3. Leverage in the Financial Sector
Leverage at banks and broker-dealers remained low, while leverage continued to be high at life insurance companies and somewhat elevated at hedge funds
Banks continued to weather the pandemic well. Although banks may still experience some losses from loans in loss-mitigation programs, their capital and loan loss reserves remained above pre-pandemic levels, and profitability was strong during the first half of 2021. Leverage continued to be at historically low levels at broker-dealers as well as at property and casualty (P&C) insurers. However, leverage stayed high at life insurance companies, and the most comprehensive available measures of hedge fund leverage remained somewhat above their historical averages. Although securitization volumes continued to be subdued, issuance volumes of CLOs and ABS were elevated. Bank lending to NBFIs continued to grow notably.
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||24,385||7.1||6.3|
|Property and casualty||3,010||12.4||5.9|
|Outstanding (billions of dollars)|
Note: The data extend through 2021: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 2021:Q1. Growth rates for the hedge fund data are measured from Q1 of the year immediately preceding the period through Q1 of 2021.
** Broker-dealer assets are calculated as unnetted values.
*** Non-agency securitization excludes securitized credit held on balance sheets of banks and finance companies.
Source: Federal Reserve Board (FRB), Statistical Release Z.1, "Financial Accounts of the United States"; FRB, "Enhanced Financial Accounts of the United States."
Bank capital ratios rose above pre-pandemic levels, although some challenging conditions remain
The common equity Tier 1 (CET1) ratio—a regulatory risk-based measure of bank capital adequacy—increased in the first half of 2021 for most banks, exceeding pre-pandemic levels (figure 3-1). The increase resulted from the recovery of bank profitability to above pre-pandemic levels, which was driven by strong trading and capital market activity as well as releases of loan loss reserves associated with improvements in the economic outlook.16 The ratio of tangible capital to total assets—a measure of bank capital adequacy that does not account for the riskiness of credit exposures and excludes items such as goodwill from capital—at large banks remained near multi-decade highs but below pre-pandemic levels due to growth in low-risk assets such as central bank reserve balances and Treasury securities (figure 3-2).
In June, the Federal Reserve released the results of its annual bank stress tests.17 The large banks that were tested all remained well above their risk-based minimum capital requirements during a severe hypothetical recession that included, among other features, substantial stress in U.S. CRE, housing, and corporate debt markets. Additional restrictions on the capital distributions of banks put in place during the pandemic ended on June 30, as previously announced, and large banks announced plans for increased capital distributions and resumed share repurchases.18
CET1 ratios at large banks, as of June 30, exceeded regulatory requirements, including the new stress capital buffers that were put into effect on October 1. These stress capital buffers were computed based on the June 2021 stress-test results.19 In addition, based on preliminary data for the third quarter of 2021, earnings at the U.S. global systemically important banks remained high enough to support CET1 ratios well above required minimum levels despite the increased capital payouts (as shown in figure 3-1). However, the ability of banks to accumulate equity capital may be affected in the future, as bank profitability remains under pressure from historically low net interest margins.
Measures of the credit quality of bank loan portfolios continued to improve broadly over the first half of the year amid an improved economic outlook as well as significant monetary and fiscal support, including forbearance programs, expanded unemployment benefits, and the PPP. The credit quality of firms with outstanding loans at large banks improved in the first half of the year, as measured by the outstanding amounts of loans that experienced credit rating upgrades minus those that experienced downgrades. The leverage of these firms declined during the same period but remained somewhat elevated relative to levels observed since 2013 (figure 3-3). The overall delinquency rates of loans held by banks fell during the first half of 2021. However, delinquency rates on commercial and industrial (C&I) loans to industries most affected by the pandemic—including oil and gas, transportation, and leisure—and CRE loans backed by hotels and retail properties remained elevated.
In response to the July 2021 SLOOS, banks generally reported that standards for C&I loans eased from the first to the second quarter of 2021, which followed the large tightening in 2020 (figure 3-4). In terms of levels, banks reported that the standards on C&I loans are at the easier end of the range of standards observed since 2005 and generally close to their pre-pandemic levels. Demand for C&I loans also strengthened over the second quarter, although market commentary and write-in comments to the SLOOS suggest it remained generally weak. New C&I loan originations for businesses of all sizes increased in the first half of 2021, though not enough to offset the overall decline in C&I loan balances.
Shares of consumer and small business loans in loss-mitigation programs at large banks continued to decline in the first quarter. However, the shares of C&I, CRE, and residential mortgage loans as well as home equity lines of credit in loss-mitigation programs stayed elevated during the same period. Although banks maintained significant loan loss reserves, concerns about the future path of credit quality remain because of the anticipated end of loss mitigation and the government support mentioned earlier as well as the uncertain course of the virus.
Broker-dealer leverage remained at historically low levels...
Broker-dealer leverage remained near historically low levels through the first half of 2021 (figure 3-5). Primary dealers' net secured borrowings decreased over the past year. Total secured borrowing and lending, a measure of funding intermediation activity by dealers, remained roughly unchanged over the same period. However, total secured borrowing and lending backed by equity securities have increased, coinciding with the large gains in broader equity markets. Dealer trading revenues were robust in the first half of the year, led by equity trading. In response to a set of special questions in the September 2021 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS) motivated by the meme stock episode in January 2021, three-fifths of respondents reported tightening of initial and variation margins for clients using over-the-counter derivatives and structured products with exposure to individual stocks over the same period.
