Board of Governors of the Federal Reserve System

3. Leverage in the Financial Sector

Vulnerabilities associated with financial leverage remained notable, reflecting fair value losses on fixed-rate assets for some banks and elevated leverage at some nonbanks

The banking system, overall, remained sound and resilient. Measures of regulatory capital for banks increased over the second half of 2023 and point to the resilience of the banking sector as a whole. Nevertheless, fair value losses on fixed-rate assets remained sizable for some banks, and some banks have concentrated exposures to loans backed by CRE.

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 market stress remained a structural vulnerability. Life insurers continued to take on liquidity and credit risk, while their leverage increased and stood around its median. Measures of hedge fund leverage increased in the third quarter of 2023 to the highest level observed since the beginning of data availability, with the increase driven primarily by the largest hedge funds.

Table 3.1 shows the sizes and growth rates of the 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

Bank profitability remained robust

Amid the considerable increase in interest rates over the past two years, the profitability of the banking sector stayed solid. Banks' average rates on interest-earning assets remained well above the average interest expense rates on liabilities (figure 3.1). That said, interest expenses increased somewhat faster than interest income, reflecting a higher share of interest-bearing deposits on banks' balance sheets and somewhat higher deposit rates. As a result, net interest margins, which measure banks' yield on their interest-earning assets after netting out interest expenses, declined a notch in the aggregate in 2023.

Measures of banks' capital increased, while fair value losses in fixed-rate assets remained sizable for some banks

The common equity Tier 1 (CET1) ratio—a regulatory risk-based measure of bank capital adequacy—increased during the fourth quarter of 2023 across all bank categories (figure 3.2). CET1 ratios for global systemically important banks (G-SIBs) reached the highest levels recorded in the past decade, while CET1 ratios for large non–G-SIBs and other bank holding companies were close to pre-pandemic levels.

Higher interest rates continued to affect the fair value of banks' holdings of fixed-rate assets. As interest rates rose from pandemic lows over the past two years, the fair value of these securities declined, but these declines started to moderate somewhat toward the end of 2023. At the end of the fourth quarter of 2023, banks had declines in fair value of $204 billion in available-for-sale (AFS) portfolios and $274 billion in held-to-maturity portfolios (figure 3.3).

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 does include fair value declines on AFS securities for all banks. The tangible common equity ratio moved up across all bank categories in the second half of the year (figure 3.4). Nonetheless, this ratio remained at a level below its average over the past decade.

Credit quality at banks remained sound overall, despite rising delinquencies in some consumer and commercial real estate loan segments

As of the fourth quarter of 2023, aggregate credit quality in the nonfinancial sector remained sound overall. That said, the quality of outstanding loans worsened in some sectors, as the delinquency rates for credit card, auto, and CRE loans—especially those backed by office properties—increased in the second half of 2023. Exposures in auto and credit card loans remained concentrated in a few large banks. As interest rates increased over the past two years, banks continued to build their allowances for loan losses on credit card and CRE portfolios in anticipation of rising delinquencies. Nevertheless, risks on loans backed by CRE properties remained elevated, and banks with concentrated exposure to this sector are particularly vulnerable.

Borrower leverage for bank commercial and industrial (C&I) loans decreased somewhat since the October report (figure 3.5). Recent SLOOS survey responses indicated that lending standards continued to tighten across most loan categories during the second half of 2023, suggesting that banks were limiting their exposure to this risk. That said, the pace at which standards were tightened has reportedly slowed, especially for C&I loans, as the percentage of banks reporting tightening standards declined relative to the first half of 2023 (figure 3.6).

Leverage at broker-dealers remained low

Risks posed to the financial system by broker-dealer leverage remained low. Despite a small uptick in the fourth quarter of 2023, the leverage ratio stood near historically low levels (figure 3.7), as dealer equity kept up with the continued expansion in assets. Reflecting seasonal trends, end-of-year profits declined, dropping below typical pre-pandemic levels (figure 3.8). The share of fixed income, rates, and credit in trading profits decreased in the most recent data, while the share of equity increased (figure 3.9). Since the October report, net secured borrowing of primary dealers declined somewhat but remained elevated overall and in line with net positions. Dealers' intermediation activity remained broadly stable at elevated levels. That said, insufficient intermediation capacity during periods of stress remained a structural vulnerability in the sector.

