3. Leverage in the Financial Sector

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Purpose and Framework Overview 1. Asset Valuations 2. Borrowing by Businesses and Households 3. Leverage in the Financial Sector 4. Funding Risks 5. Near-Term Risks to the Financial System

3. Leverage in the Financial Sector

Poor risk management undermined some banks, while the broader banking system remained sound and resilient; meanwhile, leverage at some types of nonbank financial institutions appeared elevated

Vulnerabilities related to overall financial-sector leverage appeared to remain moderate. In March 2023, poor interest rate and liquidity risk management contributed to runs on SVB and Signature Bank and stresses at some additional banks, subsequently leading to the failure of First Republic Bank on May 1. Actions taken by the official sector reassured depositors, and the broad banking system remained sound and resilient. For the banking system as a whole, aggregate bank capital levels were ample. At potentially vulnerable banks, examiners have increased the frequency and depth of monitoring, with examination activities directed to assessing the current valuation of investment securities, deposit trends, the diversity of funding sources, and the adequacy of contingency funding plans.

Broker-dealer leverage remained low, but vulnerabilities persisted regarding their willingness and ability to intermediate in fixed-income markets during periods of stress. Some types of nonbank financial firms continued to operate with high leverage.

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

Item	Total assets (billions of dollars)	Growth, 2021:Q4–2022:Q4 (percent)	Average annual growth, 1997–2022:Q4 (percent)
Banks and credit unions	25,594	−.1	6.1
Mutual funds	17,333	−22.0	8.9
Insurance companies	11,867	−8.5	5.5
Life	8,844	−10.3	5.6
Property and casualty	3,023	−2.5	5.5
Hedge funds*	9,067	−5.7	7.9
Broker-dealers**	4,927	−.7	4.8
	Outstanding (billions of dollars)
Securitization	13,161	9.1	5.6
Agency	11,698	9.5	6.1
Non-agency ***	1,464	5.8	3.6

Note: The data extend through 2022:Q4 unless otherwise noted. Outstanding amounts are in nominal terms. 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 2022:Q3. Growth rates for the hedge fund data are measured from Q3 of the year immediately preceding the period through Q3 of the final year of the period.

** Broker-dealer assets are calculated as unnetted values.

*** 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."

Concerns over interest rate risk and declines in the fair value of some assets led to stress in the banking sector and raised concerns about spillovers

Rising interest rates affect banks in several ways. Higher interest rates on floating-rate and newly acquired fixed-rate assets lead to higher interest income for banks. The costs of bank funding also increase, but generally much more slowly than market rates. As a result, the net interest margins of most banks typically increase in a rising rate environment as the rates they receive on their assets outpace their funding costs.⁸ Over the past year, interest rates increased considerably as policy rates rose from near-zero levels. The overall banking sector has remained profitable and resilient as rates have risen, with net interest margins reflecting higher interest income on floating-rate loans coupled with interest expense on many deposits staying well below market rates (figure 3.1).

Figure 3.1. Banks' average interest rate on interest-earning
assets and average expense rate on liabilities increased

In the aggregate, more than 45 percent of bank assets reprice or mature within a year, reducing exposure to legacy fixed-rate assets in the overall banking system. Nonetheless, higher interest rates substantially affected the value of banks' existing holdings of fixed-rate assets in 2022. In 2020 and 2021, banks added nearly $2.3 trillion in securities to their balance sheets, primarily fixed-rate U.S. Treasury securities and agency-guaranteed mortgage-backed securities, most of which were placed in their available-for-sale (AFS) and held-to-maturity (HTM) securities portfolios. By the end of 2022, banks had declines in fair value of $277 billion in AFS portfolios and $341 billion in HTM portfolios (figure 3.2).⁹ Additionally, banks have other long-duration fixed-rate assets, such as fixed-rate residential mortgages, whose interest income did not increase with rising interest rates.

Figure 3.2. The fair values of banks' securities portfolios declined
in 2022 as interest rates rose

As discussed in the box "The Bank Stresses since March 2023," SVB did not effectively manage the interest rate risk associated with its securities holdings or develop effective interest rate risk measurement tools, models, and metrics. SVB also had a concentrated business model and failed to manage the liquidity risks of liabilities that were largely composed of uninsured deposits from venture capital firms and the tech sector.

