Market turmoil touched off by the coronavirus outbreak was exacerbated by the financial system, the Federal Reserve said on Friday, warning that it remains a source of vulnerability as the economic downturn places ongoing strains on households and businesses.
The financial system “amplified the shock” in March, the Fed said, as short-term funding markets in particular seized up. Some hedge funds were “severely affected” and “reportedly” contributed to market dislocations, according to the central bank’s financial stability report.
The Fed used the annual report to sound a warning bell on weaknesses that have the potential to worsen the fallout in markets — which could then spill back into the rest of the economy — as coronavirus lockdowns slow growth, spurring job losses and causing companies and consumers to miss rent and mortgage payments.
Businesses came into the crisis highly indebted, the Fed pointed out. While banks started out well-capitalized, lower interest rates and the potential for credit losses could hurt their profitability and ability to replenish that capital.
“Economic activity is contracting sharply, and the associated reduction in earnings and increase in credit needed to bridge the downturn will expand the debt burden and default risk of a highly leveraged business sector,” the report said.
“We will be monitoring closely for solvency stresses among highly leveraged business borrowers, which could increase the longer the Covid pandemic persists,” Governor Lael Brainard said in a statement accompanying the release, noting that the Fed’s early interventions “have been effective in resolving liquidity stresses.”