Board of Governors of the Federal Reserve System

3. Leverage in the Financial Sector

While the overall banking system remains sound, declines in the fair value of assets at some banks remained sizable and leverage at some nonbanks continued to be somewhat elevated

Measures of regulatory capital for banks increased over the first half of the year and remained solid. Nevertheless, declines in the fair value of fixed-rate assets have been sizable relative to the regulatory capital at some banks, especially for a subset of large (but non–global systemically important) banks and regional banks. Outside the banking sector, leverage at broker-dealers stayed near historically low levels, but limited capacity or willingness of broker-dealers to intermediate in Treasury markets during periods of stress remained a concern for liquidity in these markets. Hedge funds continued to operate with somewhat elevated leverage, and their exposures are difficult to monitor due to lags in existing data.

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

Bank profitability remained robust amid further declines in the fair value of some assets held on banks' balance sheets

Amid the considerable increase in interest rates over the past year and a half, the overall banking sector remained profitable. Net interest margins, which measure banks' yield on their interest-earning assets after netting out interest expenses, remained relatively constant in the aggregate, reflecting higher interest income on floating-rate loans coupled with interest expense on many deposits that remained well below market rates (figure 3.1). However, pressures to raise deposit rates to compete with higher-yielding alternatives to bank deposits as well as banks shifting to more expensive alternative sources of funding may continue to affect profit margins for some banks.

Higher interest rates also substantially affected the fair value of banks' existing holdings of fixed-rate assets over this period. At the onset of the coronavirus pandemic, when longer-term interest rates were low relative to current levels and banks experienced sizable inflows of deposits, banks invested heavily in fixed-rate long-duration securities—primarily U.S. Treasury securities and agency-guaranteed mortgage-backed securities. As interest rates rose over the past year and a half, the fair value of these securities declined. As of the end of the second quarter of 2023, banks had declines in fair value of $248 billion in available-for-sale (AFS) portfolios and $310 billion in held-to-maturity portfolios (figure 3.2).

Policy interventions by the U.S. Department of the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation played a key role in mitigating the stresses in the banking system that emerged in March. Since then, a number of banks continued to reduce their holdings of securities, but declines in the fair value of bank securities holdings remained large relative to historical norms.

Banks' risk-based capital increased, but tangible common equity remained below its average over the past decade

The common equity Tier 1 (CET1) ratio—a regulatory risk-based measure of bank capital adequacy—increased during the second quarter of the year across all bank categories and stood around the median of its range since the end of the Great Recession (figure 3.3). Global systemically important banks (G-SIBs) increased their CET1 ratios in the first half of the year as they cut back on stock repurchases.

An alternative measure of bank capital is the ratio of tangible common equity to total tangible assets. The tangible common equity ratio has similarities to the CET1 ratio in that both exclude intangible items such as goodwill from the measurement of capital, but there are also important differences between the two. In contrast with CET1, the tangible common equity ratio does not account for the riskiness of assets, but it does include fair value declines on AFS securities for all banks. The tangible common equity ratio edged up across all bank categories in the first half of the year, especially at G-SIBs (figure 3.4). Nonetheless, it remained at a level well below its average over the past decade, 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.

On July 27, 2023, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation requested comment on a proposal to increase the strength and resilience of the banking system.⁶ The proposal would modify large bank capital requirements to better reflect underlying risks and increase the consistency of how banks measure their risks. The changes would implement the final components of the regulatory reforms introduced in response to the Great Recession. Additionally, following the banking turmoil in March 2023, the proposal seeks to further strengthen the banking system by applying a more stringent set of capital requirements to a broader set of banks, specifically those with more than $100 billion in assets.

Banks' vulnerability to future credit losses appeared to be moderate

Aggregate credit quality in the nonfinancial sector remained solid, and loan delinquency rates remained low overall. However, the quality of outstanding loans worsened in some sectors, as the delinquency rates for consumer and CRE loans—especially those backed by office properties—increased in the first half of 2023. Additionally, borrower leverage for bank commercial and industrial (C&I) loans increased over the same period (figure 3.5). Data from the April and July 2023 SLOOS indicated that banks continued to tighten lending standards on C&I and CRE loans in the first half of 2023 amid concerns about the economic outlook and loan performance (figure 3.6; see also figure 1.16).⁷ In response to a set of special questions about the level of lending standards, banks reported that, on balance, levels of lending standards were on the tighter end of their historical ranges for all loan categories. Meanwhile, banks reported that demand for most categories of loans continued to weaken.

Leverage at broker-dealers remained low

Broker-dealer leverage ratios remained largely flat over the first half of 2023 at near historically low levels (figure 3.7). Dealers' equity growth has generally kept up with the growth of their assets, boosted in part by solid trading profits (figures 3.8 and 3.9). Net secured borrowing of primary dealers increased slightly since the May report, consistent with an increase in net securities positions. Primary dealer Treasury market activities, including market making and repurchase agreements, increased during the first half of 2023.