In early March 2023, depositors became increasingly concerned about the health of SVB, and the bank experienced substantial deposit outflows. On March 10, SVB failed. The equity prices of some banks declined sharply, and some banks saw sizable outflows from uninsured depositors. On March 12, Signature Bank failed. Concerns over stresses in the banking sector led the U.S. Department of the Treasury, the Federal Reserve, and the FDIC to intervene on March 12 to assure depositors of the safety of their deposits (see the box "The Federal Reserve's Actions to Protect Bank Depositors and Support the Flow of Credit to Households and Businesses"). Deposit outflows slowed considerably thereafter. Nonetheless, First Republic Bank continued to experience continued stress, leading to its failure and subsequent acquisition on May 1 by JPMorgan Chase Bank with government support. The Federal Reserve will continue to closely monitor conditions in the U.S. banking system, and it is prepared to use all its tools for institutions of any size, as needed, to support the safety and soundness of the U.S. banking system.

On April 28, 2023, the Federal Reserve published a report examining the factors that contributed to the failure of SVB and the role of the Federal Reserve, which was the primary federal supervisor for the bank and its holding company, Silicon Valley Bank Financial Group.¹⁰ That same day, the FDIC published a report examining the failure of Signature Bank, whose primary federal supervisor was the FDIC.¹¹

Box 3.1. The Bank Stresses since March 2023

The banking system came under severe stress late in the week of March 6, 2023. On Wednesday, March 8, Silvergate Bank, an institution supervised by the Federal Reserve with $11 billion in assets at the end of 2022, announced its intention to voluntarily wind down its operations and to fully repay all deposits.¹

On that Wednesday afternoon, SVB, an institution supervised by the Federal Reserve with $209 billion in assets at the end of 2022, announced it had sold $21 billion from its AFS securities portfolio at an after-tax loss of $1.8 billion, was planning to increase nondeposit borrowing from $15 billion to $30 billion, and was commencing a public offering to raise capital by $2.25 billion.² The bank also noted that it had been in dialogue with a rating agency that was considering a negative rating action, with the possibility that another agency would follow suit. Later that day, the bank received a one-notch rating downgrade, and its rating outlook was changed from stable to negative. These announcements led to a loss of confidence in the bank, as reflected in the sharp decline in SVB's stock market price, illustrated in figure A, and unprecedented deposit withdrawals from customers, totaling $42 billion in a single business day on Thursday, March 9. As additional deposit withdrawal requests accumulated, the bank informed regulators on the morning of Friday, March 10, that $100 billion in deposit withdrawals were scheduled or expected for that day.³ The bank was unable to pay those obligations, and, on the morning of Friday, March 10, the Department of Financial Protection and Innovation of the State of California declared SVB insolvent, took possession of the bank, and appointed the FDIC as receiver.

Figure A. Bank stock prices and stock indexes

It appeared that contagion from SVB's failure could be far-reaching and cause damage to the broader banking system. The prospect of uninsured depositors not being able to access their funds appeared to raise concerns about the possibility of destabilizing runs at other U.S. commercial banks. This concern over broader contagion led to sizable declines in bank stocks, as reflected by the declines in the KBW bank indexes (as shown in figure A). On March 10, Signature Bank, an institution supervised by the FDIC with $110 billion in assets at the end of 2022, continued experiencing stock price declines and suffered a run, with depositors withdrawing 20 percent of deposit balances.⁴ Signature Bank was closed on Sunday, March 12, by the New York State Department of Financial Services, and the FDIC was named receiver.⁵ The speed and magnitude of the runs on uninsured deposits at SVB and Signature Bank generated broader concerns about the resilience of banks with a large concentration of uninsured deposits and significant declines in the fair value of fixed-rate assets in a rising rate environment. The bank runs at SVB and Signature Bank contributed to a further deterioration of confidence in banks, amplifying the initial bank stresses. Other banks also saw notable deposit outflows, threatening households' and businesses' ability to access accounts they routinely use to make payments. In contrast, the largest banks saw significant deposit inflows. On Sunday, March 12, the Federal Reserve, together with the FDIC and the U.S. Department of the Treasury, announced decisive actions to protect households and businesses (see the box "The Federal Reserve's Actions to Protect Bank Depositors and Support the Flow of Credit to Households and Businesses").

