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
Item Total assets
(billions of dollars)
Growth,
2019:Q4–2020:Q4
(percent)
Average annual growth,
1997–2020:Q4 (percent)
Banks and credit unions 23,454 17.0 6.2
Mutual funds 19,563 10.8 10.0
Insurance companies 12,278 10.0 6.1
Life 9,337 9.8 6.2
Property and casualty 2,941 11.0 5.8
Hedge funds* 8,097 1.8 8.6
Broker-dealers 3,676 6.0 4.9
  Outstanding
(billions of dollars)
   
Securitization 11,330 6.7 5.4
Agency 10,094 7.3 6.0
Non-agency ** 1,236 2.5 3.2

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).

3-1. Common Equity Tier 1 Ratio of Banks
Figure 3-1. Common Equity Tier 1 Ratio of Banks

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Note: The data are seasonally adjusted by Federal Reserve Board staff. Sample consists of banks as of 2020:Q4. Before 2014:Q1, the numerator of the common equity Tier 1 ratio is Tier 1 common capital for advanced‐approaches bank holding companies (BHCs) and intermediate holding companies (IHCs) (before 2015:Q1 for non‐advanced‐approaches BHCs). Afterward, the numerator is common equity Tier 1 capital. G‐SIBs are global systemically important U.S. banks. Large non–G‐SIBs are BHCs and IHCs with greater than $100 billion in total assets that are not G‐SIBs. The denominator is risk‐weighted assets. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research (NBER): March 2001–November 2001, December 2007–June 2009, and February 2020–present. As of the publication of this report, the NBER has not declared an end to the current recession.

Source: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Holding Companies.

3-2. Ratio of Tangible Bank Equity to Assets
Figure 3-2. Ratio of Tangible Bank Equity to Assets

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Note: Bank equity is total equity capital net of preferred equity and intangible assets, and assets are total assets. The data are seasonally adjusted by Federal Reserve Board staff. G‐SIBs are U.S. global systemically important banks. Large non–G‐SIBs are bank holding companies (BHCs) and intermediate holding companies with greater than $100 billion in total assets that are not G‐SIBs. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research (NBER): July 1990–March 1991, March 2001–November 2001, December 2007–June 2009, and February 2020–present. As of the publication of this report, the NBER has not declared an end to the current recession.

Source: Federal Financial Institutions Examination Council, Call Report Form FFIEC 031, Consolidated Reports of Condition and Income (Call Report).

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.

3-3. Borrower Leverage for Bank Commercial and Industrial Loans
Figure 3-3. Borrower Leverage for Bank Commercial and Industrial
Loans

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Note: Weighted median leverage of nonfinancial firms that borrow using commercial and industrial loans from the 26 banks that have filed in every quarter since 2013:Q1. Leverage is measured as the ratio of the book value of total debt to the book value of total assets of the borrower, as reported by the lender, and the median is weighted by committed amounts.

Source: Federal Reserve Board, Form FR Y-14Q (Schedule H.1), Capital Assessments and Stress Testing.

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).

3-4. Change in Bank Lending Standards for Commercial and Industrial Loans
Figure 3-4. Change in Bank Lending Standards for Commercial and
Industrial Loans

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Note: Banks' responses are weighted by their commercial and industrial loan market shares. Survey respondents to the Senior Loan Officer Opinion Survey on Bank Lending Practices are asked about the changes over the quarter. Results are shown for loans to large and medium‐sized firms. The shaded bars with top caps indicate periods of business recession as defined by the National Bureau of Economic Research (NBER): March 2001–November 2001, December 2007–June 2009, and February 2020–present. As of the publication of this report, the NBER has not declared an end to the current recession.

Source: Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank Lending Practices; Federal Reserve Board staff calculations.

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

3-5. Leverage at Broker-Dealers
Figure 3-5. Leverage at Broker-Dealers

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Note: Leverage is calculated by dividing total assets by equity.

Source: Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States."

. . . 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.

3-6. Leverage at Insurance Companies
Figure 3-6. Leverage at Insurance Companies

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Note: Ratio is calculated as (total assets – separate account assets)/(total capital – accumulated other comprehensive income) using generally accepted accounting principles. The largest 10 publicly traded life and property and casualty insurers are represented.

