June30, 2023, marking the end of LIBOR as a representative benchmark. The transitions from the

euro, Swiss franc, Japanese yen, and sterling LIBOR rates, which ended last year, went smoothly, but

the transition from USD LIBOR poses particular risks because of the very large exposures to these

rates both domestically and abroad. The Alternative Reference Rates Committee (ARRC) has estimated

that USD LIBOR is used in $74trillion of ﬁ nancial contracts maturing after June2023, and it is also

used extensively in nonﬁ nancial contracts.

New activity

Following guidance issued by the Federal Reserve, FDIC, and Ofﬁ ce of the Comptroller of the Currency

warning that most new use of USD LIBOR in contracts after 2021 would create safety and soundness

risks, almost all new transactions have moved to SOFR. Adjustable-rate retail mortgage originations

and almost all ﬂ oating-rate debt issuance are now based on SOFR, and SOFR represents more than

90percent of risk traded in new derivatives activity. Although SOFR just began publication in 2018,

there are now more than $60trillion of SOFR derivatives and $4trillion in SOFR loans and debt

instruments outstanding.

While most new derivatives, ﬂ oating-rate debt, and consumer products reference SOFR or averages

of SOFR directly, the bulk of new lending activity has moved to term SOFR rates. The term SOFR

rates are forward-looking benchmarks with 1-, 3-, 6- , and 12-month maturities similar to LIBOR.

They are derivatives products based on futures markets for SOFR rather than drawing directly from

transactions in the Treasury repurchase agreement (repo) market that overnight SOFR is based on

and, thus, depend on the continued high level of transaction depth in overnight SOFR futures and other

derivatives markets in order to be robustly produced.

Recently, CME Group, the administrator of the term SOFR rates, has moved to explicitly incorporate

limits on the use of its rates that mirror the ARRC’s recommendations in its licensing agreements,

which should help ensure that use of these rates remains in line with ﬁ nancial stability considerations.

The FSOC and Financial Stability Board have both recognized the use of these types of term rates

in legacy LIBOR cash products and some business loans but have warned against more widespread

use. In line with these recommendations, the ARRC has recognized the use of term SOFR rates as a

fallback in legacy cash products and certain new issuances of cash products, particularly business

loans, but has recommended that use of term SOFR rates in derivatives and most other cash markets

remain limited.

Legacy products

In December, the Board issued its ﬁ nal rule implementing the Adjustable Interest Rate (LIBOR) Act

(LIBOR Act). The LIBOR Act directed the Board to select spread-adjusted benchmark replacements

based on SOFR for LIBOR contracts that mature after June30, 2023, and do not have clear and

practicable fallback language. While the International Swaps and Derivatives Association and the

ARRC have worked over the past several years to develop and encourage the use of fallback language

that adequately addresses the impending cessation of LIBOR, many older contracts only have

fallbacks appropriate for a temporary outage of LIBOR rather than its permanent cessation, and some

contracts do not have any fallbacks at all. This is a particular problem for legacy ﬂ oating-rate debt,

securitizations, and consumer products, all of which are difﬁ cult to amend. The Board’s ﬁ nal rule will

replace (or allow for the replacement of) LIBOR in these products with spread-adjusted versions of CME

Group’s term SOFR rates or averages of SOFR following June30, 2023.

(continued)

14 Financial Stability Report

While the banks submitting to the remaining USD LIBOR rate panel will withdraw as of June30, 2023,

the U.K. Financial Conduct Authority (FCA) has announced that it will require the administrator of

LIBOR to continue publishing 1-, 3-, and 6-month USD LIBOR on a “synthetic” basis for an additional

15 months, through September2024. The FCA has stated that these synthetic LIBOR rates will be

nonrepresentative, meaning that, in the FCA’s ofﬁ cial judgement, they will not reﬂ ect the underlying

market that LIBOR was intended to represent. The FCA has also stated that it intends the publication

of these synthetic rates to help the transition of legacy contracts not subject to U.S. law and therefore

not covered by the LIBOR Act. The synthetic version of USD LIBOR will be published as LIBOR but

would match the spread-adjusted term SOFR rates that the Board has selected under the LIBOR Act

as the benchmark replacement rate applicable to most nonconsumer cash products. Most contracts

under U.S. law will not be affected by the publication of these synthetic rates either because they

have more recent fallback language designed to move away from LIBOR once it is declared to be

nonrepresentative or because they are covered by the LIBOR Act. Nonetheless, there are some

contracts issued under U.S. law that would fall back to a non-LIBOR rate (and so are not covered by

the LIBOR Act) that may reference the synthetic LIBOR rates, primarily older loan agreements that

otherwise would fall back to the prime rate (which is much higher than LIBOR) if LIBOR is unavailable.

LCH and CME Group are implementing plans to convert outstanding LIBOR derivatives that they clear

to SOFR over April and May2023. The Board has encouraged banks to similarly remediate their LIBOR

loans ahead of June30, 2023, where feasible, citing operational risks that could arise from attempting

to convert a large book of LIBOR loans in a short period of time following June2023. While ﬁ rms have

set deadlines to complete the remediation of their outstanding LIBOR loans ahead of June30, 2023,

there are risks that they will fall behind schedule. Progress in remediating syndicated leveraged loans,

which can require consent or nonobjection from a majority of the lenders—in many cases including

nonbank ﬁ nancial institutions (NBFIs)—has been particularly slow, although there have been recent

signs that the pace of remediation may be increasing. Many ﬁ rms had planned to use reﬁ nancing as

an opportunity to move these loans off of LIBOR, but reﬁ nancing activity has declined over the past

year. Securities cannot easily be remediated ahead of the June30, 2023, deadline, but the ARRC and

FSOC have encouraged issuers and other relevant parties to use the Depository Trust and Clearing

Corporation’s LIBOR Replacement Index Communication Tool in order to inform investors about the rate

changes that will take effect after June2023.

Box 1.1—continued

Asset Valuations 15