In the September 2023 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), which covered the period between mid-May 2023 and mid-August 2023, dealers reported that terms under which they facilitated securities and derivatives transactions were largely unchanged for most types of clients.⁸ Additionally, some dealers continued to report that they had increased the resources and attention they devoted to managing their concentrated credit exposure to other dealers and other financial intermediaries over the past three months.

Leverage at life insurers edged up but remained near the middle of its historical range

While leverage at property and casualty insurers stayed low relative to historical norms, leverage at life insurers remained near the middle of its historical range and well below its pandemic peak despite increasing slightly, on net, since the previous report (figure 3.10). Life insurers continued to allocate a high percentage of assets to risky instruments, such as leveraged loans, high-yield corporate bonds, privately placed corporate bonds, and alternative investments. Moreover, insurance companies are large holders of commercial mortgage-backed securities (CMBS), and they also have material exposures to commercial mortgages. A significant correction in commercial property values could lead to credit losses by insurance companies, putting pressure on their capital positions.

Leverage at hedge funds continued to be somewhat elevated

Comprehensive data collected by the Securities and Exchange Commission (SEC) indicate that measures of leverage averaged across all hedge funds remained above their historical norms in the first quarter of 2023. These somewhat elevated levels hold true for both average on-balance-sheet leverage (blue line in figure 3.11)—which captures financial leverage from secured financing transactions, such as repurchase agreements and margin loans, but does not capture leverage embedded through derivatives—as well as for average gross leverage of hedge funds (black line in figure 3.11)—a broader measure that incorporates off-balance-sheet derivatives exposures. Leverage at the largest funds was significantly higher, with the average on-balance-sheet leverage of the top 15 hedge funds by gross asset value rising in the first quarter of 2023 to about 17-to-1 (figure 3.12). These high levels of leverage were facilitated, in part, by low haircuts on Treasury collateral in some markets where many hedge funds obtain short-term financing.⁹ More recent data from the September 2023 SCOOS suggested that the use of financial leverage by hedge funds remained largely unchanged between mid-May 2023 and mid-August 2023 (figure 3.13).

Data from the Commodity Futures Trading Commission (CFTC) Traders in Financial Futures report showed that leveraged funds' short Treasury futures positions increased notably since the beginning of the year. 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—trades that involve the sale of a Treasury future and the purchase of a Treasury security, funded by repurchase agreement, deliverable into the futures contract—and several indicators suggest that the trade likely gained in popularity recently as well. The data from the CFTC Traders in Financial Futures report suggest that the recent growth of the trade could be, in part, attributed to increased demand from asset managers—including mutual funds, pension funds, and other investor types—for exposure to interest rates in the futures market. Because the basis trade is often highly leveraged, a funding shock or heightened volatility in Treasury markets could force leveraged funds to abruptly unwind their positions at potentially distressed prices. This deleveraging could amplify initial disruptions in Treasury markets, possibly impairing market liquidity and market functioning. However, recent SCOOS surveys suggest that these risks are likely mitigated by tighter financing terms applied to hedge funds by dealer counterparties over the past several quarters.

Issuance of non-agency securities by securitization vehicles remained subdued

Non-agency securitization issuance—which increases the amount of leverage in the financial system—was relatively subdued after a notable slowdown since 2022 amid weak demand for loans that are used as collateral in securitization deals (figure 3.14).¹⁰ Credit spreads on major securitized products generally narrowed since the last report but remained relatively wide compared with historical norms. Measures of credit performance across securitized products backed by riskier loan collateral indicated signs of credit deterioration. Specifically, loan delinquency rates in below-prime consumer asset-backed securities deals and leveraged loan downgrades in collateralized loan obligations increased. Loan delinquency rates in non-agency CMBS deals remained relatively low, on average, but rose for deals backed by office properties.

Bank lending to nonbank financial institutions remained high

Bank lending to nonbank financial institutions (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, resumed growing in the second quarter of 2023 (figure 3.15). The year-over-year growth rate in committed amounts was largely due to loans to special purpose entities and securitization vehicles, which grew about 25 percent at the end of the second quarter of 2023 (figure 3.16). 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. Because NBFIs rely primarily on their bank credit lines to meet their liquidity needs, loan commitments can experience sudden, correlated drawdowns. These drawdowns could be material relative to banks' available buffers of high-quality liquid assets (HQLA) and thus could generate liquidity pressures at large banks during times of financial stress. More generally, information on NBFIs' alternative funding sources, and the extent to which those sources may be fragile, is limited, and this lack of data could mask additional vulnerabilities in the financial sector.

 

References

 

6. See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (2023), "Agencies Request Comment on Proposed Rules to Strengthen Capital Requirements for Large Banks," joint press release, July 27, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230727a.htm. Return to text

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

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

9. Ayelen Banegas and Phillip Monin (2023), "Hedge Fund Treasury Exposures, Repo, and Margining," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, September 8), https://doi.org/10.17016/2380-7172.3377. 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 collateralized loan obligations (predominantly backed by leveraged loans), asset-backed securities (often backed by credit card and auto debt), CMBS, and residential mortgage-backed securities. Return to text