Perspective on Risk - April 20, 2024

LLMs Summarizes Changes To Fed's Financial Stability Report

A quicky.

Federal Reserve Financial Stability Report (and LLMs)

I prompted Claude, GPT-4 and Google’s Gemini 1.5 Pro to compare the Federal Reserve’s April 2024 Financial Stability Report with its prior October 2023 Report. Here is the prompt and Claude’s answer. GPT-4 and Gemini in the footnotes, but substantially similar.¹²

Prompt: Please review these two reports and tell me how the Federal Reserve's perspective on financial stability has changed from October 2023 to April 2024

Claude: Based on my review of the October 2023 and April 2024 Financial Stability Reports from the Federal Reserve, their perspective on financial stability has evolved in the following ways from October 2023 to April 2024:

Asset Valuations:

• Equity valuations continued rising to levels that are high relative to fundamentals. The forward price-to-earnings ratio moved from the upper ranges of its historical distribution in October 2023 to the upper end of its historical distribution by April 2024.

• Corporate bond spreads narrowed from near the middle of their historical ranges in October 2023 to levels that are low relative to long-run averages by April 2024.

• Commercial real estate prices declined amid weak fundamentals, especially for office properties, while in October 2023 prices had remained high despite deteriorating fundamentals.

• Residential real estate prices remained elevated relative to fundamentals as of both reports.

Borrowing by Businesses and Households:

• The total private debt to GDP ratio continued edging down, approaching its historical average by April 2024, while it remained close to but above average in October 2023.

• Business debt remained high relative to GDP in both periods but continued declining in real terms with subdued risky debt issuance. Debt servicing capacity remained robust.

• Household debt stayed at modest levels relative to GDP and concentrated among prime borrowers as of both reports.

Leverage in the Financial Sector:

• Banks remained sound with capital ratios well above requirements as of April 2024, similar to October 2023. However, some banks still faced sizable losses on fixed-rate assets in both periods.

• Hedge fund leverage grew from elevated levels in October 2023 to historic highs by April 2024, driven by the largest hedge funds.

• Broker-dealer leverage stayed near historical lows in both reports.

Funding Risks:

• Most banks maintained ample liquid assets and stable funding in both periods. However, some banks continued facing funding pressures, especially those with high uninsured deposits.

• Structural vulnerabilities persisted at money market funds and other cash-management vehicles as of both reports.

• Life insurers continued holding a high share of risky/illiquid assets from October 2023 to April 2024.

In summary, the Fed grew more concerned about high asset valuations, especially in equities and corporate bonds, and rising hedge fund leverage, while overall bank capital and liquidity remained strong despite some banks facing continued funding and asset valuation pressures. Vulnerabilities from stable business and household debt, money market funds, and life insurers persisted.

1. GPT-4

The Federal Reserve's perspectives on financial stability between October 2023 and April 2024 reflect nuanced changes in assessments and emphasis on certain risks. Here are the key points of comparison:

Asset Valuations and Debt Levels

Both reports note high equity prices and high price-to-earnings ratios. Corporate bond spreads narrowed, indicating lower perceptions of risk or higher demand for bonds. In October 2023, equity prices were described as growing faster than expected earnings​​. By April 2024, valuations were still high relative to fundamentals, but with emphasis on the narrowing of corporate bond spreads and rising equity prices outpacing earnings​​.

Borrowing by Businesses and Households

The analysis in both periods highlights robust corporate debt servicing capabilities despite high levels of business debt relative to GDP. Household debt levels remained moderate with most debt held by prime-rated borrowers​​​​. However, in April 2024, there was a noted decline in real terms of business debt, emphasizing the continuing robustness of firms' ability to service their debts amid subdued risky debt issuance​​.

Financial Sector Leverage and Stability

The banking sector continued to be described as sound and resilient in both reports. In October 2023, there was a focus on the stability and ample capital levels in the banking sector​​. By April 2024, there was a more detailed discussion about hedge fund leverage reaching historically high levels and specific vulnerabilities from fair value losses on fixed-rate assets held by some banks​​.

Funding Risks

Both reports discuss vulnerabilities related to funding pressures from uninsured deposits and potential market runs on money market funds and stablecoins. There is a consistent concern across the reports about these structural vulnerabilities, although specific details about funding strains and the impacts of high interest rates on asset values appear more prominently in the April 2024 report​​​​.

Near-Term Risks

The reports indicate ongoing concerns about persistent inflationary pressures and potential impacts on monetary policy. The April 2024 report highlights more focused concerns regarding geopolitical tensions, policy uncertainty, and their potential spillovers to financial stability​​​​.

In summary, from October 2023 to April 2024, while the broad themes of financial stability assessments by the Federal Reserve remained consistent, the focus slightly shifted towards increased scrutiny of hedge fund leverage, sustained high asset valuations, and specific vulnerabilities within the banking sector. There was also a heightened awareness of the global geopolitical risks and their potential impacts on U.S. financial stability.

2. Gemini:

Evolution of the Federal Reserve's Perspective on Financial Stability (October 2023 - April 2024):

Based on the provided Financial Stability Reports, the Federal Reserve's concerns regarding financial stability evolved in several key areas:

Increased Concerns:

• Asset Valuations: The Fed's worries about inflated asset prices across major categories like equities, corporate bonds, and real estate intensified. They noted price-to-earnings ratios at the upper end of historical distributions and low corporate bond spreads.

• Policy Uncertainty: The potential impact of policy uncertainty on the financial system became a more prominent concern, likely driven by factors like upcoming elections and ongoing geopolitical tensions.

• Hedge Fund Leverage: The report highlighted a significant increase in hedge fund leverage, particularly among the largest funds, raising concerns about potential vulnerabilities and amplification of market shocks.

Moderating Concerns:

• Overall Debt Levels: The ratio of private debt to GDP continued to decline, indicating a reduced vulnerability from excessive borrowing by businesses and households.

• Bank Liquidity: Despite some remaining funding challenges for a subset of banks, the overall banking system demonstrated ample liquidity and reduced reliance on short-term wholesale funding.

• Commercial Real Estate Losses: While still a concern, the perceived risk of large losses in the CRE sector decreased slightly, possibly due to ongoing price corrections and adjustments.

Persistent Concerns:

• Persistent Inflation & Monetary Tightening: The risk of persistent inflation leading to a more restrictive monetary policy stance remained the top concern throughout this period, as it could trigger market volatility, asset price corrections, and economic slowdown.

• Funding Risks in Certain Sectors: Structural vulnerabilities persisted in prime and tax-exempt money market funds, similar cash-investment vehicles, and stablecoins, leaving them susceptible to runs and potential disruptions in short-term funding markets.

• Liquidity Risks for Life Insurers: Life insurers continued to rely on a higher-than-average share of nontraditional liabilities while holding an increasing share of illiquid and risky assets, creating potential vulnerabilities in meeting sudden withdrawals or claims.

Additional Observations:

• The Federal Reserve acknowledged the effectiveness of the Bank Term Funding Program in mitigating funding pressures and supporting financial stability during the March 2023 banking stresses.

• The reports mentioned the Federal Reserve's ongoing efforts to assess climate-related financial risks and their potential impact on financial institutions and markets.

Overall, the Federal Reserve's perspective on financial stability shifted towards greater concern about asset valuations and policy uncertainty, while acknowledging improvements in overall debt levels and bank liquidity. However, persistent inflationary pressures and structural vulnerabilities in certain financial sectors remain significant concerns.