Board of Governors of the Federal Reserve System

3. Leverage in the Financial Sector

Leverage at banks and broker-dealers remained relatively low, while leverage at some types of nonbank financial firms appeared elevated

Overall, vulnerabilities related to financial sector leverage appeared to remain moderate. Some types of nonbank financial firms operate with high leverage, and their exposures can be difficult to monitor because of limitations in existing data; these challenges raise the risk that hidden pockets of leverage could amplify adverse shocks. At the same time, the higher levels of loss-absorbing capacity in the banking sector and among broker-dealers that have prevailed since the structural reforms introduced following the 2007–09 financial crisis signal resilience in those institutions. 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

Bank capital remained within the range established over the past decade

The aggregate common equity tier 1 ratio (CET1)—a regulatory risk-based measure of bank capital adequacy—declined slightly in the second quarter of 2022 and stood close to the average that has prevailed since the end of the 2007–09 financial crisis. Regarding the largest banks, global systemically important banks' (G-SIBs) risk-based capital measures slightly reversed earlier declines in the second quarter of 2022 (figure 3.1). The results of the 2022 stress test indicate that large banks would maintain capital ratios well above the minimum risk-based requirements even during a substantial economic downturn. Moreover, the features of this year's severely adverse scenario resulted in larger required capital buffers for several large U.S. banks that took effect at the start of the fourth quarter of 2022. Three G-SIBs have seen an increase in their G-SIB surcharges for 2023—that is, the amount of capital G-SIBs must hold in excess of their minimum capital requirements and stress capital buffers. To meet these higher regulatory capital requirements, G-SIBs have started to reduce their risk-weighted assets, and some have also announced pauses in their respective stock repurchase programs to bolster retained earnings. Relatedly, bank profitability continued to be healthy in the second quarter of 2022, in line with pre-pandemic levels and broadly unchanged from the previous quarter. Strong profitability bolsters banks' resiliency, as retained earnings are the most straightforward way for banks to boost their capital position.

The ratio of tangible common equity to tangible assets—a measure of bank capital adequacy that treats all assets as equally risky and excludes intangible items such as goodwill from both capital and total assets—is lower compared with the beginning of the year, and the industry-wide average now stands just below the median of its historical distribution (figure 3.2). This decline was driven in part by a mix of robust balance sheet expansion earlier in the year and a substantial drop in tangible equity from unrealized losses on securities in the available-for-sale (AFS) portfolio as a result of increases in interest rates.⁸ Some large banks, including all G-SIBs, also must reflect the decline in market value on their AFS portfolio in their CET1 regulatory capital ratio, however smaller banks are not obligated to do so.⁹

Banks' vulnerability to future credit losses appears to be moderate. As noted in Section 2, aggregate credit quality in the nonfinancial sector remained strong. Borrower leverage for bank commercial and industrial (C&I) loans continued to trend downward relative to the start of the year (figure 3.3). Moreover, according to data from the July 2022 SLOOS, banks indicated a recent tightening of lending standards for C&I (figure 3.4) and CRE (as shown in figure 1.14) loans.

Leverage at broker-dealers stayed at historically low levels

Broker-dealer leverage ratios remained near their recent historically low levels (figure 3.5). Dealers' equity growth has generally kept up with the growth of their assets, boosted in part by strong trading profits since March 2020 amid heighted market volatility (figures 3.6 and 3.7). Net secured borrowing of primary dealers edged higher since the May 2022 Financial Stability Report but remained near the bottom of its range, while gross financing and borrowing has changed little. Primary dealer Treasury market activities, including market making and repo, remained largely flat over the year, even as the amount of outstanding Treasury securities available to investors continued to increase. As the gap between dealer market activity and the total amount of Treasury securities held by investors continues to grow, there may be increased vulnerabilities associated with dealers' reduced willingness or ability to accommodate a surge in intermediation demand during market stress.

Dealer respondents from the June and September Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS) indicated that they had, on net, tightened the terms associated with securities financing and over-the-counter derivatives transactions, particularly for hedge funds and trading real estate investment trusts.¹⁰ In response to a set of special questions about client trading activity and terms offered to their clients for cleared and uncleared commodity derivatives, respondents indicated that price and nonprice terms have tightened since the beginning of the year for both financial and nonfinancial clients that engage in commodity derivatives trading, consistent with heightened commodity price volatility.

Leverage in parts of the nonbank financial sector appears to be above average and can be difficult to assess

Vulnerability to leverage among the various categories of nonbank financial firms varies considerably. Leverage at property and casualty (P&C) insurers remained at historically low levels but declined to near the middle of its historical distribution at life insurance companies. While comprehensive measures of hedge fund leverage remained somewhat above their historical averages, these measures are only available with a considerable lag. More generally, leverage at many types of NBFIs can be difficult to measure or monitor in a timely way with available data. These gaps raise the risk that such firms are using leveraged positions, which could amplify adverse shocks, especially if they are financed with short-term funding.

