3. Leverage in the financial sector
Current debt levels point to financial-sector resilience
The banking sector is well capitalized, in part due to the regulatory reforms enacted after the financial crisis. However, several large banks have announced plans to distribute capital to their shareholders in excess of expected earnings, implying that capital at those banks will decrease. In addition, the outlook for profitability of a range of financial institutions has weakened. (See the box "The Recent Decline in Interest Rates and Implications for Financial Stability.") Leverage at hedge funds stands near the top of its range since 2014. Leverage at life insurance companies has also risen but remains close to its average level over the past two decades. Broker-dealers as well as property and casualty insurance companies continue to operate with historically low levels of leverage.
To gauge the sizes of the types of financial institutions discussed in this section, table 3 shows the levels of their total assets over the past year and past two decades.
Table 3. Size of Selected Sectors of the Financial System, by Types of Institutions and Vehicles
|Item||Total assets (billions of dollars)||Growth,2018:Q2–2019:Q2 (percent)||Average annual growth, 1997–2019:Q2 (percent)|
|Banks and credit unions||19,506||3.1||5.7|
|Property and casualty||2,581||7.3||5.8|
|Outstanding (billions of dollars)|
Note: The data extend through 2019:Q2. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period. Life insurance companies' assets include both general and separate account assets.
* Hedge fund data start in 2013:Q4 and are updated through 2018:Q4.
** Non-agency securitization excludes securitized credit held on balance sheets of banks and finance companies.
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.
The Recent Decline in Interest Rates and Implications for Financial Stability
In line with sovereign yields globally, yields on U.S. Treasury securities have declined substantially over the past year, in part reflecting decisions by the Federal Open Market Committee designed to keep the U.S. economy strong. However, yields at longer maturities have fallen more than those at some shorter maturities. Market equity-to-book ratios for some financial intermediaries have fallen over recent quarters. If interest rates were to remain low for a prolonged period, the profitability of banks, insurers, and other financial intermediaries could come under stress and spur reach-for-yield behavior, thereby increasing the vulnerability of the financial sector to subsequent shocks.
To be sure, the profitability of banks is currently strong. However, the fall in long-term interest rates has the potential to compress net interest margins and thus weaken the profitability of banks. The interest rates that banks earn on loans are typically set at a spread over an interest rate benchmark and are therefore likely to come down as benchmark rates decline. By contrast, the interest rates that banks pay to depositors are already quite low and unlikely to decline much further. Taken together, falling loan rates and largely unchanged deposit rates could compress the net interest income of banks. Moreover, the pressures on profitability among banks could encourage reach-for-yield behavior, including an erosion of lending standards and an increased willingness to extend credit to firms with weaker balance sheets and households with lower credit ratings.
A decrease in interest rates can also weaken the profitability outlook for life insurance companies by affecting both their assets and their liabilities. Life insurance companies hold asset portfolios of long-term fixed-income securities to back the stream of payments on even longer-term insurance liabilities. Falling interest rates tend to induce policyholders to surrender their contracts less frequently because new policies will likely offer lower rates than existing policies. In addition, low rates can reduce the yield insurers earn on their assets, as higher-yielding assets gradually mature and are replaced with lower-yielding ones.
Low interest rates may also increase risk-taking among some financial institutions. In addition to the pressures on banks and insurance companies, low interest rates could affect pension funds and other institutional investors who offer pre-specified returns for policyholders that are significantly higher than the general level of interest rates. In order to meet the specified yield, these asset managers may hold riskier investment portfolios, which are expected to generate higher returns. Furthermore, this decision could artificially increase the price of risky assets.
While vulnerabilities related to low interest rates have the potential to grow, thus calling for caution and continued monitoring, so far, the financial system appears resilient.
Banks are well capitalized
Tangible capital at large banks—a measure of bank equity that excludes goodwill—changed little in 2019, and regulatory capital ratios stayed well above their required minimum levels (figure 3-1 and figure 3-2). Solvency risk at the largest banks appears to have remained low, and the results of the most recent stress test, released in June 2019, indicated that these banks are well positioned to continue lending to households and businesses even in the event of a severe global recession.10 Nonetheless, recent declines in interest rates have dimmed the outlook for bank profitability. In addition, in recent discussions with investors, several large banks announced regulatory capital targets 1 to 2 percentage points below their current levels.
