3. Leverage in the Financial Sector
Leverage at banks and broker-dealers remains low, while leverage at hedge funds and life insurance companies continues to be high
Table 3 shows the sizes and growth rates of the types of financial institutions discussed in this section.
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||23,454||17.0||6.2|
|Property and casualty||2,941||11.0||5.8|
(billions of dollars)
Note: The data extend through 2020:Q4. 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 2020:Q3. Growth rates for the hedge fund data are measured from Q3 of the year immediately preceding the period through Q3 of 2020.
** 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."
Bank capital ratios rose above pre-pandemic levels, though some heightened credit risk remains
Banks have weathered the pandemic well. The common equity Tier 1 ratio—a regulatory risk-based measure of bank capital adequacy—increased, on net, over the past year for most banks (figure 3-1). Over the second half of 2020, profitability recovered, credit quality held up much better than many had expected, and the largest banks reduced capital distributions amid mandatory caps on dividends and restrictions on share repurchases.11 Even so, rapid growth in low-risk assets like central bank reserves, Treasury securities, and government-guaranteed PPP loans raised total assets significantly. As a result, the ratio of tangible capital to total assets at large banks remained below pre-pandemic levels through the end of 2020 (figure 3-2).
In December, the Federal Reserve released results from the second round of bank stress tests for 2020, which assessed the resilience of large banks under two hypothetical scenarios with severe global downturns and substantial stress in financial markets.12 The analysis showed that risk-based capital ratios for all banks would remain above the minimum requirements under both scenarios.13 Given banks' resilience, the Federal Reserve announced that it would allow banks to resume share repurchases in the first quarter of 2021 as long as the total payouts, including dividends, did not exceed their average quarterly net income from the previous four quarters. On March 25, the Federal Reserve announced that the additional restrictions on capital distributions would end on June 30 for banks that maintained capital ratios in excess of their minimum risk-based capital requirements in the 2021 stress test.14
Measures of the credit quality of bank loans have improved since the November report, as fiscal and monetary policy support mitigated the effect of the pandemic. However, credit risk remains elevated in the business sectors most affected by the pandemic as well as in some commercial property segments. The share of loan balances in loss-mitigation programs at the largest banks has declined, especially for consumer and small business loans. But the shares of commercial and industrial (C&I), CRE, and residential mortgage loans in loss mitigation have remained elevated. The leverage of firms with existing C&I loans from the largest banks declined during the second half of 2020, though it stayed somewhat elevated relative to historical levels (figure 3-3). Over the same period, delinquency rates remained about unchanged for most types of loans but rose for CRE loans secured by COVID-affected properties, such as hotels and retail properties.
While delinquencies have generally been flat, some uncertainty remains about whether the credit quality of bank loans will hold up after loss-mitigation programs end and government support runs out. In response to a set of special forward-looking questions in the January 2021 SLOOS, banks, on balance, reported they expect loan quality to deteriorate for most loan categories later this year. Nevertheless, banks' willingness to lend is apparently increasing in some cases. Banks, reflecting changes at the largest banks, generally reported that they had eased lending standards during the fourth quarter of 2020 for C&I loans to large and medium-sized firms (figure 3-4).
Banks built up substantial loan loss allowances in the first half of last year, and that buffer against a future deterioration in asset quality remained well above pre-pandemic levels for all loan categories. Following improvements in the economic outlook, banks significantly reduced the pace of additional loan loss provisioning during the second half of last year for most loan categories.15 The only exception was CRE loans, for which banks continued to build allowances, consistent with the elevated credit risk in this segment.
A key factor in banks' ability to accumulate equity capital has been bank profitability—measured as either return on equity or return on assets—which recovered during the second half of 2020. The reduction in loan loss provisions contributed notably to this recovery. In addition, trading and investment banking revenues were robust. Nonetheless, bank profitability remains under pressure from historically low net interest margins and uncertainty about the credit quality of loans exiting loss-mitigation programs. Based on preliminary data for the first quarter of 2021, profitability at the U.S. global systemically important banks (G–SIBs) continued to be strong, although one G-SIB announced a large loss from prime brokerage activities.
Leverage is at historically low levels at broker-dealers...
