Board of Governors of the Federal Reserve System

3. Leverage in the Financial Sector

Vulnerabilities associated with financial leverage remained notable

While banks and broker-dealers have maintained solid capital positions, leverage for some other types of financial entities—such as hedge funds and life insurers—was elevated relative to historical standards. When taken together, the overall level of vulnerability due to financial-sector leverage was notable.

In the first quarter of 2025, hedge fund leverage was as high as it has been since comprehensive data have been collected. Hedge funds' use of leverage increased across a range of trading strategies supporting large positions in Treasury securities, interest-rate derivatives, and equities. Life insurers' leverage was in the upper quartile of its historical distribution.

The banking system remained sound and resilient, but many banks continued to carry fair value losses that are not reflected in their regulatory capital ratios. Leverage at broker-dealers stayed near historically low levels. However, the potential for strains on the willingness of dealers to intermediate during periods of market stress remained a vulnerability to Treasury markets.

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, but their fair value losses and exposure to interest rate risk remained sizable

Robust capital positions allow banks to pursue growth opportunities while providing a cushion against unexpected losses. The common equity Tier 1 (CET1) ratio, a regulatory risk-based measure of bank capital adequacy, remained at historically high levels across bank types (figure 3.1). The income-generating capacity of banks is an additional potential source of resiliency, as banks can accrete capital to buffer against future losses by retaining a portion of their current earnings. Banks' return on equity—a measure of profitability—remained within recent historical ranges through the second quarter of 2025 (figure 3.2).⁷

A decline in interest rates caused the fair value of banks' fixed-rate assets to increase over the first half of 2025, but fair value losses remained sizable. As of June 30, 2025, the fair values of banks' available-for-sale (AFS) and held-to-maturity (HTM) portfolios were below their book values by $143 billion and $251 billion, respectively (figure 3.3). The duration of banks' securities portfolios—a measure of the sensitivity of the market value of assets to changes in interest rates—remained elevated, although it has decreased significantly from its peak level in 2022.

An alternative measure of bank capital—the ratio of tangible common equity to total tangible assets, which, unlike the CET1 ratio, does not factor in the riskiness of assets but does include fair value declines on AFS securities for all banks—increased for large non–G-SIBs and regional banks but remained below its median level over the past decade for all bank categories (figure 3.4).

Credit quality at banks remained sound

Recent responses from the Senior Loan Officer Opinion Survey on Bank Lending Practices indicated that overall bank lending standards showed some signs of easing (figure 3.5). At the same time, delinquency rates on bank loans declined across key categories (figure 3.6).

Delinquencies of loans backed by commercial properties were stable or decreased over the first half of 2025. Larger banks, where these delinquencies are concentrated, tend to have more substantial loan loss allowances and appear to be positioned to manage potential portfolio losses. Banks also continued to actively manage their CRE exposures by modifying loan terms, such as by requiring additional collateral from some borrowers.

Broker-dealers' leverage remained low

The ratio of broker-dealers' assets to equity was at the lower end of its historical distribution through the first half of 2025 (figure 3.7). Smoothing through seasonal factors, trading profits continued to increase, and the distribution of trading profits remained balanced across equities; fixed income, rates, and credit; and other business lines (figures 3.8 and 3.9).

Dealers are important intermediaries in Treasury markets, serving in key roles that support orderly market functioning. Measures of dealer intermediation activity in Treasury markets increased further due to growth in secured lending, particularly repurchase agreement (repo) lending to hedge fund clients. While dealers' intermediation capacity remains adequate for market functioning in normal times, their willingness and ability to intermediate can be tested during periods of market stress due to internal risk limits as well as regulatory requirements. The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued proposed rules in June to recalibrate G-SIBs' enhanced supplemental leverage ratio. Among other things, the proposed rules are intended to reduce regulatory disincentives for U.S. G-SIBs' broker- dealer subsidiaries to engage in certain low-risk activities such as intermediating in Treasury markets.⁸

The September 2025 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS) focused on recent trends in dealers accepting securities in lieu of cash as collateral to satisfy variation margin (VM) obligations for over-the-counter derivatives transactions.⁹ While allowing clients to post securities as collateral instead of cash for margin payments can help counterparties avoid selling securities in order to raise cash during periods of stress, it exposes dealers to the interest rate and credit risk of the securities. One-third of SCOOS respondents reported an increase since January 2023 in the share of VM taking the form of securities, primarily in response to client demand coupled with more aggressive competition from other dealers. One-third of respondents expect the share of the volume of securities delivered as VM to increase somewhat over the next 12 months.

Leverage at life insurance companies was in the upper quartile of its historical distribution

Leverage at life insurers remained in the upper quartile of its historical distribution over the first half of 2025, while leverage at property and casualty insurers remained at historically low levels (figure 3.10).

Hedge funds' leverage was elevated and continued to grow

In the first quarter of 2025, the most recent quarter for which comprehensive data from the Securities and Exchange Commission's Form PF data are available, measures of hedge funds' leverage were at their highest levels since the adoption of Form PF in 2013 (figure 3.11). The use of leverage over the past couple of years has increased across a range of strategies and supported significant positions in key markets, such as Treasury securities, interest rate derivatives, and equities. Looking across strategies, the largest funds generally continued to be the most leveraged (figure 3.12). According to data from the SCOOS, dealers reported that hedge funds' use of financial leverage pulled back a bit in April, possibly because some hedge funds unwound leveraged positions during that period (figure 3.13).

Issuance of non-agency securities remained strong

Issuance of non-agency securities remained robust through June (figure 3.14).¹⁰ Credit spreads on most major securitized products have narrowed notably after widening in April. Credit performance across a range of securitized products was stable or modestly improved since the last report.

Bank lending to other financial entities continued to grow at a robust pace

Bank credit commitments to other financial entities grew appreciably in the first half of 2025 to $2.5 trillion, reflecting the growth in market-based finance and other forms of private nonbank lending (figure 3.15). Bank lending to other financial entities is not significantly concentrated in any one sector, but recent growth has been notably robust for the category of special purpose entities, CLOs, and asset-backed securities, followed by the category of other financial vehicles and the category of private equity, business development companies (BDCs), and private credit (figure 3.16).

 

References

 

 7. The return on equity for large non–G-SIBs (global systemically important banks) as a group fluctuated in the first half of 2025 due to one-off effects stemming from acquisitions involving two banks. Third-quarter earnings calls through the data close showed a sizable increase in the return on equity for large banks relative to the third quarter of 2024. Return to text

 8. See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (2025), "Agencies Request Comment on Proposal to Modify Certain Regulatory Capital Standards," joint press release, June 27, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20250627a.htm. Return to text

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

 10. 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), commercial mortgage-backed securities, and residential mortgage-backed securities. Return to text