The runs on SVB and Signature Bank were of unprecedented speed compared with previous runs. During the run on Washington Mutual in 2008—to date, the run that caused the largest failure of an insured depository institution by inflation-adjusted total assets—depositors withdrew about $17 billion over the course of eight business days, with the largest deposit withdrawal in one day reaching just over 2 percent of pre-run deposits.⁶ By comparison, the highest one-day withdrawal rate was more than 20 percent in the case of SVB and Signature Bank, at the time the second- and third-largest depository institutions by inflation-adjusted total assets, respectively, that failed due to a bank run (figure B).⁷ At SVB, withdrawals would have been even larger had regulators not closed the bank on the morning of March 10. Figure B also compares the speed of the runs on Washington Mutual, SVB, and Signature Bank with the run on Continental Illinois, the fifth-largest depository institution by inflation-adjusted total assets to fail due to a bank run. Continental Illinois sustained sizable withdrawals of uninsured deposits for six consecutive days in May 1984, with a peak one-day withdrawal rate of 7.8 percent of deposits, before a public assistance package was put in place.⁸ The unprecedented speed of the run on SVB was likely facilitated by widespread adoption among SVB's tightly networked depositor base of technologies enabling depositors to submit withdrawal requests electronically and to share messages about the bank's perceived problems via messaging apps and on social media. But the faster speed of the run in the Continental Illinois case relative to Washington Mutual also points to the role of the concentration of uninsured deposits.

Figure B. Peak 1-day withdrawal rates for runs on the largest
banks, by inflation-adjusted total assets

In international markets, Credit Suisse came under renewed pressure. In recent years, Credit Suisse had experienced a succession of risk-management, corporate-governance, and compliance failures. And in 2022, it reported the largest after-tax loss since the 2007–09 financial crisis and experienced significant deposit outflows in the last quarter of the year. During the week of March 13, the firm published its annual report, which was originally scheduled for publication the previous week, and its largest shareholder announced it would not buy additional shares in the bank. The bank stock price declined further, and on March 16, Credit Suisse announced its intention to access emergency liquidity support provided by the Swiss National Bank for up to CHF 50 billion. Despite the announcement of this liquidity support, investors' confidence continued to deteriorate, as reflected by the continued price decline of Credit Suisse shares (as shown in figure A). On Sunday, March 19, UBS agreed to merge with Credit Suisse in a deal that involved triggering the write-off of a certain type of Credit Suisse's contingent convertible capital instruments, as well as liquidity support and loss sharing from the Swiss government. In addition, on Sunday, March 19, the Federal Reserve, together with other central banks, announced measures to enhance the provision of liquidity in global funding markets (see the box "The Federal Reserve's Actions to Protect Bank Depositors and Support the Flow of Credit to Households and Businesses"). The spillovers of the stresses related to Credit Suisse to the U.S. have so far been muted.

Following the runs on SVB and Signature Bank, First Republic Bank, an institution supervised by the FDIC with $213 billion in assets at the end of 2022, experienced notable deposit outflows between March 10 and March 16. The bank's equity price declined significantly through the end of March and declined even further following the publication of its first quarter earnings on April 24. The California Department of Financial Protection and Innovation took possession of First Republic Bank before markets opened on Monday, May 1, appointing the FDIC as receiver.⁹ At the same time, the FDIC entered into a purchase and assumption agreement with JPMorgan Chase Bank to assume all of the deposits and most of the assets of the failed bank, with the bank and the FDIC entering into a loss-sharing agreement.¹⁰

1. See Silvergate Bank (2023), "Silvergate Capital Corporation Announces Intent to Wind Down Operations and Voluntarily Liquidate Silvergate Bank," press release, March 8, https://ir.silvergate.com/news/news-details/2023/Silvergate-Capital-Corporation-Announces-Intent-to-Wind-Down-Operations-and-Voluntarily-Liquidate-Silvergate-Bank/default.aspx. The announcement followed deposit outflows in the fourth quarter of 2022 that reduced deposit balances by more than 50 percent. Return to text

