3. Leverage in the Financial Sector
Leverage remained low at banks and broker-dealers but high at life insurance companies and somewhat elevated at hedge funds
The banking sector continued to be well capitalized, but banks have a large share of long-duration assets that are exposed to rising interest rates. Leverage at broker-dealers and at property and casualty (P&C) insurers remained at historically low levels. Leverage continued to be high at life insurance companies, and the most comprehensive available measures of hedge fund leverage remained somewhat above their historical averages. However, comprehensive measures of hedge fund leverage are only available with a considerable lag, and the sector is difficult to monitor in real time. Issuance volumes of non-agency securitized products reached new post-2008 highs, and bank lending to nonbank financial institutions (NBFIs) continued to grow rapidly. Direct exposures of U.S. financial institutions to Russia were small, but the ongoing geopolitical tensions could affect the U.S. financial sector through indirect channels.
Table 3.1 shows the sizes and growth rates of the types of financial institutions discussed in this section.
Table 3.1. Size of selected sectors of the financial system, by types of institutions and vehicles
(billions of dollars)
|Average annual growth,
|Banks and credit unions||25,606||9.2||6.3|
|Property and casualty||3,111||8.1||5.8|
|Hedge funds *||9,217||20||10.1|
(billions of dollars)
Note: The data extend through 2021:Q4. Outstanding amounts are in nominal terms. Average annual growth rates are measured from Q4 of the year immediately preceding the period through Q4 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:Q2. Growth rates for the hedge fund data are measured from Q2 of the year immediately preceding the period through Q2 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, Statistical Release Z.1, "Financial Accounts of the United States"; Federal Reserve Board, "Enhanced Financial Accounts of the United States."
Banks remained well capitalized
The common equity Tier 1 ratio (CET1)—a regulatory risk-based measure of bank capital adequacy—remained at high levels relative to pre-2008 norms. In the second half of last year, this ratio was unchanged at U.S. global systemically important banks (G-SIBs) and declined somewhat for other large banks because of a general increase in bank lending (figure 3.1). In the first quarter of 2022, CET1 ratios decreased at G-SIBs, as heightened market volatility caused risk-weighted assets to rise. The ratio of tangible equity to total assets—a measure of bank capital adequacy that does not account for the riskiness of credit exposures and excludes intangible items such as goodwill from capital—continued to trend down in the second half of 2021 due to growth in low-risk assets, funded by inflows of core deposits (figure 3.2). Bank profitability declined somewhat in the first quarter of 2022 as banks increased loan loss provisions amid higher uncertainty about the economic outlook, but banks continue to report that rising interest rates will support their profitability going forward.
Measures of credit quality for most loan portfolios continued to improve during the second half of 2021. The outstanding amounts of bank loans to firms that experienced credit rating upgrades outpaced those that experienced credit rating downgrades. The leverage of firms with outstanding loans at large banks declined during the same period but remained somewhat elevated relative to the levels observed since 2013 (figure 3.3). Delinquency rates on most loans to businesses and households that are held by banks continued to decline, but delinquency rates on C&I loans to COVID-19-affected industries, and in certain segments of the CRE sector, remained elevated.
The October 2021 and January 2022 SLOOS indicated that banks continued to ease lending standards on most types of loans in the second half of 2021, albeit at a slower pace than in the first half of the year (figure 3.4).11 To date, available measures do not seem to indicate that the continued easing of lending standards for bank credit has led to a broad-based increase in risk-taking by banks. In response to a set of special forward-looking questions in the January 2022 SLOOS, banks reported expecting an improvement in the quality of most business loans and a deterioration in the quality of household loans in their portfolio over 2022.
Vulnerabilities of U.S. banks to the Russian invasion of Ukraine appear to be limited. Before the invasion, banks maintained relatively small footprints in Russia and Ukraine, and their outstanding loans to borrowers in those countries were small. Exposures of large banks to counterparties that are active in commodity markets increased markedly, but banks appear to have managed risks amid the extremely high volatility seen in these markets since the beginning of the invasion. However, several indirect channels could pose risks for U.S. banks, including heightened volatility in asset markets; disruptions in payment, clearing, and settlement systems due to sanctions; and interconnections with large European banks, which could be adversely affected through the effect of the conflict on the European economy, as discussed in the Near-Term Risks to the Financial System section.
Leverage at broker-dealers stayed at historically low levels...
Broker-dealer leverage was little changed in the second half of 2021 and remained near historically low levels (figure 3.5). Net secured borrowing by primary dealers and their net securities positions decreased modestly over the same period. Gross secured borrowing and lending—a measure of funding intermediation activity by dealers—stayed largely unchanged, but secured financing backed by equity collateral remains near historical highs. Measures of dealer balance sheet costs continued to lie in the lower range of their distributions over the past few years, and dealers' trading revenues remained strong.
