The Fed's Third-Party Supply Chain Risks and Their Implications for Risk Asset Valuation

The Fed has responded by recalibrating its stress testing frameworks to incorporate third-party risks. The proposed 2026 stress test scenarios, for instance, include a 5.5% spike in unemployment to a peak of 10%, a 29% decline in home prices, and a 54% drop in equity prices. These severe scenarios reflect the agency's acknowledgment that third-party failures could exacerbate macroeconomic downturns. Federal Reserve Governor Lisa Cook has emphasized that while large asset valuation declines in equities, corporate bonds, and housing markets are possible, the financial system's current resilience may mitigate broader destabilization.

However, the Fed's focus on third-party risks extends beyond stress testing. Regulatory efforts to enhance transparency in service provider contracts and operational resilience standards are gaining traction. For example, the 2025 revisions to the Large Financial Institution (LFI) rating system now prioritize liquidity risk management and operational robustness, ensuring firms can withstand disruptions from external dependencies.

Liquidity Expansion and the Risk-On Cycle

In parallel, the Fed's liquidity expansion measures in 2025 have created a fertile environment for risk asset valuations. The decision to end the balance sheet runoff as of December 1, 2025, was explicitly aimed at maintaining ample reserves for banks, supporting a "safe and efficient banking system" amid economic uncertainties. This liquidity injection has bolstered short-term gains in equity markets, with the S&P 500's earnings yield reaching historically low levels, suggesting stretched valuations.

The interplay between liquidity and third-party risks is nuanced. While the Fed's liquidity provisions stabilize the financial ecosystem, they may also encourage risk-taking. For instance, the availability of cheap reserves could lead institutions to underinvest in robust third-party risk management frameworks, assuming that central bank liquidity will buffer against potential shocks. This dynamic is particularly concerning given the April 2025 Treasury market liquidity crisis, where abrupt tariff announcements triggered a temporary but sharp deterioration in market depth.

Balancing Stability and Innovation

The Fed faces a delicate balancing act: fostering innovation in financial technology while mitigating systemic risks from third-party dependencies. As stated by Dallas Fed President Lorie Logan, the normalization of the balance sheet size aims to avoid repeating the 2019 repo market turmoil, which was partly attributed to liquidity fragmentation. Yet, the absence of explicit policies targeting third-party supply chain risk mitigation remains a gap. While banks are increasingly adopting dynamic scenario analysis and updating contingency funding plans, regulatory frameworks lag behind the pace of technological integration.

Conclusion

The Fed's liquidity expansion in 2025 has undeniably supported risk asset valuations, but it has also heightened the stakes for third-party risk management. As financial institutions navigate a landscape of concentrated service providers and volatile policy environments, the Fed's dual mandate-promoting stability while enabling innovation-will be tested. Investors must remain vigilant: while current liquidity conditions may fuel a risk-on cycle, the long-term sustainability of asset valuations hinges on the Fed's ability to address systemic vulnerabilities in the supply chain ecosystem.