2. See Silicon Valley Bank (2023), "Strategic Actions/Q1'23 Mid-Quarter Update" (Santa Clara, Calif.: SVB, March 8), available at https://ir.svb.com/events-and-presentations/default.aspx. Return to text

3. The $42 billion in deposit withdrawals on March 9 comes from the order taking possession of property and business from the Department of Financial Protection and Innovation of the State of California available on the department's website at https://dfpi.ca.gov/wp-content/uploads/sites/337/2023/03/DFPI-Orders-Silicon-Valley-Bank-03102023.pdf?emrc=bedc09. The $100 billion in scheduled or expected deposit withdrawals for March 10 comes from Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank available on the Federal Reserve's website at https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf. Return to text

4. See Federal Deposit Insurance Corporation (2023), FDIC's Supervision of Signature Bank (Washington: FDIC, April), https://www.fdic.gov/news/press-releases/2023/pr23033a.pdf. Return to text

5. See New York State Department of Financial Services (2023), "Superintendent Adrienne A. Harris Announces New York Department of Financial Services Takes Possession of Signature Bank," press release, March 12, https://www.dfs.ny.gov/reports_and_publications/press_releases/pr20230312. Return to text

6. See Office of Thrift Supervision (2008), "OTS Fact Sheet on Washington Mutual Bank," September 25, www.fcic.gov/documents/view/905. The one-day deposit withdrawal rate is estimated using only consumer and small business deposits; see Declaration of Thomas M. Blake to the U.S. Bankruptcy Court, District of Delaware, Chapter 11 Case No. 08-12229 (MFW) and Adversary Proceeding No. 09-50934 (MFW) (2009). Return to text

7. After the data close on April 21, 2023, First Republic Bank failed, making it the second-largest depository institution to fail due to a bank run. Return to text

8. See Mark Carlson and Jonathan Rose (2019), "The incentives of Large Sophisticated Creditors to Run on a Too Big to Fail Financial Institution," Journal of Financial Stability, vol. 41 (April), pp. 91–104. Return to text

9. See the order taking possession of property and business from the Department of Financial Protection and Innovation of the State of California available on the department's website at https://dfpi.ca.gov/2023/05/01/california-financial-regulator-takes-possession-of-first-republic-bank/. Return to text

10. See Federal Deposit Insurance Corporation (2023), "JPMorgan Chase Bank, National Association, Columbus, Ohio Assumes All the Deposits of First Republic Bank, San Francisco, California," press release, May 1, https://www.fdic.gov/news/press-releases/2023/pr23034.html. Return to text

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Banks' risk-based capital remained within the range established over the past decade, but tangible common equity declined at non–global systemically important banks

Notwithstanding the banking stress in March, high levels of capital and moderate interest rate risk exposures mean that a large majority of banks are resilient to potential strains from higher interest rates. As of the fourth quarter of 2022, banks in the aggregate were well capitalized, especially U.S. global systemically important banks (G-SIBs). The common equity Tier 1 (CET1) ratio—a regulatory risk-based measure of bank capital adequacy—remained close to the median of its range since the end of the 2007–09 financial crisis (figure 3.3). In the second half of 2022, G-SIBs increased their CET1 ratios by cutting back on stock repurchases and reducing risk-weighted assets to meet higher capital requirements resulting from an increase in their 2023 G-SIB surcharges—that is, the amount of capital G-SIBs must have above their minimum capital requirements and stress capital buffers. In contrast, CET1 ratios decreased at large non-G-SIB and other banks that continued to grow their risk-weighted assets, though their CET1 ratios remained well above requirements.

Figure 3.3. Banks' risk-based capital ratio remained near the
median level since the 2007–09 financial crisis

The ratio of tangible common equity to total tangible assets—a measure of bank capital that does not account for the riskiness of credit exposures and, like CET1, excludes intangible items such as goodwill from capital—edged up at G-SIBs in the fourth quarter of 2022 but continued to decline at large non-G-SIB and other banks (figure 3.4). The decreases in tangible common equity ratios of non–G-SIBs were partly due to a substantial drop in tangible equity from declines in fair value on Treasury and agency-guaranteed mortgage-backed securities in AFS portfolios.

