3. Leverage in the Financial Sector
Leverage at banks and broker-dealers remains low; in contrast, measures of leverage at life insurance companies are at post-2008 highs and remain elevated at hedge funds relative to the past five years
Table 3. Size of Selected Sectors of the Financial System, by Types of Institutions and Vehicles
(billions of dollars)
|Average annual growth,
|Banks and credit unions||22,780||16.7||6.6|
|Property and casualty||2,725||6.2||5.6|
|Hedge funds *||7,623||-3.0||7.3|
(billions of dollars)
Note: The data extend through 2020: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 2012:Q4 and are updated through 2020:Q1.
** 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, "Enhanced Financial Accounts of the United States."
Banks continue to be well capitalized, though challenging conditions remain
The pandemic has tested the resilience of banks. The ratio of tangible capital—a measure of bank equity that excludes items such as goodwill—to total assets at large banks decreased in the first half of the year (figure 3-1). The common equity Tier 1 (CET1) ratio—a regulatory risk-based measure of bank capitalization—also declined significantly in the first quarter as many firms tapped credit lines at the onset of the pandemic, but the ratio recovered to pre-pandemic levels in the second quarter for most banks as demand for bank credit waned and earlier drawdowns were generally repaid. The initial decline in the CET1 capital ratio was also driven by a temporary pickup in risk-weighted assets related to banks' trading operations amid heightened volatility in many financial markets. The CET1 capital ratio at both the largest banks and other BHCs remained well above required minimum levels (figure 3-2).
In June, the Federal Reserve released the results of the 2020 Dodd-Frank Act stress tests and the Comprehensive Capital Analysis and Review along with a sensitivity analysis to assess the resilience of large banks under three hypothetical downside scenarios that could have resulted from the coronavirus event. The analysis under the more severe downside scenarios, which did not incorporate the effects of planned capital distributions, showed that most banks would remain well capitalized but several would approach their minimum capital levels.9 Given the heightened uncertainty in the economy and markets at that time, the Federal Reserve announced that it would require banks to resubmit their capital plans in the fourth quarter of 2020. The scenarios to be used for the resubmission were released on September 17, 2020, and the Federal Reserve will release bank-specific results of its independent assessment by the end of the year.10 The Federal Reserve also took steps in June to restrict capital distributions in the third quarter by banks with more than $100 billion in assets, including prohibiting share repurchases and limiting dividends based on the previous four quarters of earnings. On September 30, the Federal Reserve voted to extend restrictions to the fourth quarter.11
As of the second quarter of 2020, the credit quality of bank loans had deteriorated considerably. Commercial and industrial (C&I) and CRE loans in loss-mitigation programs increased sharply in the second quarter and remain elevated, despite some recent moderation. The credit quality of firms taking C&I loans continued to deteriorate through June, as measured by credit rating downgrades, and remained one of the largest drivers of the increase in loan loss provisions. Furthermore, as of the second quarter of 2020, the leverage of firms that obtained C&I loans from the largest banks stood at historically high levels (figure 3-3). Credit quality of CRE loans also continued to deteriorate, as rental income declined, vacancies increased, and consumer spending weakened, particularly in COVID-affected properties such as hotels and retail establishments. Consumer loans and mortgages in loss-mitigation programs also increased.
Because of the implementation of loss-mitigation programs, government stimulus payments, and PPP loans, the true status of credit quality is not reflected in loan delinquencies. As these programs expire, some of these accounts in loss mitigation could roll into and be reflected in higher bank delinquency rates later this year and early next year, followed by higher charge-off rates and losses. All told, a great deal of uncertainty about the future path of these losses remains.
Allowances for loan losses surged in the first half of 2020 as large banks implemented the current expected credit losses (CECL) accounting standard and reassessed their losses (especially in credit card loans and corporate lending) in light of the COVID-19 shock.12 Under CECL accounting standards, banks must set aside allowances for the expected losses over the life of a loan. Under the previous method, banks were not able to provision for loan losses until later in a credit cycle, when the losses were incurred.
The increase in loan loss allowances along with the expectation that interest rates will remain low for a longer time weakened the bank profitability outlook, a key factor in banks' ability to accumulate equity capital. Net income contracted sharply in the first half of the year because banks set aside a higher fraction of revenues as loan loss provisions and net interest margins were compressed. An increase in trading and investment banking revenues partly offset these downward pressures on income.
Data from the July 2020 SLOOS indicate that banks continued to tighten standards on C&I loans in the second quarter (figure 3-4). Banks cited the uncertain economic outlook and industry-specific problems as the main reasons. More broadly, banks reported tightening across all loan types. In particular, nearly all major credit card lenders reported lending standards becoming stricter. While most banks reported that the level of C&I lending standards is on the tighter end of the range of standards that has prevailed since 2005, only a modest share reported standards as being at the tightest point. This information suggests that banks' strong capital positions at the onset of the pandemic may have mitigated some of the disruption in credit availability relative to during the 2007–09 financial crisis. The contraction in credit availability was also mitigated by the PPP, under which approximately $500 billion in PPP loans were placed on banks' balance sheets at the end of the second quarter. However, tighter lending standards may make obtaining credit difficult for some creditworthy businesses and households. Credit availability contributes to a more robust recovery, which, in turn, improves credit quality and thus leads to better financial stability outcomes.
Based on preliminary earnings data, CET1 capital ratios at the U.S. global systemically important banks slightly increased above pre-pandemic levels in the third quarter (as shown in figure 3-2), as the required restrictions on capital payouts continued. Declines in risk-weighted assets, driven in part by slowed loan demand and tighter lending standards, also contributed to the rise in CET1 capital ratios. Large banks improved earnings relative to the first two quarters of 2020, predominantly because of lower loan loss provisions. As a result, allowances for losses remained about the same at large banks in the third quarter.