In the March 2022 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), which covered the period between December 2021 and February 2022, dealers reported little change in the use of leverage and in the terms associated with securities financing and over-the-counter (OTC) derivatives transactions.12 In response to a set of special questions about the potential effects of rising interest rates, nearly one-half of dealers expect somewhat increased demand for funding from some hedge funds and insurance companies if interest rates across all maturities increase by a similar amount. These responses suggest that if dealers are unable to meet the increased demand for funding, rising interest rates could lead to a deterioration of market liquidity.
. . . but leverage at life insurance companies remained high...
Leverage at life insurers remained near its highest level of the past two decades (figure 3.6). Life insurers continued to invest heavily in corporate bonds, collateralized loan obligations (CLOs), and CRE debt, which leaves their capital positions vulnerable to sudden drops in the value of these risky assets. Gradually rising interest rates improve the profitability outlook of life insurers, as their liabilities generally have longer effective durations than their assets, and higher interest rates may reduce life insurers' incentives to invest in riskier assets. However, a large and unexpected increase in interest rates could induce policyholders to surrender their contracts at a higher-than-expected rate. If the increase in surrenders is substantial enough, it could put downward pressure on life insurers' financial performance.
Meanwhile, leverage at P&C insurers remained low relative to historical levels, and vulnerabilities in the insurance sector arising from direct exposures to Russian-domiciled firms and indirect exposures through European banks appeared limited.
. . . and hedge fund leverage continued to be somewhat elevated
In response to the March 2022 SCOOS—the most recent source of information on hedge fund leverage—dealers reported little change in hedge funds' use of leverage over the previous three months (figure 3.7). More comprehensive measures, based on confidential data collected by the Securities and Exchange Commission (SEC), suggest that in the third quarter of 2021, on--balance-sheet leverage increased modestly to a level above its historical average, while gross leverage, which includes off-balance-sheet derivatives exposures, remained elevated (figure 3.8). Because these measures are only available with a significant lag, real-time monitoring of hedge fund leverage is difficult.
According to confidential data collected by the SEC, large hedge fund advisers had small direct exposures to Russia in the third quarter of 2021. However, hedge funds could be indirectly exposed to the associated geopolitical tensions through their positions in commodity derivatives.
Issuance of non-agency securities by securitization vehicles reached post-2008 highs...
Following a decline early in the pandemic, issuance of non-agency securities recovered in 2021 and reached new post-2008 highs, although they are still at a fraction of their pre-2008 levels mainly due to a still-moribund market for non-agency residential mortgage-backed securities (figure 3.9).13 Issuance was generally elevated across asset classes, with CLOs and commercial mortgage-backed securities (CMBS) experiencing particularly high volumes. This growth was driven by strong investor demand for products with wider spreads amid improving economic conditions. Similar to bank loans, some securitized products are floating rate, which makes them attractive to investors in a rising interest rate environment and has been further supporting investor demand recently. Meanwhile, credit performance of assets underlying most securitized products improved, although delinquencies in non-agency CMBS backed by properties hit the hardest by the pandemic remained relatively high. Leverage embedded in securitization products remained generally stable.
. . . and bank lending to nonbank financial institutions continued to grow rapidly
Bank lending to NBFIs, which can be informative about the use of leverage by NBFIs and shed light on their interconnectedness with the core of the financial system, continued to increase notably. The growth in committed amounts of credit from large banks to NBFIs in 2021 outpaced the already rapid growth of 2020, driven by lending to real estate lenders and lessors, open-end investment funds, broker-dealers, and other financial vehicles (figure 3.10). The utilized amounts of credit increased for most NBFI sectors during the same period (figure 3.11). However, delinquency rates on loans by large banks to NBFIs declined modestly in 2021, returning to their average levels over the past decade. Further, the overall level of delinquency rates on loans by large banks to NBFIs was below the delinquency rates on loans by large banks to nonfinancial borrowers. Because NBFIs rely primarily on their bank credit lines to meet unexpected liquidity needs, loan commitments can experience sudden, correlated drawdowns. These drawdowns could be material relative to banks' available buffers of high-quality liquid assets (HQLA) and thus could generate liquidity pressures at large banks during times of financial stress. Some NBFIs—such as commodity trading firms—have been directly affected by the Russia–Ukraine conflict, but loan exposures of large U.S. banks to these firms are currently small.
11. The survey is available on the Federal Reserve Board's website at https://www.federalreserve.gov/data/sloos.htm. Return to text
12. The survey is available on the Federal Reserve Board's website at https://www.federalreserve.gov/data/scoos.htm. Return to text
13. 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), asset-backed securities (often backed by credit card and auto debt), CMBS, and residential mortgage-backed securities. 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 capitalrequirements. Return to text