Figure 3.4. The ratio of tangible common equity to tangible assets
increased for global systemically important banks but decreased for
other banks

Banks' overall vulnerability to future credit losses appeared moderate

Aggregate credit quality in the nonfinancial sector remained strong even as delinquency rates in certain loan segments—such as auto loans, credit cards, and CRE loans backed by office and retail buildings—have increased. Borrower leverage for bank commercial and industrial (C&I) loans continued to trend downward in the fourth quarter of 2022 relative to the start of the year (figure 3.5). Moreover, according to data from the January 2023 SLOOS, banks continued to tighten lending standards on C&I loans and CRE loans in the second half of 2022 (figure 3.6; see also figure 1.16). At the same time, most banks reported weaker loan demand, especially in interest-rate-sensitive segments such as residential real estate and CRE. A material decrease in commercial property prices could lead to credit losses for banks with sizable CRE exposures (see the box "Financial Institutions' Exposure to Commercial Real Estate Debt"). Overall, bank profitability was below its 2021 level but close to its pre-pandemic average.

Figure 3.5. Borrower leverage for bank commercial and industrial
loans continued to decrease

Figure 3.6. Lending standards for bank commercial and industrial
loans have tightened

Leverage at broker-dealers remained low

Broker-dealer leverage ratios decreased slightly in 2022:Q4 and remained near their recent historically low levels (figure 3.7). Dealers' equity growth has generally kept up with the growth of their assets, boosted in part by trading profits that have remained strong despite seasonal declines in 2022:Q4 (figures 3.8 and 3.9). Net secured borrowing of primary dealers has increased since the November report but remained near its historical average, while gross financing and borrowing have increased. Primary dealer Treasury market activities, including market making and repo, increased since the November report but did not keep pace with the amount of Treasury securities available to investors. During the volatile period in mid-March, dealers faced elevated client flows that resulted in their inventories of Treasury securities increasing somewhat, suggesting that dealers continued to intermediate in Treasury markets.

Figure 3.7. Leverage at broker-dealers remained historically
low

Figure 3.8. Trading profits decreased in 2022:Q4, consistent
with seasonal patterns

Figure 3.9. Shares of trading profits by trading desks

In the March 2023 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), which covered the period between December 2022 and February 2023, dealers reported that they had, on net, tightened terms associated with securities financing and over-the-counter derivatives transactions offered to REITs and nonfinancial corporations.¹² Respondents also reported that liquidity and market functioning for non-agency residential mortgage-backed securities and consumer asset-backed securities (ABS) had improved. In response to a set of special questions about volatility products referencing interest rates, foreign exchange (FX), and credit spreads, respondents reported that, since January 2021, clients' interest in trading volatility products had increased, driven by increased demand for hedging volatility, and that market liquidity and functioning had improved for FX and credit spread volatility products.

Leverage at life insurers edged up but remained below its pandemic peak

Leverage at life insurers increased slightly since the previous report, but it remained near the middle of its historical range and well below its pandemic peak. Meanwhile, leverage at property and casualty insurers stayed low relative to historical levels (figure 3.10). Life insurers continued to allocate a high percentage of assets to instruments with higher credit or liquidity risk, such as high-yield corporate bonds, privately placed corporate bonds, and alternative investments. These assets can suffer sudden increases in default risk, putting pressure on insurer capital positions. Rising interest rates have likely had a positive effect on the profitability of life insurers, as their liabilities generally 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-than-expected rate, potentially causing some funding strains.

Figure 3.10. Leverage at life insurance companies edged up but
remained below its pandemic peak

Hedge fund leverage remained somewhat elevated, especially at the largest funds

According to comprehensive data collected by the Securities and Exchange Commission (SEC), average on-balance-sheet leverage and average gross leverage of hedge funds, which includes off-balance-sheet derivatives exposures, remained above their historical averages in the third quarter of 2022 (figure 3.11). While average financial leverage was modest, leverage at the largest hedge funds was substantially higher. The average on-balance-sheet leverage of the top 15 hedge funds by gross asset value, which at times has exceeded 20-to-1, decreased in 2022:Q3 to about 14-to-1 (figure 3.12). These high levels of leverage are consistent with the low haircuts on Treasury collateral in the noncentrally cleared bilateral repo market.¹³ More recent data from the March 2023 SCOOS suggested that the use of financial leverage by hedge funds had not changed, on net, between December 2022 and February 2023 amid unchanged price and nonprice borrowing terms (figure 3.13).

