(Bloomberg) -- Higher-than-expected interest rates amid persistent inflation are perceived as the biggest threat to financial stability among market participants and observers, according to the Federal Reserve.

“The risk of persistent inflationary pressures leading to a more restrictive than expected monetary policy stance remained the most frequently cited risk,” the Fed said in its semiannual Financial Stability Report published Friday.

The report includes results from a survey of financial-market contacts as well as the central bank’s assessment of risks in four main areas, including asset valuations, borrowing by businesses and households, leverage in the financial sector and funding risks.

The banking sector “remained sound and resilient overall, and most banks continued to report capital levels well above regulatory requirements” since the release of the last report in October, the Fed wrote. But the central bank flagged that “available data suggest that hedge fund leverage grew to historic highs, driven primarily by borrowing by the largest hedge funds.”

US agencies have been sounding the alarm on leverage tied to hedge funds. In February, US Securities and Exchange Commission Chair Gary Gensler said he’s concerned about “where the banking sector and the non-banking sector come together.”

Read More: For Gensler, Financial Risks Lie Where Banks and Non-Banks Meet

Losses from commercial real estate loans, which have been under pressure amid the increase in remote work over the past few years, were seen as less of a threat now than last year, according to the survey of Fed contacts, which was conducted at the beginning of 2024.

In the report, the Fed said business and household balance sheets remained healthy, but called attention to households with low credit scores.

“Homeowners have solid equity cushions, and many households continued to benefit from lower interest rate payments associated with refinancing or home purchases several years ago,” the Fed said. “That said, some borrowers continued to be financially stretched, and auto loan and credit card delinquencies for nonprime borrowers increased.”

The central bank said some smaller lenders are still facing pressure from losses on fixed-rate assets. The Fed and other financial regulators last year grappled with the failures of several regional banks, including Silicon Valley Bank.

The Fed highlighted several vulnerabilities in funding markets, particularly among smaller banks and some money market mutual funds, and said that Treasury market liquidity was at the low end of its historical range.

“Conditions in the Treasury cash market appear challenged and could amplify shocks,” the report said, adding that broker-dealers’ limited capacity or unwillingness to intermediate in the Treasury market during bouts of market stress remain a structural vulnerability.

Policymakers have said they’ll soon slow the pace at which they’re reducing the Fed’s balance sheet. Such a move would help ensure ample liquidity in financial markets. 

Risk Areas

The report focuses on four areas of risk. 

Asset valuations: Valuations rose to levels near historical peaks and were high relative to fundamentals. Residential real estate prices also continued to rise and were high compared to fundamentals. Commercial real estate prices fell amid weak demand for office space.

Borrowing by businesses and households: Business and household balance sheets remained strong. Business debt declined last year but are high. Household debt was modest.

Leverage in the financial sector: The banking system remained sound and resilient and banks reported capital levels above regulatory requirements. Some banks experienced sizable losses on fixed-rate assets and some banks with commercial real estate exposure experienced stress.

Funding risks: Liquidity at most US banks remained ample. Some banks saw funding strains and structural vulnerabilities remained in some short-term funding markets. Prime and tax-exempt money market funds remained vulnerable to runs. 

(Updates with more details beginning in fifth paragraph.)

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