. . . but leverage at life insurance companies stayed high
Leverage of life insurance companies remained at post-2008 highs (figure 3-6). Corporate bonds, CLOs, and CRE debt continued to account for a large proportion of life insurers' assets. If these assets lose value, life insurers' capital positions—and, hence, their ability to honor debt obligations—could be impaired.
As discussed in the November 2020 Financial Stability Report, climate change might increase financial stability risks associated with financial leverage.20 P&C insurers are one type of financial institution whose leverage may be affected by climate change. Leverage at P&C insurers remained at historically low levels in the first half of 2021. The low leverage allowed P&C insurers to cover claims from recent severe weather events without solvency issues.21
Leverage at hedge funds continued to be somewhat elevated
Hedge fund leverage remained somewhat higher than its historical average in the first quarter of 2021, according to the most comprehensive available measures. On-balance-sheet leverage at hedge funds, based on confidential data collected by the Securities and Exchange Commission (SEC), decreased in the first quarter to a level close to its historical average. Gross leverage at hedge funds—based on the same source but including off-balance-sheet derivatives exposures—continued to be above its historical average in the first quarter (figure 3-7). Several indicators of leverage intermediated by dealers on behalf of hedge funds, such as hedge funds' margin and securities borrowing in prime brokerage accounts, suggest that hedge fund leverage associated with equity market activities remained at high levels in January 2021, the most recent data. More recently, in response to the September SCOOS, dealers reported that the use of financial leverage by hedge funds decreased between May and August, on net, amid tighter nonprice terms on financial leverage extended to hedge funds (figure 3-8).
Issuance of non-agency securitized products has hit a post-2008 high
Although securitization volumes of non-agency securities—that is, those not guaranteed by a government-sponsored enterprise or by the federal government—remained subdued compared with pre-2008 levels, the volumes rose beyond pre-pandemic levels in the first half of 2021 and remained high in the third quarter (figure 3-9).22 This growth resulted, in part, from strong investor demand for assets with higher yields. Issuance of residentialmortgage-backed securities (RMBS) and some types of CRE-related securitization deals—such as CMBS and CRE CLOs—had been subdued since the onset of the pandemic but increased substantially this year. Issuance of ABS, including subprime auto ABS, was elevated over the same period. CLO issuance continued to be brisk through the third quarter of this year. CLO fundamentals, such as average loan ratings or holdings of triple-C-rated loans, continued to improve over the same period but remained slightly worse than pre-pandemic levels.
Bank lending to nonbank financial institutions continued to grow notably
Bank lending to financial institutions operating outside the banking sector continued to increase notably in terms of both committed and utilized amounts. Committed amounts of credit from large banks to NBFIs grew above pre-pandemic levels in the first half the year (figure 3-10). This growth was driven by real estate lenders and lessors; special purpose entities, CLOs, and ABS; open-end investment funds; and other financial vehicles (figure 3-11). The utilization rates of credit lines remained at normal levels over the same period. Delinquency rates on loans by large banks to NBFIs declined in the first half of 2021 but remained somewhat elevated compared with historical levels.
15. For hedge funds, the growth rate is computed from the first quarter of 2020 through the first quarter of 2021 and the average annual growth rate from the fourth quarter of 2012 through the first quarter of 2021. Return to text
16. Under accounting rules, banks prepare for possible loan losses before they occur. Loan loss provisions in the bank's income statement are expenses set aside for estimated credit losses and are added to the loan loss reserves. The decline in loan loss reserves during the first half of 2021 was notable for most loan categories, with the exception of CRE loans, consistent with elevated credit risk in some CRE segments. Return to text
17. See Board of Governors of the Federal Reserve System (2021), "Federal Reserve Board Releases Results of Annual Bank Stress Tests, Which Show That Large Banks Continue to Have Strong Capital Levels and Could Continue Lending to Households and Businesses during a Severe Recession," press release, June24, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20210624a.htm. Return to text
18. See Board of Governors of the Federal Reserve System (2021), "Federal Reserve Announces Temporary and Additional Restrictions on Bank Holding Company Dividends and Share Repurchases Currently in Place Will End for Most Firms after June 30, Based on Results from Upcoming Stress Test," press release, March 25, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20210325a.htm. This action followed a previous announcement by the Federal Reserve that allowed banks to resume share repurchases in the first quarter of 2021 following the release of the results from the second round of bank stress tests for 2020. Return to text
19. 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
20. For more information, see the box "The Implications of Climate Change for Financial Stability" in Board of Governors of the Federal Reserve System (2020), Financial Stability Report (Washington: Board of Governors, November), pp. 58–59, https://www.federalreserve.gov/publications/files/financial-stability-report-20201109.pdf. Return to text
21. For instance, losses of the magnitude of those from Hurricane Ida or Hurricane Katrina, in the range of $15 billion to $65 billion, would have minimally affected the P&C insurance industry at the end of 2020, as P&C insurers' capital levels, at more than $900 billion, easily exceeded such losses. Return to text
22. 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. Examples of the resulting securities include CLOs (predominantly backed by leveraged loans), ABS (often backed by credit card and auto debt), CMBS, and RMBS. By funding assets with debt issued by investment funds known as special purpose entities (SPEs), securitization can add leverage to the financial system, in part because SPEs are generally subject to regulatory regimes, such as risk retention rules, that are less stringent than banks' regulatory capital requirements. Return to text