Figure 3.11. Leverage at hedge funds remained elevated

Figure 3.12. Leverage at the largest hedge funds decreased but
remained high

Figure 3.13. Dealers indicated that the use of leverage by hedge
funds was unchanged recently

Data from the Commodity Futures Trading Commission Traders in Financial Futures report showed that, before the bank stresses of March 2023, leveraged funds' short Treasury futures positions had increased notably since the November report. In the past, high levels of short positions in Treasury futures held by leveraged funds coincided with hedge fund activities in Treasury cash-futures basis trades, and that trade may have gained in popularity recently as well. The basis trade is often highly leveraged and involves the sale of a Treasury futures and the purchase of a Treasury security deliverable into the futures contract, usually financed through repo.¹⁴ Amid increased interest rate volatility following the SVB failure, some hedge funds that were short Treasury futures or were engaged in other bets that U.S. short-term rates would continue to rise faced margin calls and partially unwound those positions. The unwinds may have contributed to the large movements and increased volatility in short-term Treasury markets and to volatility in interest rate markets.

Like hedge funds, private credit funds are private pooled investment vehicles about which relatively little is known. The box "Financial Stability Risks from Private Credit Funds Appear Limited" assesses the vulnerabilities posed by private credit funds.

Box 3.2. Financial Stability Risks from Private Credit Funds Appear Limited

Private credit refers to direct lending to businesses by nonbank institutions and is distinct from bank loans, leveraged loans, or corporate bonds that involve lending by banks, by bank-led syndicates, or through public markets, respectively. Within the private credit market, private credit funds are the largest class of lenders and manage over five times more in assets than business development companies, the second-largest class of lenders. Private credit funds are pooled investment vehicles that originate or invest in loans to private—that is, not publicly traded—businesses. Only institutional investors or high-net-worth individuals are eligible to invest in such funds. Despite private credit funds' growing presence, available information about their activities and risks is limited. Using the SEC Form PF data, this discussion examines the financial stability risks that private credit funds can pose through their use of financial leverage or through liquidity transformation.¹ The analysis suggests that such risks are likely limited. While private credit funds have grown rapidly since the 2007–09 financial crisis and the assets they hold are mostly illiquid, the funds typically use little leverage, and investor redemption risks appear low. However, the sector remains opaque, and it is difficult to assess the default risk in private credit portfolios.

Since the 2007–09 financial crisis, private credit funds have experienced substantial growth, as the privately negotiated loans that they extend have become an increasingly important source of credit for some businesses, particularly middle-market companies.² As of 2021:Q4, their assets under management (AUM) stood at $1 trillion, and the estimated "dry powder" (committed but uncalled capital) amounted to $228 billion (figure A).³ The industry grew further in 2022, according to private-sector estimates.⁴ Over the past decade, private credit fund assets grew faster than leveraged loans (at annual rates of 13 percent and 10 percent, respectively) and as of 2021:Q4 were similar in size to the volume of outstanding leveraged loans and U.S. high-yield bonds (approximately $1.4 trillion and $1.5 trillion, respectively).

Figure A. Private credit fund assets and dry powder

Private credit funds follow a diverse set of investment strategies and invest in loans with varying characteristics. Direct lending funds are the largest category of private credit funds in terms of assets. These funds hold senior secured, unrated, floating-rate loans to middle-market companies. Some private credit funds invest in loans that are categorized under a broad class of credit opportunities. For instance, distressed credit funds lend to businesses experiencing liquidity problems or invest in deeply discounted debt. Regardless of strategy, the loans held by private credit funds appear largely illiquid, with their valuations not based on prices readily available in active markets.⁵

Investors in private credit funds are diversified institutional investors and high-net-worth individuals (figure B). Based on Form PF, as of 2021:Q4, public and private pension funds held about 31 percent ($307 billion) of aggregate private credit fund assets. Other private funds made up the second-largest cohort of investors at 14 percent ($136 billion) of assets, while insurance companies and individual investors each had about 9 percent ($92 billion). Given the rapid growth of private credit funds, these investors are increasingly indirectly exposed to the liquidity and credit risks of assets in private credit fund portfolios.

