The Federal Reserve Board released its semiannual financial stability report on Friday. While the review concluded that the banking system is on sound footing overall, it noted that elevated asset valuations, pockets of higher leverage and funding issues at some banks represent potential vulnerabilities.

The report included a survey of professionals at broker-dealers, investment funds, research and advisory firms, and academics on the top issues facing the financial system. The top two concerns were persistent inflation and monetary tightening, and commercial real estate, or CRE, each of which was flagged by 72% of respondents, up from 56% and 52%, respectively, in the Fed's prior stability report.

Respondents fear that, despite recent positive developments on curbing inflation, price growth might accelerate again in the near term, potentially resulting in "further monetary policy tightening and volatile market conditions." Some worry that inflation expectations could become "entrenched," necessitating an aggressive response from the Fed that tips the economy into a recession.

The report also details elevated concerns about CRE related to higher interest rates, falling property values and a long-term weakening in the demand for office space resulting from the widespread adoption of remote and hybrid work. The report points to small and regional banks as being the biggest point of vulnerability on this front, given their outsized holdings of CRE loans. It adds that recent surveys of senior loan officers show weaker demand and tighter lending standards for issuing new CRE loans.

Despite deteriorating fundamentals in certain types of commercial property — especially office buildings — the report said valuations on these assets remain elevated, indicating that already-distressed assets may have farther to fall. 

Similarly, the report pointed to a recent uptick in home prices as part of a broader trend of asset value inflation. It noted the growing spread between owner's equivalent rent — the approximate price an owned home would rent for — and actual market rents as a sign that housing market valuations were "increasingly stretched."

Overall banking sector stress was the third most cited concern by respondents, at 56%, the same rate reported in May.

"Although survey respondents noted the banking sector has stabilized since the period of acute stress earlier this year, many highlighted risks of renewed deposit outflows given that large portions of deposits remain uninsured," the report states. "Many respondents continued to link risks of reemerging banking-sector stress to potential losses on CRE exposures, particularly among smaller and regional banks."

The report said funding risks are elevated for a minority of banks. It did not specify the types of institutions struggling under this type of pressure, but it noted that the banks impacted most by the sector's volatility this past spring continue to face the highest levels of funding risk. 

Competition for deposits that followed the failures of Silicon Valley Bank, Signature Bank and First Republic earlier this year has led to an increased reliance on short-term wholesale funding, and the overall level of insured deposits remains high, despite having fallen more 15% year-over-year. During the previous 26 years, uninsured deposits had grown at an average rate of 11% annually. 

Overall, the report shows strong levels of high-quality liquid assets in the banking system. It also points to diminished use of its Bank-Term Funding Program — the emergency funding facility set up to stabilize the system after the failures of Silicon Valley and Signature — as an indication that financial conditions have generally improved during the past six months. 

The other two salient risks cited were market liquidity strains and volatility, with 56% of respondents raising it as a top concern, followed by a weakening Chinese economy, which was flagged by 44% of respondents — up from 12% in May.

The final responses for the survey were collected on Oct. 4, three days before the paramilitary group Hamas launched an attack on Israeli civilians that elevated geopolitical tension in the Middle East. A senior Fed official said had the survey been closed later, the unrest likely would have been a bigger concern for stakeholders. 

Though not a major concern among survey takers, the Fed report also flagged higher levels of leverage — driven by falling asset values — among hedge funds and insurance companies as a potential threat to financial stability. 

Since 2019, the Fed has put out two reports on financial stability annually, typically one in the spring and another in the fall. In May, following a series of large bank failures, the agency issued a report highlighting the importance of liquidity readiness and managing interest rate risks.