Overall, credit quality of bank loans remains strong, although there is some evidence of increased risk-taking by banks. Data from the July and October 2019 SLOOS indicate that large banks eased standards and terms on commercial and industrial (C&I) loans to large and middle-market firms in the second quarter and left standards unchanged in the third quarter of 2019 (figure 3-3). Lending standards for these loans have remained on the easier end of their range since 2005 according to data from the July 2019 SLOOS. Meanwhile, leverage increased at firms that obtain C&I loans from the largest banks, reflecting the overall upward trend in business leverage in recent years (figure 3-4).
Leverage stayed low at broker-dealers and remained moderate at life insurance companies...
Leverage at broker-dealers changed little in the first half of 2019 and remained at historically low levels (figure 3-5). Leverage at life insurance companies rose and stands near the median of its historical range, while leverage at property and casualty insurers stayed at lower levels than in previous years (figure 3-6).11 Insurance companies are important investors in the corporate bond and collateralized loan obligation (CLO) markets, exposing them to risks stemming from elevated leverage in the corporate sector. However, the modest level of leverage at insurance companies should help limit the amplification of possible shocks emanating from the business sector.
. . . while hedge fund leverage remains elevated relative to the past five years
Gross leverage of hedge funds appears to have leveled off in 2018 after having risen steadily over the previous few years (figure 3-7). In the September Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), dealers reported that the use of leverage by hedge fund clients decreased in the third quarter of 2019 after increasing in the second quarter of the year (figure 3-8). Dealers also reported in the September SCOOS that the current level of hedge fund leverage is roughly halfway between the pre-crisis peak, around June 2007, and the post-crisis trough, around March 2009.
Securitization volumes were largely unchanged...
Securitization allows financial institutions to bundle loans or other financial assets and sell claims on the cash flows generated by these assets as securities that can be traded, much like bonds. This process often involves the creation of claims with different levels of seniority and thus represents a form of credit risk transformation, whereby highly rated securities can be created from a pool of lower-rated underlying assets. Examples of the resulting securities include CLOs, asset-backed securities, and commercial and residential mortgage-backed securities. Issuance volumes of non-agency securities (that is, those not guaranteed by a government-sponsored enterprise or by the federal government) remain well below the levels seen in the run-up to the financial crisis (figure 3-9).
CLO issuance has increased rapidly since 2012 and continues to be robust in 2019 after reaching a record level in 2018. These securities fund more than 50 percent of outstanding institutional leveraged loans. Unlike open-end mutual funds, CLOs do not generally permit early redemptions and do not rely on funding that must be rolled over before the underlying assets mature. As a result, CLOs avoid run risk associated with a rapid reversal in investor sentiment.
. . . while bank lending to nonbank financial institutions continued to grow notably
Data on bank lending to financial institutions operating outside the banking sector—such as finance companies, asset managers, securitization vehicles, and mortgage real estate investment trusts—can be informative about the use of leverage by nonbanks and shed light on the credit exposures of banks to these institutions. Committed amounts of credit from large banks to nonbanks have nearly doubled since 2013 and reached about $1.4 trillion by mid-2019 (figure 3-10). To date, about one-half of these committed amounts have been borrowed by nonbanks in the form of term loans or credit-line drawdowns. The outstanding loans to nonbanks represent about 11 percent of total loans of large banks, and the share of loans to nonbanks that are investment-grade loans remains stable at roughly 70 percent.
10. See Board of Governors of the Federal Reserve System (2019), Dodd-Frank Act Stress Test 2019: Supervisory Stress Test Results(Washington: Board of Governors, June), https://www.federalreserve.gov/publications/files/2019-dfast-results-20190621.pdf. Return to text
11. Leverage for insurance companies is measured using generally accepted accounting principles and thus includes publicly traded insurers. Insurer leverage as measured using statutory accounting rules increased for life insurers in 2018, largely because of the effects of the Tax Cuts and Jobs Act of 2017. Return to text