Figure B. Shares of private credit fund assets held by different
investors

Financial stability risks associated with investor redemptions from private credit funds appear low. Most private credit funds have a closed-end fund structure and typically lock up the capital of their investors (that is, limited partners) for 5 to 10 years. Those funds that are structured as hedge funds routinely restrict share redemptions of their investors through redemption notice periods, lockups, and gates.⁶ Thus, private credit funds engage in limited liquidity and maturity transformation.

Although private credit funds are not runnable themselves, they can pose liquidity demands on their investors in the form of capital calls, the timing of which investors do not control.⁷ Generally, investors have 10-day notice periods to provide capital when called, though notice periods may differ across funds. Although most institutional investors would likely be able to manage such capital calls, unanticipated calls may pose a liquidity risk for some investors, potentially forcing them to sell other assets to raise liquidity.

Risks to financial stability from leverage at private credit funds appear low. Indeed, most private credit funds are unlevered, with no borrowings or derivative exposures. A minority of funds, however, use modest amounts of financial or synthetic leverage. Figure C shows that the most levered funds (those at the 95th percentile) have borrowings-to-assets ratios of about 1.27 and derivatives-to-assets ratios of about 0.66. In the aggregate, private credit funds borrowed about $200 billion in 2021:Q4, mainly from U.S. financial institutions, and held about $200 billion of derivative gross notional exposure.⁸ Risks to lenders of private credit funds, typically banks, appear moderate due to the relatively modest amount of borrowings of private credit funds and their secured nature.

Figure C. Leverage ratios of private credit funds

Overall, the financial stability vulnerabilities posed by private credit funds appear limited. Most private credit funds use little leverage and have low redemption risks, making it unlikely that these funds would amplify market stress through asset sales. However, a deterioration in credit quality and investor risk appetite could limit the capacity of private credit funds to provide new financing to firms that rely on private credit. Moreover, despite new insights from Form PF, visibility into the private credit space remains limited. Comprehensive data are lacking on the forms and terms of the financing extended by private credit funds or on the characteristics of their borrowers and the default risk in private credit portfolios.

1. Private credit funds are structured as "private funds"—that is, issuers that would be investment companies according to the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that act. SEC-registered investment advisers with $150 million or more in regulatory assets under management in private funds provide information about their private funds on Form PF. Form PF does not break out private credit funds. To identify private credit funds in Form PF, Board staff (1) name-matched a sample of private credit funds from PitchBook; (2) searched fund names for terms commonly included in private credit fund names (for example, "senior credit" and "mezzanine"); (3) included funds filing as hedge funds on Form PF whose reported strategy allocations were mostly to private credit (based on a keyword search of strategy descriptions); and (4) removed collateralized loan obligations (CLOs), collateralized debt obligations (CDOs), and various types of other funds (for example, equity hedge funds) that were erroneously included in the previous steps. The sample does not include business development companies, CLOs or CDOs, registered investment companies pursuing private credit strategies, or private credit funds that are too small or are not required to file Form PF. Return to text

2. Middle-market businesses are defined by the National Center for the Middle Market at Ohio State University's Fisher College of Business as businesses with annual revenues between $10 million and $1 billion. Return to text

3. For comparison, business development companies, the second-largest class of lenders, managed about $180 billion in assets. Return to text

4. Preqin estimates that the industry's total AUM grew by 8.9 percent in 2022. Return to text

5. The majority of private credit funds' assets rely on values quoted by market participants or estimated by valuation models rather than through real-time transactions; hence, they are classified as Level 2 or 3 under generally accepted accounting principles. Return to text

6. For the purposes of filing Form PF, a private equity fund is a private fund that does not offer investors redemption rights in the ordinary course and is not a hedge fund or one of the other types of funds defined in the form (liquidity fund, real estate fund, securitized asset fund, or venture capital fund). There is no requirement that a private equity fund conduct private equity transactions such as leveraged buyouts. On Form PF, a hedge fund is defined as a private fund whose adviser may be paid a performance fee, can take leverage, and can sell securities short; the definition does not mention investor share restrictions. Return to text