Leverage at life insurance companies decreased this year to the middle of its historical distribution

Leverage at life insurers has decreased since the previous Financial Stability Report to the middle of its historical distribution (figure 3.8). However, these insurers continued to increase the share of assets allocated to risky instruments—in particular, to high-yield corporate bonds, investment-grade privately placed corporate bonds, and alternative investments—which leaves insurers' capital positions vulnerable to sudden increases in default risk. The upward trend in the proportion of risky assets became steeper after the beginning of the pandemic. Rising interest rates likely have a positive effect on the profitability of life insurers, as their liabilities generally have had longer effective durations than their assets. However, an unexpected and sharp surge in interest rates may induce policyholders to surrender their contracts at a higher-than­expected rate, potentially causing some funding strains. Meanwhile, leverage at P&C insurers remained low relative to historical levels.

Hedge fund leverage continued to be somewhat elevated

Comprehensive measures of hedge fund leverage, based on confidential data collected by the Securities and Exchange Commission, suggest that, in the first quarter of 2022, both on-balance-sheet leverage and gross leverage, which includes off-balance-sheet derivatives exposures, remained above their historical averages (figure 3.9). However, moderate net fractions of primary dealer survey respondents in the June and September 2022 SCOOS indicated that the use of hedge fund leverage had decreased between mid-February and mid-August amid tighter price and nonprice borrowing terms (figure 3.10).

Issuance of non-agency securities by securitization vehicles has slowed

After robust issuance in 2021 and in the first few months of 2022, non-agency securitization issuance—which contributes to the amount of leverage in the financial system—slowed significantly (figure 3.11).¹¹ Reportedly, overall investor demand for non-agency securitized products has declined somewhat this year, driven in part by a pullback by U.S. banks and open-end bond funds as well as regulatory capital considerations affecting demand from insurance companies.¹² Most securitization sectors exhibit relatively stable credit performance, indicated by low loan delinquency or default rates compared with historical long-term averages.

Bank lending to nonbank financial institutions continued to grow rapidly

Bank lending to NBFIs, which can be informative about the amount of leverage used by NBFIs and shed light on their interconnectedness with the rest of the financial system, continued to increase notably. Banks' credit commitments to NBFIs have grown rapidly in recent years, having reached a new high of almost $2 trillion in the second quarter of 2022 (figure 3.12). This increase was broad based and most pronounced in the category of private equity, business development companies, and credit funds. The size of unused credit lines provided by banks has proven manageable even as utilized amounts of revolving credit lines have grown notably over the past year (figure 3.13). Delinquency rates on banks' exposure to NBFIs have been lower than rates for the nonfinancial business sector since the data became available in 2013. However, the limited information we have on NBFIs' alternative funding sources, and the extent to which these sources may be fragile, could contribute to increased vulnerabilities in the financial sector.

 

References

 

 8. In contrast to securities held in AFS portfolios, banks have the option to book securities that they intend to own until their maturity in hold-to-maturity portfolios. These portfolio holdings do not get marked to market, and thus changes in their valuations do not alter their capital ratios. However, in a rising rate environment, the value of banks' deposit franchise increases and provides a buffer against these unrealized losses that is also not captured by Generally Accepted Accounting Principles. Return to text

 9. Category 1 and category 2 banks are not allowed to opt out of including accumulated other comprehensive income for capital calculation and therefore have to include changes in value of AFS securities in CET1. In contrast, category 3 and category 4 banks are not obligated to include changes in the value of their securities portfolio in CET1; as such, changes in securities prices do not affect their CET1 capital ratios. See a visual representation of the Federal Reserve's tailoring rules at https://www.federalreserve.gov/aboutthefed/boardmeetings/files/tailoring-rule-visual-20191010.pdf. Return to text

 10. The SCOOS is available on the Federal Reserve's website at https://www.federalreserve.gov/data/scoos.htm. Return to text

 11. 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. 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. Examples of the resulting securities include collateralized loan obligations (CLOs) (predominantly backed by leveraged loans), asset-backed securities (often backed by credit card and auto debt), commercial mortgage-backed securities, and residential mortgage-backed securities. Return to text

 12. In 2021, a regulatory capital rule change implemented in the National Association of Insurance Commissioners (NAIC) capital treatment for insurance company investments divides the existing capital treatment framework into more granular categories. The new capital rules changed requirements minimally for triple-A-rated tranches but increased capital requirements notably for more junior tranches. Return to text