Board of Governors of the Federal Reserve System

3. Leverage in the financial sector

Leverage in the financial sector has remained low

Leverage at financial firms remained low relative to historical levels, as regulatory reforms enacted after the financial crisis continue to support the resilience of key financial institutions. 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. Leverage at broker-dealers and insurance companies remained low. Meanwhile, hedge fund leverage—which, up to last summer, had been relatively high—appears to have declined over the past six months.

To put the relative size of the types of financial institutions discussed in this section into perspective, table 3 shows the level and growth rates of their total assets over the past year and over the past two decades. Of note, asset holdings of hedge funds and broker-dealers grew at a rapid pace over the past year, while other institutions' asset holdings grew at rates below their longer-term average rates.

Table 3. Size of Selected Sectors of the Financial System, by Types of Institutions and Vehicles

Bank capitalization remained strong, while credit performance improved...

The ratio of tangible bank equity to assets changed little over the fourth quarter of 2018, while the common equity Tier 1 ratio of large banks edged down but remained well above levels seen before the financial crisis (figures 3-1 and 3-2). Buffers designed to conserve capital when capital ratios approach the minimum requirements and surcharges applicable to the largest banks became fully phased-in on January 1, 2019. Meanwhile, the largest banks have paid a sizable share of their profits to their shareholders over the past two years.

Credit performance of bank loans continued to improve on balance. At the largest banks, delinquency rates have trended down; at all other banks, delinquency rates have remained stable. Banks reported in the SLOOS that their commercial and industrial lending standards changed little in the fourth quarter of 2018 after several quarters of easing, suggesting that banks' standards for such loans remained relatively loose, although they had not decreased further (figure 3-3). Meanwhile, the leverage of firms that borrow from the largest banks stayed high, reflecting the overall upward trend in business leverage in recent years (figure 3-4).

...and leverage at broker-dealers and insurance companies stayed low...

Leverage of broker-dealers edged up since November 2018, the time of the previous FSR, but remains near historically low levels (figure 3-5). At life insurance companies and at property and casualty insurance firms, leverage has also stayed low, although it has been increasing slightly at life insurance companies (figure 3-6).

...while hedge fund leverage appears to have declined modestly after rising significantly earlier in 2018...

Gross leverage of hedge funds rose steadily over the first part of last year (figure 3-7). However, some indicators of hedge fund leverage, particularly for equity hedge funds, show that leverage decreased at the end of 2018 as equity market volatility rose. In addition, margin debt provided by New York Stock Exchange broker-dealers to fund their clients' equity positions—a measure of leverage that comprises credit extended to both individual and institutional investors including hedge funds—declined over the same period. Meanwhile, in the most recent Senior Credit Officer Opinion Survey on Dealer Financing Terms, or SCOOS, dealers indicated that the use of leverage by hedge funds remained about unchanged over the first quarter of 2019 (figure 3-8).

...and securitization and borrowing at other nonbank financial firms continued to increase

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 bonds. Examples of the resulting securities are collateralized loan obligations (CLOs), asset-backed securities, and commercial and residential mortgage-backed securities (MBS). Issuance volumes of "private label" securities (that is, those for which the security is not guaranteed by a government-sponsored enterprise or by the federal government) have risen in recent years but remain well below the levels seen in the years ahead of the financial crisis (figure 3-9). Of note, CLO issuance has increased rapidly since 2012 and reached a record level in 2018, with these securities funding more than 50 percent of outstanding leveraged loans.

Data on bank lending to nonbank financial institutions (nonbanks) can be informative about the use of leverage by nonbanks and may shed light on how credit losses at nonbanks could be transmitted to banks.⁶ Committed amounts of credit from large banks to nonbanks—such as finance companies, asset managers, securitization vehicles, and mortgage real estate investment trusts—continued to increase in the second half of 2018 (figure 3-10).⁷ Nonbanks currently use about one-half of the amounts committed in the form of term loans and drawdowns on credit lines.

References