7. It is estimated that, as of 2021:Q4, pensions had $69 billion in uncalled capital commitments to private credit funds, while insurance companies had $23 billion. Uncalled capital (dry powder) is estimated as regulatory AUM (which includes uncalled capital commitments) minus total balance sheet assets. Return to text

8. Form PF has detailed data on derivative exposures for only the relatively small subset of private credit funds filing as qualifying hedge funds. The derivatives exposures of these funds are concentrated in credit default swaps, FX derivatives, and interest rate derivatives. Return to text

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Issuance of non-agency securities by securitization vehicles has slowed

Non-agency securitization issuance—which increases the amount of leverage in the financial system—slowed significantly in 2022 and in the first quarter of 2023 (figure 3.14).¹⁵ In particular, non-agency CMBS issuance volumes were well below their five-year averages. Credit spreads of non-agency securitized products have narrowed since the November report. However, spreads between senior and junior tranches were higher, particularly for those deal types experiencing weakness in underlying credit, such as subprime consumer ABS deals and CMBS. Most securitization sectors exhibited relatively stable credit performance, indicated by low loan delinquency or default rates compared with historical long-term averages. However, delinquencies in non-agency CMBS backed by CRE remained relatively high.

Figure 3.14. Issuance of non-agency securitized products has
slowed significantly since 2021

Bank lending to nonbank financial institutions remained high

The growth in 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, slowed significantly since the November report. Banks' credit commitments to NBFIs grew rapidly in recent years and reached about $2 trillion in the fourth quarter of 2022 (figure 3.15). The year-over-year growth rate in committed amounts to special purpose entities and securitization vehicles was about 40 percent at the end of last year, more than double its growth rate in 2021 (figure 3.16). Banks are also important creditors to nonbank mortgage companies. Nonbank mortgage companies' profitability has come under pressure as mortgage originations have declined; should mortgage delinquencies rise, some of these companies could become distressed and see a reduction in their access to credit. Utilization rates on credit lines to NBFIs remained steady and averaged about 50 percent of total committed amounts. Delinquency rates on banks' lending to NBFIs have been lower than delinquency rates for the nonfinancial business sector since the data became available in 2013. However, the limited information available on NBFIs' alternative funding sources, and the extent to which those sources may be fragile, could contribute to increased vulnerabilities in the financial sector.

Figure 3.15. Bank credit commitments to nonbank financial institutions
remained high

Figure 3.16. Aggregate loan commitments and utilization rates
of nonbank financial institutions increased during 2022 but varied
across sectors

References

8. Net interest margin measures a bank's yield on its interest-bearing assets after netting out interest expense. Return to text

9. In addition, there was a decline in fair value of $28 billion related to securities transferred from AFS to HTM accounts. Return to text

10. See Board of Governors of the Federal Reserve System (2023), Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank (Washington: Board of Governors, April), https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf. Return to text

11. See Federal Deposit Insurance Corporation (2023), FDIC's Supervision of Signature Bank (Washington: FDIC, April), https://www.fdic.gov/news/press-releases/2023/pr23033a.pdf. Return to text

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

13. See Samuel J. Hempel, R. Jay Kahn, Robert Mann, and Mark Paddrik (2022), "OFR's Pilot Provides Unique Window into the Non-centrally Cleared Bilateral Repo Market," The OFR Blog, December 5, https://www.financialresearch.gov/the-ofr-blog/2022/12/05/fr-sheds-light-on-dark-corner-of-the-repo-market. Return to text

14. Between 2018 and March 2020, hedge funds built up large positions in the basis trade, which were then unwound, along with other Treasury trades, in March 2020 and reportedly contributed to Treasury market dislocations at that time. See Ayelen Banegas, Phillip J. Monin, and Lubomir Petrasek (2021), "Sizing Hedge Funds' Treasury Market Activities and Holdings," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, October 6), https://doi.org/10.17016/2380-7172.2979. Return to text

15. 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 (predominantly backed by leveraged loans), ABS (often backed by credit card and auto debt), CMBS, and residential mortgage-backed securities. Return to text

Last Update: May 15, 2023

Financial Stability Report - May 2023