Broker-dealer leverage remained near historically low levels through the fourth quarter of 2020 (figure 3-5). Net borrowing of primary dealers has decreased somewhat since the November report but remains higher than in recent years, as dealers continue to finance sizable inventories of Treasury securities. No notable effect on Treasury market functioning followed the expiration in March 2021 of temporary changes to the supplementary leverage ratio (SLR), which were implemented to ease strains in Treasury market intermediation during the onset of the pandemic. To ensure that the SLR—established in 2014 as an additional capital requirement—remains effective in an environment of higher reserves, the Board will soon be inviting public comment on several potential SLR modifications.16
. . . and is high at life insurance companies
Leverage at life insurance companies remains high (figure 3-6). Life insurers invest heavily in corporate bonds and hold CLOs, which leaves them vulnerable to risks from elevated leverage in the corporate sector. They also invest heavily in CRE debt. If the performance of their debt holdings deteriorates, life insurers' capital positions could be impaired. Meanwhile, based on information through the fourth quarter of 2020, leverage at property and casualty insurers stayed at low levels relative to historical averages.
Available measures of hedge fund leverage are somewhat above average but may not be capturing important risks
While data on hedge fund leverage come from different sources with various lags, most measures increased in the second half of 2020 and are now somewhat above their historical averages, reversing the decrease in the first half of the year amid the March 2020 market turmoil. Gross leverage at hedge funds, as reported in publicly available Securities and Exchange Commission (SEC) disclosures, fell in the first half of 2020, the most recent data available, but the average remained near 2018 levels (figure 3-7).17 In addition, 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 is at high levels. More recently, in the Senior Credit Officer Opinion Survey on Dealer Financing Terms, around one-fifth of dealers, on net, reported hedge fund clients reducing their use of leverage between September and November 2020; dealers reported hedge funds' use of leverage as basically unchanged from December 2020 to February 2021 (figure 3-8). Overall, the available data suggest that leverage remains somewhat elevated at hedge funds. The FSOC has restarted its Hedge Fund Working Group to better share data, identify risks, and strengthen the financial system.
A few recent episodes have highlighted the opacity of risky exposures and the need for greater transparency at hedge funds and other leveraged financial entities that can transmit stress to the financial system. For example, some hedge funds with substantial short positions sustained losses during the meme stock episode in January 2021, when intense social media activity contributed to fluctuations in the prices of some specific stocks, though the effects on the hedge fund sector overall appear to have been limited (see the box "Vulnerabilities from Asset Valuations, Risk Appetite, and Low Interest Rates" in the Asset Valuations section).
In a separate episode in late March, a few banks took large losses when a highly leveraged family office, Archegos Capital Management, was unable to meet margin calls related to total return swap agreements and other positions financed by prime brokers.18 Price declines in the concentrated stock positions held by Archegos triggered the margin calls, prompting sales of the stock positions, which led to further declines in the prices of affected stocks and, ultimately, substantial losses for some banks. While broader market spillovers appeared limited, the episode highlights the potential for material distress at NBFIs to affect the broader financial system.
Although overall securitization volumes remained subdued, issuance of collateralized loan obligations and nonmortgage asset-backed securities was elevated
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 residential mortgage-backed securities (RMBS). By funding assets with debt issued by investment funds knows as "special purpose entities" (SPEs), securitization can add leverage to the financial system, in part because SPEs are generally subject to rules such as risk retention that are less stringent than banks' regulatory capital requirements.19 In addition, the process commonly involves the creation of securities, or "tranches," with different levels of seniority. As a result, securitization allows the creation of highly rated securities from pools of lower-rated assets.
On balance, issuance volumes of non-agency securities—that is, those securities not guaranteed by a government-sponsored enterprise (GSE) or by the federal government—remained subdued and ended last year 20 percent below their 2019 levels despite support from the Term Asset-Backed Securities Loan Facility (TALF) (figure 3-9). Issuance recovered somewhat in the first quarter of 2021, though the recovery was uneven across asset classes. Amid increased investor risk appetite, CLO and ABS issuance was elevated, whereas non-agency CMBS and RMBS issuance was weak during the first quarter.
