3. Leverage in the financial sector
Leverage in the financial sector has been low in recent years
Leverage at financial firms is low relative to historical standards, in part because of regulatory reforms enacted since the financial crisis. In particular, regulators require that banks--especially the largest banks--meet much higher standards in the amount and quality of capital on their balance sheets and in the ways they assess and manage their financial risks. A greater amount and a higher quality of capital improve the ability of banks to bear losses while continuing to lend and support the economy. Capital levels at broker-dealers have also increased substantially relative to pre-crisis levels, and major insurance companies have strengthened their financial positions since the crisis. However, some indicators suggest that hedge fund leverage is at post-crisis highs.
To put into perspective the relative size of the types of financial institutions discussed in this section, table 3 shows the level and the growth rates, recently and over a longer period, of their total assets.
Table 3: Size of Selected Types of Financial Institutions and Vehicles
(billions of dollars)
|Average annual growth,
|Banks and credit unions||18,976||2.9||5.8|
|Property and casualty||2,401||4.0||5.4|
(billions of dollars)
Note: The data extend through 2018:Q2.
* Hedge fund data start in 2013:Q4 and are updated through 2017:Q4.
Source: Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States"; Federal Reserve Board staff calculations based on Securities and Exchange Commission, Form PF, Reporting Form for Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors.
Banks have strong capital positions...
Capital ratios for the larger banks are well above levels seen before the financial crisis (figures 3-1 and 3-2). Regulatory capital ratios also exceed the fully phased-in enhanced minimum requirements plus regulatory buffers. Banks appear well positioned to maintain capital through retained earnings as profitability has advanced beyond post-crisis lows on account of increased net income and lower tax rates. The scenarios used in the supervisory stress tests routinely feature a severe global recession, steep declines in asset prices, and a substantial deterioration in business credit quality. The results of the most recent stress test released in June by the Federal Reserve Board indicate that the nation's largest banks would be able to continue to lend to households and businesses even during such a severe scenario.8
Across the entire banking sector, the credit quality of bank loans appears strong, although there are some signs of more aggressive risk-taking by banks. For example, lending standards for commercial and industrial (C&I) loans and mortgages have been easing somewhat in recent quarters, and the leverage of borrowers who are receiving C&I loans from the largest banks has been trending up in recent years, reflecting the overall upward trend in business leverage (figure 3-3).
. . . and broker-dealers and insurance companies have strengthened their financial positions since the crisis...
Leverage of broker-dealers has been trending down and is now substantially below pre-crisis levels (figure 3-4). At property and casualty insurance firms, leverage has also been falling, while it has been roughly constant over the past decade for life insurance companies (figure 3-5).
. . . even as there are signs of increased borrowing at other nonbank financial firms
Several indicators suggest that hedge fund leverage has been increasing over the past two years. A comprehensive measure that incorporates margin loans, repurchase agreements (repos), and derivatives--but is only available with a significant time lag--suggests that average hedge fund leverage has risen by about one-third over the course of 2016 and 2017 (figure 3-6). Consistent with this indicator, dealers responding to the Federal Reserve's Senior Credit Officer Opinion Survey on Dealer Financing Terms, or SCOOS, reported some increase in the use of leverage by hedge funds, on average, over the past two years (figure 3-7) as well as some easing in both price terms (for example, interest rates and lending fees) and nonprice terms (for example, margins and loan maturities) for credit extended to hedge funds. The increased use of leverage by hedge funds exposes their counterparties to risks and raises the possibility that adverse shocks would result in forced asset sales by hedge funds that could exacerbate price declines. That said, hedge funds do not play the same central role in the financial system as banks or other institutions.
In a process known as "securitization," financial institutions bundle loans or other financial assets together and sell investors claims on the bundle as securities that can be traded much like a bond. Examples of the resulting securities, or securitized instruments, are collateralized loan obligations (CLOs), asset-backed securities, and commercial and residential mortgage-backed securities. By funding assets with debt obligations, securitization can add leverage to the financial system. Issuance volumes of non-agency securitized instruments (that is, those for which the instrument is not guaranteed by a government-sponsored enterprise or by the federal government) have been rising in recent years but remain well below the levels seen in the years ahead of the financial crisis (figure 3-8). A type of securitization that has grown rapidly over the past year is CLOs, which are predominantly backed by leveraged loans. Amid the general deterioration in the underwriting standards on leveraged loans (discussed in the section on business leverage), gross issuance of CLOs hit $71 billion in the first half of 2018. This pace represents an increase by about one-third compared with the same period last year, and CLOs now purchase about 60 percent of leveraged loans at origination. It is important to continue to monitor developments in this sector.
Because information on the financial institutions that operate outside of the banking sector is limited, data on banks' lending to these institutions can be informative about nonbanks' use of leverage. Nonbank financial institutions--such as finance companies, asset managers, securitization vehicles, and mortgage real estate investment trusts--have access to about $1 trillion in committed lines of credit, an increase of about two-thirds over the past five years (figure 3-9). To date, borrowing institutions have utilized $300 billion of these lines of credit.
8. See Board of Governors of the Federal Reserve System (2018), "Federal Reserve Board Releases Results of Supervisory Bank Stress Tests," press release, June 21, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20180621a.htm. Return to text