Yellen warns financial system still faces commercial real estate, crypto risks

The US financial system continued to face vulnerabilities from commercial real estate risk and digital assets in 2024, Treasury Secretary Janet Yellen said on Friday, even as cooling inflation and low unemployment bolstered the broader economy.She signalled top US regulators on the Financial Stability Oversight Council have remained focused on monitoring credit risk in commercial real estate and urged officials to continue to focus on Wall Street’s ability to address it.Yellen added that FSOC has stepped up efforts to address emerging risks from significant technological changes including digital assets and artificial intelligence. She said such innovations may offer potential benefits to markets, such as efficiencies, but also pose worrisome risks, including those around cyber and third-party service providers."The council continues to call for legislation to create a comprehensive federal prudential framework for stablecoin issuers and for legislation on cryptoassets that addresses the risks we have identified. And we recommend building further inter-agency expertise to analyse and monitor potential systemic risks associated with the use of AI in the financial services sector while facilitating innovation,” Yellen said.FSOC, which also includes the heads of the Federal Reserve and Securities and Exchange Commission, was set up after the 2008 financial crisis to deal with systemic risks. It has previously flagged a number of risks that AI could introduce or amplify at financial institutions, including its ability to apply discriminatory bias in lending, especially for AI programs that operate as "black boxes,” making their output difficult to explain.This will be FSOC’s last annual report published under the Biden administration. The outgoing Treasury chief has often defended the role of regulation in supporting a resilient financial system and took aim at the state of financial monitoring at the end of Donald Trump’s first term.In her remarks, Yellen reiterated her views on the importance of a strengthened FSOC, including through increased staff, and the development of tools such as the analytic framework for financial stability risks.Increasing vacancies, slower rent growth and higher borrowing costs weighed on the commercial real estate market in a more pronounced way than the multifamily sector, according to FSOC."These pressures on borrowers have led to increasing delinquencies, loan losses, and provision expenses for banks,” the report said. "The council recommends regulators continue to focus on the financial industry’s ability to withstand CRE stress from declines in property prices and loan quality.”The findings come after the Fed said in November that the delinquency rate for CRE loans has increased to its highest level in a decade, jumping to 11% at the large banks in the second quarter of 2024.Still, US banks added to credit reserves in the first half of 2024 to protect against further losses from commercial real estate and some consumer loans, the Fed said.The report acknowledged that the opaque nature of private credit lenders makes it difficult for regulators to assess risk management practices and the buildup of risks in the sector. Private credit came of age after the 2008 financial crisis as an alternative to banks and has become a serious rival to mainstream lending for all kinds of businesses, from real estate firms to tech startups.The panel is continuing to scrutinize the "rising interconnections with banks and insurance companies, limited transparency around private credit valuations, and increased retail investor participation in the industry via semi-liquid investment vehicles,” which may indicate expanding risks. The report said it supports enhanced data collection on private credit to learn more about potential risks.FSOC also called out cyberattacks as potentially destabilizing events for the US financial system. Late last year Industrial & Commercial Bank of China Ltd was hit by a cyberattack, rendering it unable to clear swathes of US Treasury trades after entities responsible for settling the transactions swiftly disconnected from the stricken systems. The incident highlighted the prospect of a cyberattack that could someday cripple a key piece of the financial system’s wiring."Severe incidents at major financial institutions could pose an acute threat to financial stability given the high degree of interconnectedness among global financial institutions and systems,” they wrote. FSOC said the number of incidents has risen since the pandemic, and the US financial system is even more at risk because of ongoing geopolitical tensions and wars.The panel recommended information sharing among parties and to take additional steps to assess and mitigate cyber-related risks.