Leverage is at historically low levels at broker-dealers...
Leverage at broker-dealers changed little in the first half of 2020 and stayed at historically low levels (figure 3-5). The deterioration in liquidity in March across dealer-intermediated markets demonstrated that, despite dealers' low leverage, fragilities still remain and pose a concern for financial stability (see the box "A Retrospective on the March 2020 Turmoil in Treasury and Mortgage-Backed Securities Markets"). Dealer usage of the PDCF, established in March 2020 amid an extraordinary increase in demand for dealer intermediation and financing, has steadily declined to less than $1 billion. Dealers reported strong earnings in the third quarter, after having had record earnings in the second quarter, driven by high underwriting and trading revenues. Net borrowing of primary dealers is unchanged since May but remains high relative to recent years. Primary dealers' Treasury positions declined slightly, on net, during the same period but remain at the upper end of their historical range.
. . . but is at post-2008 highs at life insurance companies...
Leverage at life insurance companies rose to post-2008 highs (figure 3-6). This leverage measure is calculated using the book value of assets and thus does not immediately reflect the decrease in asset market values—notably, of corporate bonds—in the first quarter and the subsequent improvement. Life insurers hold a sizable proportion of their assets as corporate bonds and remain vulnerable to significant decreases in corporate bond prices. In addition, poor performance of CRE debt in life insurers' general accounts could harm their capital positions. Meanwhile, based on information through the second quarter of 2020, leverage at property and casualty insurers stayed at lower levels relative to historical averages.
. . . and remains elevated at hedge funds relative to the past five years
Gross leverage of hedge funds decreased somewhat in the second half of 2019, the most recent data available, but still remained near the upper end of its historical distribution (figure 3-7).13 More recently, in the SCOOS, most dealers reported that the use of leverage by hedge fund clients declined between February and May, but few dealers reported additional changes in the use of leverage by hedge funds between May and August (figure 3-8). Moreover, several indicators of leverage intermediated by dealers on behalf of hedge funds have reverted to their pre-pandemic levels near the upper ends of their historical distributions. The COVID-19 shock exposed vulnerabilities at hedge funds. Extreme market volatility and lower liquidity in asset markets led to substantial losses at some hedge funds and sizable margin calls (see the box "A Retrospective on the March 2020 Turmoil in Treasury and Mortgage-Backed Securities Markets"). As a result of these losses and, to a lesser extent, outflows, hedge funds' assets dropped substantially in the first quarter. In the second quarter, hedge funds' assets partially recovered from these losses as market conditions improved, but outflows continued, albeit at a slower pace.
Securitization volumes increased after coming to a halt in March but remain significantly below 2019 levels...
Securitization allows financial institutions to bundle loans or other financial assets and sell claims on the cash flows generated by these assets as tradable securities, 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 produced from a pool of lower-rated underlying assets. Examples of the resulting securities include collateralized loan obligations (CLOs), ABS, CMBS, and RMBS. Issuance volumes of non-agency securities—that is, those not guaranteed by a government-sponsored enterprise (GSE) or by the federal government—have resumed after coming to a halt from mid-March to early April but remain about 20 percent lower through September of this year compared with the same period in 2019 (figure 3-9). The recovery, facilitated by the reestablishment of the TALF by the Federal Reserve in March, was uneven across asset classes. Securities backed by asset classes perceived to be less risky, such as auto and credit card ABS, recovered earlier than other securities, such as CMBS, and have experienced more robust issuance amid strong investor demand. However, the September SCOOS showed easing in credit conditions for non-agency CMBS.
. . . and bank lending to nonbank financial firms decreased in the second quarter, as credit drawdowns in the first quarter were repaid quickly
The outstanding amount of bank loans to financial institutions operating outside the banking sector—such as finance companies, asset managers, securitization vehicles, and REITs—increased $113 billion (about 15 percent) in the first quarter of 2020, reflecting drawdowns of credit lines. The outstanding amount then declined $89 billion in the second quarter (about 10 percent) as nonbank financial institutions repaid the drawn amounts. Committed lines of credit from large banks to nonbank financial firms, which include undrawn amounts, edged down slightly in the second quarter of 2020 but remained close to $1.5 trillion (figure 3-10).14
9. See Board of Governors of the Federal Reserve System (2020), "Federal Reserve Board Releases Results of Stress Tests for 2020 and Additional Sensitivity Analyses Conducted in Light of the Coronavirus Event," press release, June 25, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200625c.htm. Return to text
10. See Board of Governors of the Federal Reserve System (2020), "Federal Reserve Board Releases Hypothetical Scenarios for Second Round of Bank Stress Tests," press release, September 17, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200917a.htm. Return to text
11. See Board of Governors of the Federal Reserve System (2020), "Federal Reserve Board Announces It Will Extend for an Additional Quarter Several Measures to Ensure That Large Banks Maintain a High Level of Capital Resilience," press release, September 30, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200930b.htm. Return to text
12. Under accounting rules, banks prepare for possible loan losses before they actually occur. Loan loss provisions, in the bank's income statement, are expenses set aside for uncollected loan payments and are added to the allowance for loan and lease losses (ALLL), which is renamed to allowance for credit losses for banks adopting CECL. On a bank's balance sheet, total loans are reported net of ALLL. For more details, see Board of Governors of the Federal Reserve System (2020), "Allowance for Loan and Lease Losses (ALLL)," webpage, https://www.federalreserve.gov/supervisionreg/topics/alll.htm. Return to text
13. 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
14. 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. See Board of Governors of the Federal Reserve System (2020), "Report Forms: FR Y-14Q," webpage, https://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDZGWnsSjRJKDwRxOb5Kb1hL. Return to text