Source: National Association of Insurance Commissioners, quarterly and annual statutory filings accessed via S&P Global Market Intelligence, S&P Capital IQ.

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.

3-7. Gross Leverage at Hedge Funds
Figure 3-7. Gross Leverage at Hedge Funds

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Note: Leverage is computed as the ratio of hedge funds' gross notional exposure to net asset value. Gross notional exposure includes the nominal value of all long and short positions and derivative notional exposures. Options are delta adjusted, and interest rate derivatives are reported at 10‐year bond equivalents. Data are reported on a three-quarter lag.

Source: Securities and Exchange Commission, Form PF, Reporting Form for Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors.

3-8. Change in the Use of Financial Leverage
Figure 3-8. Change in the Use of Financial Leverage

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Note: Net percentage equals the percentage of institutions that reported increased use of financial leverage over the past three months minus the percentage of institutions that reported decreased use of financial leverage over the past three months. REIT is real estate investment trust.

Source: Federal Reserve Board, Senior Credit Officer Opinion Survey on Dealer Financing Terms.

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.

3-9. Issuance of Non-agency Securitized Products, by Asset Class
Figure 3-9. Issuance of Non-agency Securitized Products, by Asset
Class

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Note: The data from the first quarter of 2021 are annualized to create the 2021 bar. CMBS is commercial mortgage‐backed securities; CDO is collateralized debt obligation; RMBS is residential mortgage‐backed securities; CLO is collateralized loan obligation. The "Other" category consists of other asset‐backed securities (ABS) backed by credit card debt, student loans, equipment, floor plans, and miscellaneous receivables; resecuritized real estate mortgage investment conduit (Re‐REMIC) RMBS; and Re‐REMIC CMBS. The data are converted to constant 2021 dollars using the consumer price index. Key identifies bars in order from top to bottom.

Source: Green Street Advisors, LLC, Commercial Mortgage Alert (cmalert.com) and Asset-Backed Alert (abalert.com); Bureau of Labor Statistics, consumer price index via Haver Analytics.

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.

3-10. Large Bank Lending to Nonbank Financial Firms: Committed Amounts
Figure 3-10. Large Bank Lending to Nonbank Financial Firms: Committed
Amounts

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Note: Committed amounts on credit lines and term loans extended to nonbank financial firms by a balanced panel of 26 bank holding companies that have filed Form FR Y‐14Q in every quarter since 2018:Q1. Nonbank financial firms are identified based on reported North American Industry Classification System (NAICS) codes. In addition to NAICS codes, a name‐matching algorithm is applied to identify specific entities such as real estate investment trusts (REITs), special purpose entities, collateralized loan obligations (CLOs), and asset‐backed securities (ABS). REITs incorporate both mortgage (trading) REITs and equity REITs. Broker‐dealers also include commodity contracts dealers and brokerages and other securities and commodity exchanges. Other financial vehicles include closed‐end investment and mutual funds. BDC is business development company.

Source: Federal Reserve Board, Form FR Y-14Q (Schedule H.1), Capital Assessments and Stress Testing.

3-11. Growth of Loan Commitments and Utilization to Nonbank Financial Institutions in 2020, by Sector
Figure 3-11. Growth of Loan Commitments and Utilization to Nonbank
Financial Institutions in 2020, by Sector

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Note: 2020:Q4 over 2019:Q4 growth rates as of year‐end 2020. REIT is real estate investment trust; PE is private equity; BDC is business development company; SPE is special purpose entity; CLO is collateralized loan obligation; ABS is asset‐backed securities. Key identifies bars in order from left to right.

Source: Federal Reserve Board, Form FR Y-14Q (Schedule H.1), Capital Assessments and Stress Testing.

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.

References

 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.htmReturn 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.htmReturn 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.htmReturn 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.htmReturn 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.htmReturn 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.htmReturn 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+5BzDZGWnsSjRJKDwRxOb5Kb1hLReturn 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

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Last Update: May 13, 2021