By Pete Schroeder

WASHINGTON (Reuters) – The U.S. Federal Reserve said Friday the U.S. banking system remains strong despite heightened volatility and geopolitical risk, but cautioned them against prime brokerage services that come with heightened risk.

In its latest bank supervision report, the Fed offered an upbeat take on the strength of U.S. banks, noting they continue to enjoy robust capital and liquidity levels, and asset quality improved in the second half of 2021.

However, the central bank noted that the Russian invasion of Ukraine has ramped up potential risk for the financial sector. While U.S. banks’ direct exposure to Russia is relatively limited, there are several related factors that could weigh on the industry, including volatility in commodity prices and heightened cybersecurity risk.

The Fed said its supervisors will be closely monitoring banks to see how they weather the turmoil coming from those heightened geopolitical tensions.

Separately, the Fed also cautioned banks that offering prime brokerage services to large investment funds carries with it “significant risks.” Citing the 2021 collapse of Archegos Capital Management, which left a handful of banks with billions of dollars in losses, the Fed noted that banks need to be on strict guard if they wish to do business in the highly complex and opaque area of the market.

“Strong risk management and controls are critical to the safety and soundness of a bank that provides these services,” the report stated.

In December, the Fed warned banks, particularly those with large derivatives portfolios and relationships with investment funds, that they should not rely on incomplete or unverified information from fund clients, and should consider not doing business with firms that resist supplying the necessary information to gauge risk.

(Reporting by Pete Schroeder; Editing by Chizu Nomiyama)