U.S. banks could be at risk for massive losses as the pandemic strains their resources, the Federal Reserve warned in its semi-annual report on financial stability.
The Fed said some of the biggest issues could come by way of high corporate debt and mass concentration of hedge funds.
U.S. banks came into the pandemic confident in their ability to weather it, with billions set aside for potential future loans. However, the Fed warns that those banks could face strains when lenders and borrowers are unable to come up with the money they’d had before the crisis, thus creating a string of problems all the way up the chain.
Asset prices are also subject to declines. And the Fed said defaults on leveraged loans were likely to continue to increase throughout the pandemic.
The pandemic has also seen banks tightening the reins on loan standards, as many focus on existing customers rather than new ones, trying to be conservative with funds as the economy bottoms out.
The Fed said the “economic and financial shocks” of the pandemic on households and businesses alike would likely “create fragilities that last for some time” that could cause trouble for banks, too.
For instance, U.S. household debt hit a record high of $14.3 trillion during the pandemic, and the decrease in consumer spending as they hole up at home has strained businesses.
Fed governor Lael Brainard said that while some early interventions had managed to ease stress about liquidity, there would need to be close attention paid to highly-leveraged business borrowers for potential solvency problems.
The Fed is also concerned with leverage levels at hedge funds, which were already high even before the pandemic and have now been severely damaged by market volatility and drops in asset pricing around the beginning of the crisis.
Another issue of concern is the concentration of those hedge funds, with the top 25 funds accounting for half of the industry’s borrowing in Q2 last year, even though they only represented around 14 percent of its net assets.