The Office of Financial Research (“OFR”) asserted that “severe adverse outcomes in the U.K. from ‘Brexit’ could pose a risk to U.S. financial stability.”
In its biannual report, titled the Financial Stability Monitor, OFR provided the results of an assessment that focused on “vulnerabilities – weaknesses in the financial system that can originate, amplify or transmit shocks, potentially destabilizing the system.” The report was organized into five risk categories: macroeconomic, market, credit, funding and liquidity, and contagion.
The report found that risks to financial stability have stayed within the medium range, but also have risen as a result of the U.K. withdrawal referendum. The report specified that “Brexit” could pose moderate risks to the financial stability of the United States:
- Trade: Although a recession in the United Kingdom or countries in the European Union would reduce the demand for U.S. exports, it is unlikely that the reduction would threaten U.S. financial stability due to the low percentage of U.S. exports to the European Union and vice versa. However, a reduction in exports could slow U.S. growth moderately.
- Financial Exposures: The financial claims of the United States on the United Kingdom and, more broadly, the European Union could be vulnerable to losses due to (i) currency depreciations and volatility, (ii) declines in asset market prices, and (iii) increased defaults on debt claims.
- Confidence and Indirect Effects: Financial instability in the United Kingdom or, more broadly, the European Union could do lasting damage to the confidence of global investors, and that damage could become “self-perpetuating.” Additionally, “U.S. long-term interest rates reached historic lows in the week after the [“Brexit”] referendum,” which in turn “underpin[ned] excesses in investor risk-taking.”
- Funding and Liquidity Risks: Although “[k]ey funding risks are much lower than before the financial crisis due to major changes in short-term funding markets,” several vulnerabilities still persist. These include risks in certain money market funds and short-term investment vehicles, and sharp falls in market liquidity during certain moderate stress events.
- Contagion Risks: “[C]ontagion risk is greater than available metrics indicate. . . . It is unlikely that the contagion risks disappeared as stress receded. It is more plausible that underlying factors – such as risky assets’ tendency to become more correlated during market stress – pose enduring contagion risks.”
The report stated:
Because the U.K. economy and especially the U.K. financial system are highly connected with the rest of Europe and the United States, severe adverse outcomes in the U.K. could pose a risk to U.S. financial stability.
Lofchie Comment: The value of these government reports is questionable. Statements in the OFR report like: “severe adverse outcomes in the U.K. could pose a risk to U.S. financial stability,” are trivial given the current economic environment, and they offer no useful insight for market participants. More remarkable, however, was the failure of the Financial Stability Oversight Council (“FSOC”) to identify “Brexit” as a risk in its own annual report, produced just before the “Brexit” vote. The OFR’s biannual report and FSOC’s annual report raise necessary but basic questions: (1) are these agencies particularly skilled at identifying risks before the fact, and (2) do they have anything useful to say about risks after the fact?