Board of Governors of the Federal Reserve System

3. Leverage in the Financial Sector

Vulnerabilities associated with financial leverage remained notable

The banking system remained sound and resilient. Measures of regulatory capital for banks increased over the second half of 2024. However, fair value losses on fixed-rate assets remained sizable for certain banks, while some banks continued to have concentrated exposures to CRE loans.

Outside the banking sector, leverage at broker-dealers decreased in the fourth quarter of 2024 and stayed near historically low levels. However, the potential for strains on dealers' intermediation capacity during periods of market stress remained a vulnerability to Treasury markets. Life insurers' leverage remained at the upper end of its historical distribution, and life insurers continued to hold a significant share of illiquid and risky assets. While hedge funds' leverage rose to historical highs in the third quarter of 2024 and remained concentrated among the largest hedge funds, it likely decreased in early April as some hedge funds unwound leveraged positions amid heightened market volatility.

Table 3.1 shows the sizes and growth rates of assets of financial institutions discussed in this section.

Table 3.1. Size of selected sectors of the financial system, by types of institutions and vehicles

Banks maintained historically high levels of regulatory capital, though fair value losses in fixed-rate assets remained sizable

The common equity Tier 1 (CET1) ratio, a regulatory risk-based measure of bank capital adequacy, continued to rise since the last report. This increase was primarily driven by strong retained earnings, bringing these ratios across all bank sizes to the upper end of their range from 2010 to 2024 (figure 3.1). As of the end of 2024, measures of bank profitability continued to improve and were around the median of their historical distributions. Banks' average interest rate on interest earning assets remained well above the average interest rate paid on liabilities, supporting net interest margins (figure 3.2). Earnings for the largest banks were reportedly robust in the first quarter of 2025, though early earnings calls highlighted elevated economic uncertainty and downside risk, with some banks increasing loan-loss reserves to buffer against a potential increase in defaults.

Higher interest rates continued to reduce the fair value of banks' fixed-rate assets. At the end of 2024, the fair values of banks' available-for-sale (AFS) and held-to-maturity (HTM) portfolios were below their book values by $182 billion and $297 billion, respectively (figure 3.3). The fair value of banks' securities holdings remained sensitive to changes in interest rates.

An alternative measure of bank capital is the ratio of tangible common equity to total tangible assets. While this ratio shares similarities with the CET1 ratio—as both exclude intangible items like goodwill from capital—there are important differences between the two. Unlike the CET1 ratio, the tangible common equity ratio does not factor in the riskiness of assets, but it does include fair value declines on AFS securities for all banks. While the tangible common equity ratio increased across all bank categories in the second half of 2024, it remained below its average level over the past decade (figure 3.4).

Credit quality at banks remained sound despite rising delinquencies in certain loan segments

Delinquency rates for commercial and industrial (C&I) and CRE loans increased slightly in the second half of 2024, while delinquency rates for credit card and auto loans were little changed and remained above their pre-COVID levels. Delinquencies of loans backed by office and multifamily properties remained elevated at global systemically important banks (G-SIBs) and large non–G-SIBs, while delinquencies at regional banks increased slightly, but from much lower levels. Larger banks, where the delinquencies are concentrated, tend to have more substantial loan loss allowances and appear to be positioned to manage potential portfolio losses.

Banks' CRE portfolios have a sizable share of loans backed by office and multifamily properties where weaker fundamentals have begun to show some signs of improvement. Banks have actively managed their CRE exposures by modifying loan terms, which has reduced delinquency rates.

The leverage of borrowers with C&I loans increased slightly since November (figure 3.5). Recent responses from the SLOOS indicate that lending standards for C&I loans remained unchanged, on net, following previous tightening (figure 3.6).

Broker-dealers' leverage remained low

At the end of 2024, the ratio of broker-dealers' assets to equity was at the lower end of its historical distribution (figure 3.7). Smoothing through seasonal factors, profits were up year over year (figure 3.8). The breakdown of broker-dealer profits remained relatively balanced, with earnings evenly distributed across equity; fixed income, rates, and credit; and other business lines (figure 3.9).