CLO securitization has grown rapidly in recent years, with investors attracted by higher yields. Although recently issued CLOs have been relatively sounder than the structures in use before the 2007–09 financial crisis, the value of lower-rated tranches may be highly sensitive to performance of the underlying loans.20 As a result, leveraged investors, such as hedge funds, may be vulnerable if they have substantial exposures to these lower-rated tranches and the underlying loans experience losses. In 2021, CLO issuance rose to a record pace through March that was about 100 percent above its average monthly issuance volume from the same period last year, and about 75 percent above its average volume for that same period from 2016 through 2020. In addition, a record volume of CLOs was refinanced or restructured, as CLO managers sought to lower their liability costs amid tighter market spreads. Meanwhile, CLO fundamentals have improved, following a notable deterioration in 2020. While certain collateral metrics, such as average loan ratings or holdings of triple-C-rated loans, are worse than their pre-pandemic levels, they have improved significantly relative to mid-2020.
Bank lending to nonbank financial institutions rose to pre-pandemic levels by the end of 2020
Bank lending to NBFIs represents a potential channel for transmission of stress from one part of the financial system to another. Committed amounts of credit from large banks to NBFIs, which consist mostly of revolving credit lines and include undrawn amounts, increased in the latter part of last year and reached a record $1.6 trillion by year-end (figure 3-10).21 The increase was driven by lending to open-end investment funds; SPEs, including CLOs and ABS; real estate lenders and lessors; and other financial vehicles (figure 3-11).22 These credit-line commitments provide NBFIs with liquidity insurance and a backstop to meet heightened investor redemptions or disruptions in the short-term funding markets in which they operate. As such, the credit lines represent contingent commitments from banks that can support increases in financial leverage during times of stress. Indeed, the utilization rates of NBFIs' credit lines spiked in March 2020 but generally fell back to normal levels during the second half of last year.
Delinquency rates on loans by large banks to NBFIs were higher in the second half of 2020 than before the pandemic, but they remained below delinquency rates on C&I loans to nonfinancial firms. The relatively modest delinquency rates on loans to NBFIs partly reflect actions by the Department of the Treasury and the Federal Reserve that stabilized funding markets and produced marketwide effects that reduced liquidity risks at NBFIs.
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. 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
13. See Board of Governors of the Federal Reserve System (2020), "Federal Reserve Board Releases Second Round of Bank Stress Test Results," press release, December 18, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20201218b.htm. Return to text
14. 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. Return to text
15. 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 uncollected loan payments and are added to the allowance for loan and lease losses (ALLL), which is renamed "allowance for credit losses" for banks adopting the Current Expected Credit Losses methodology. On a bank's balance sheet, total loans are reported net of ALLL. More information on ALLL is available on the Board's website at https://www.federalreserve.gov/supervisionreg/topics/alll.htm. Return to text
16. See Board of Governors of the Federal Reserve System (2021), "Federal Reserve Board Announces That the Temporary Change to Its Supplementary Leverage Ratio (SLR) for Bank Holding Companies Will Expire as Scheduled on March 31," press release, March 19, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20210319a.htm. Return to text
17. 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 in developing its assessment of vulnerabilities from hedge fund leverage. Return to text
18. Family offices are private firms that manage wealth on behalf of their owners and are exempt from registration with the SEC; thus, they are not subject to disclosing their size or leverage. Return to text
19. Following the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, federal financial regulatory agencies introduced credit risk retention rules that required sponsors of securitization vehicles to retain a minimum share of the credit risk for any asset that the sponsor transfers, sells, or conveys to a third party through securitization. Return to text
20. Unlike open-end mutual funds, CLOs do not generally permit early redemptions or rely on funding that must be rolled over before the underlying assets mature. Also, recent CLOs provide higher levels of subordination to better protect senior tranche holders than before the 2007–09 financial crisis. As a result, CLOs are generally considered more "sound" because they avoid the run risk associated with a rapid reversal in investor sentiment and have less embedded leverage. Return to text
21. The Federal Reserve is able to monitor the exposures of the largest U.S. banks to NBFIs because those banks report detailed information about their loan commitments on regulatory form FR Y-14Q, available on the Board's website at https://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDZGWnsSjRJKDwRxOb5Kb1hL. Return to text
22. Open-end investment funds include mutual funds and exchange-traded funds. Other financial vehicles include mostly private closed-end investment funds and trusts. Return to text