Board of Governors of the Federal Reserve System

3. Leverage in the financial sector

Table 3 shows the sizes and growth of the types of financial institutions discussed in this section.

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

Banks were well capitalized as of the fourth quarter of 2019

At the end of 2019, loss-absorbing capacity in the banking sector was at historically high levels. This strength permitted banks to absorb the increased credit provisions and draws on credit lines associated with the onset of the pandemic. Tangible capital at large banks—a measure of bank equity that excludes items such as goodwill—changed little in 2019, and regulatory capital ratios stayed well above their required minimum levels (figure 3-1 and figure 3-2). The Federal Reserve is currently conducting its 2020 stress test and conducting additional assessments of banks' resilience to the unprecedented economic shock caused by COVID-19.¹³

To date, banks have been able to meet surging demand for draws on credit lines from businesses (see the box "Risks Associated with Banks' Corporate Credit Exposures through Credit Lines"). Banks have publicly stated their willingness to work with business and household clients to modify the terms of existing loans, including delaying payments, and have reported a substantial increase in forbearance requests across loan types. The largest banks have also announced that they have currently suspended share buybacks. Nonetheless, recent declines in interest rates and the potential for rising credit losses have weakened the outlook for bank profitability, a key factor in banks' ability to replenish capital.

As of the fourth quarter of 2019, the credit quality of most bank loans remained strong, but it is likely to deteriorate considerably. Accordingly, banks are reassessing credit risks and writing down assets as borrowers come under increasing stress. In first-quarter earnings announcements, large banks reported significant increases in loan loss reserves. These reserves absorb losses before Tier 1 capital, adding resilience to individual banks and the entire banking system. Data from the April 2020 SLOOS indicate that a significant share of banks tightened standards on commercial and industrial (C&I) loans in the first quarter (figure 3-3). As of the fourth quarter of 2019, the leverage of firms that obtained C&I loans from the largest banks was about unchanged and stood at historically high levels (figure 3-4).

Leverage was low at broker-dealers as of the fourth quarter...

Leverage at broker-dealers changed little in the second half of 2019 and remained at historically low levels (figure 3-5 ). However, in March, constraints on dealers' intermediation capacity, including internal risk-management practices and regulatory constraints on the bank holding companies under which many dealers operate, were cited as possible reasons for deteriorating liquidity in even usually liquid markets. In response, the Federal Reserve increased repo operations, purchased Treasury securities and agency MBS, and introduced the PDCF to support smooth market functioning and facilitate the availability of credit to businesses and households (see the box "The Federal Reserve's Monetary Policy Actions and Facilities to Support the Economy since the COVID-19 Outbreak"). The Federal Reserve also announced a temporary change to the supplemental leverage ratio, removing a possible constraint for some of the largest dealers in the Treasury market.

. . . but was increasing at life insurance companies...

Leverage measured at life insurance companies using generally accepted accounting principles rose to post-2008 highs (figure 3-6). Moreover, the capitalization of the life insurance sector is likely to deteriorate in coming quarters because of lower-than-expected asset valuations and lower long-term interest rates. Insurance companies are also important investors in CRE, corporate bonds, and CLOs, exposing them to risks stemming from sharp drops in asset prices, elevated issuer leverage, potentially rising defaults in the corporate sector, and funding illiquidity risks. Meanwhile, based on information through the fourth quarter of 2019, leverage at property and casualty insurers stayed at lower levels than in previous years.

. . . while hedge fund leverage remains elevated relative to the past five years

Gross leverage of hedge funds hovered around the same range in the first half of 2019 as in 2018 after having risen steadily over the previous few years (figure 3-7).¹⁴ More recently, in the March Senior Credit Officer Opinion Survey on Dealer Financing Terms, dealers reported that the use of leverage by hedge fund clients was about unchanged in the fourth quarter of 2019 and the first quarter of 2020, though the survey closed in February before the major disruptions of COVID-19 (figure 3-8). Since then, hedge funds reportedly reduced their leverage significantly as market volatility rose and many hedge funds experienced margin calls. Some types of hedge funds are built around strategies that can result in rapid deleveraging when volatility spikes, which could, in turn, contribute to further market volatility. See the box "Institutional Activities and Market Liquidity" for more information on how asset managers such as hedge funds affect market liquidity.

Securitization volumes increased in the second half of 2019 but came to a halt in March before policy actions relieved strains

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 securities with different levels of seniority, or "tranches," and thus represents a form of credit risk transformation whereby some highly rated securities can be created from a pool of lower-rated underlying assets. Examples of the resulting securities include CLOs, ABS, and commercial and residential MBS. Issuance volumes of non-agency securities (that is, those not guaranteed by a government-sponsored enterprise or by the federal government) increased substantially in 2019 but remain well below the levels seen in the run-up to the 2007–09 financial crisis (figure 3-9). The disturbances from COVID-19 caused securitization volumes to essentially stop by the second half of March. In response, the Federal Reserve established the TALF to help meet the credit needs of consumers and small businesses by facilitating the issuance of ABS and improving the market conditions for ABS more generally.

. . . and bank lending to nonbank financial firms continued to grow notably

Banks have substantially increased their lending to financial institutions operating outside the banking sector—such as finance companies, asset managers, securitization vehicles, and REITs. Committed amounts of credit from large banks to nonbank financial firms have more than doubled since 2013, reaching $1.4 trillion by the fourth quarter of 2019 (figure 3-10).¹⁵

 

References

 

 13. In March 2020, the Board approved a final rule creating a stress capital buffer requirement for large banks. See Board of Governors of the Federal Reserve System (2020), "Federal Reserve Board Approves Rule to Simplify Its Capital Rules for Large Banks, Preserving the Strong Capital Requirements Already in Place," press release, March 4, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200304a.htm. Return to text

 14. Comprehensive data on hedge fund leverage are available only with a long lag. The Federal Reserve supplements these data with more timely but less comprehensive measures. Return to text

 15. Data on this type of bank lending can be informative about the use of leverage by nonbanks and shed light on the credit exposures of banks to these institutions. The Federal Reserve is able to monitor the exposures of the largest U.S. banks to businesses more closely than in the past because those banks now report detailed information about their loan commitments on regulatory Form FR Y-14Q, which can be found on the Board's website at https://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDZGWnsSjRJKDwRxOb5Kb1hL. Return to text