Dealer intermediation in Treasury markets rose in the first quarter of 2025, and Treasury positions increased. Such an increase was consistent with high Treasury issuance and reports from market participants highlighting reduced demand from other Treasury investors. While dealers' intermediation capacity remains adequate for market functioning in normal times, balance sheet pressures could constrain dealers' ability to intermediate in Treasury markets during periods of market stress. Heightened client demand in early April reportedly increased balance sheet pressures for some dealers.

In the March 2025 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), dealers reported a slight easing in terms for securities financing transactions and over-the-counter derivatives since November.⁸ Over the same period, their clients' use of financial leverage remained unchanged on net. Additionally, one-fifth of dealers noted a relaxation in collateral spreads for agency residential mortgage-backed securities (RMBS) and CMBS. The March SCOOS also included special questions focusing on dealers' and their clients' practices in Treasury repurchase agreement (repo) markets, specifically regarding cross-margining, which allows market participants to transfer margin from accounts with an excess of margin to accounts with insufficient margin. While most dealers indicated that their clients engage in both Treasury repo and Treasury futures or interest rate derivatives transactions, only a small fraction reported significant use of cross-margining agreements for these trades.

Insurers' leverage increased, and they continued to invest in risky and illiquid assets

While leverage at life insurers remained around the 85th percentile of its historical distribution over the second half of 2024, leverage at property and casualty insurers remained near the lower end of its historical distribution (figure 3.10). Life insurers continued to take additional credit and liquidity risk by allocating a growing share of their portfolios to riskier and less liquid assets, such as leveraged loans, collateralized loan obligations (CLOs), high-yield corporate bonds, privately placed corporate bonds, and alternative investments. Additionally, as major holders of CMBS, life insurers could face valuation pressures if commercial property values experience a significant decline.

Hedge funds' leverage has likely decreased from historically high levels due to repositioning and unwinding levered trades in April

In the third quarter of 2024, the most recent quarter for which the Securities and Exchange Commission's form PF data are available, hedge funds' leverage reached historical highs and remained heavily concentrated among the largest funds (figure 3.11 and figure 3.12). According to data from the March SCOOS, hedge funds' leverage remained largely unchanged between mid-November 2024 and mid-February 2025 (figure 3.13). More recently, however, hedge fund leverage likely declined amid elevated market volatility. This reported decrease reflects a partial unwinding of leveraged positions by some hedge funds. Hedge fund repositioning and deleveraging may have contributed to the recent market volatility, both in equities and risky assets as well as in some longer-dated Treasury securities.

Issuance of non-agency securities remained strong through March

Issuance of non-agency securities—which increases the amount of leverage in the financial system—remained robust through March (figure 3.14).⁹ Credit spreads on most major securitized products generally narrowed from November into early 2025 before widening in April. Credit performance across securitized products backed by riskier loan collateral showed continued signs of deterioration. This decline in credit performance was particularly pronounced in CRE-related securitizations, with prime auto and credit card asset-backed securities (ABS) also experiencing signs of deterioration.

Bank lending to nonbank financial institutions continued to grow

Bank credit commitments to NBFIs grew modestly in 2024 to $2.3 trillion (figure 3.15). Growth in some areas, such as commitments to open-end investment funds, special purpose entities, and securitization vehicles, was strong (figure 3.16). As outlined in the box "Changes in the Classification of Nonbank Financial Institutions," there have been a number of improvements to the methodology for the identification of different types of NBFI borrowers. One result of these improvements is that a substantial amount of loans to borrowers previously classified in categories such as "Other financial vehicles" have been identified as private equity (PE) firms, business development companies (BDCs), and private credit (PC) funds. Overall, bank lending to NBFIs is not significantly concentrated in any one sector, most commitments are rated investment grade, and these loans traditionally have had delinquency rates lower than loans to nonfinancial businesses.

 

References

 

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

 9. 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 CLOs (predominantly backed by leveraged loans), asset-backed securities (often backed by credit card and auto debt), CMBS, and RMBS. Return to text