In the March 2024 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), dealers reported that terms on securities financing transactions and over-the-counter derivatives remained about unchanged.⁶ Use of financial leverage was also reported to have changed little on net. Additionally, the special questions in the March SCOOS asked about changes in financing terms and market conditions for selected segments of the market for commercial mortgage-backed securities (CMBS) collateralized by office properties. Overall, answers to the special questions point to a tightening of financing terms and weakening of liquidity in the office CMBS market, as collateral quality has weakened and demand for funding has increased.

Life insurers continued to take on liquidity and credit risk, while their leverage remained in the middle of its historical range

In the fourth quarter of 2023, leverage at property and casualty insurers remained near the bottom of its historical distribution, while leverage at life insurers rose and stood around the median of its historical distribution (figure 3.10). Life insurers continued to take on liquidity and credit risk in their portfolios by allocating an increasing percentage of assets to risky and less liquid instruments, such as leveraged loans, high-yield corporate bonds, privately placed corporate bonds, and alternative investments. Further, because insurance companies are large holders of CMBS and have material direct exposures to commercial mortgages, a significant correction in commercial property values could put pressure on their capital positions.

Leverage at hedge funds reached its highest level in available data

Comprehensive data collected through the U.S. Securities and Exchange Commission's (SEC) Form PF indicated that measures of leverage averaged across all hedge funds increased further in the third quarter of 2023, reaching the highest level observed since the beginning of data availability. Leverage increased when measured using either 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—or average gross leverage of hedge funds (black line in figure 3.11), a broader measure that also 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 third quarter of 2023 to about 18-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 funds obtain short-term financing.⁷ More recent data from the March SCOOS suggested that hedge fund leverage flattened out as the use of financial leverage by hedge funds remained largely unchanged between mid-November 2023 and mid-February 2024 (figure 3.13).

As of the third quarter of 2023, data from Form PF showed that net repurchase agreement borrowing, one measure of the Treasury cash-futures basis trade, grew to near historic highs, while data from the Commodity Futures Trading Commission (CFTC) Traders in Financial Futures report also showed leveraged funds' short Treasury futures positions were near historical highs.⁸ Meanwhile, indicators based on data from the first quarter of 2024, including leveraged funds' short Treasury futures positions and a basis trade proxy from Treasury TRACE, suggested the basis trade might have declined from its levels at the end of 2023 but remained elevated. This highly leveraged trade, which involves shorting a Treasury futures contract and purchasing a Treasury note deliverable into that contract, with the note typically financed in bilateral repurchase agreement markets, was popular among hedge funds between mid-2018 and February 2020, and its subsequent unwinding contributed to the Treasury market turmoil in March 2020.

Issuance of non-agency securities by securitization vehicles started recovering in 2024 despite ongoing concerns about commercial real estate

Non-agency securitization issuance—which increases the amount of leverage in the financial system—started to recover in the first three months of 2024 from subdued levels experienced throughout 2023 (figure 3.14).⁹ Credit spreads on most major securitized products generally narrowed since the October report. In the CMBS segment, lower-rated tranche spreads did not decline as much as senior-tranche spreads, likely reflecting ongoing investor concerns on credit risks in CRE loans underlying CMBS deals. Credit performance across securitized products backed by riskier loan collateral continued to show signs of deterioration, indicated by increasing loan delinquency rates or default rates compared with their respective historical averages. This deterioration in credit performance was especially pronounced in CRE-related securitization deals involving office loans as well as certain segments of multifamily loans. Delinquency rates in certain CRE collateralized loan obligations also increased notably.

Bank lending to nonbank financial institutions increased

Bank lending to nonbank financial institutions (NBFIs) can be informative about the amount of leverage used by NBFIs and shed light on their interconnectedness with the rest of the financial system. After remaining flat in the third quarter of 2023, bank credit commitments to NBFIs resumed growing in the fourth quarter (figure 3.15). The year-over-year growth rate in committed amounts was largely due to loans to open-end investment funds and special purpose entities and securitization vehicles, both of which grew about 15 percent over the course of 2023 (figure 3.16). This growth was partially offset by declines in bank credit commitments to real estate investment trusts. Utilization rates on credit lines to NBFIs, which averaged close to 50 percent of total committed amounts, decreased. Delinquency rates on banks' lending to NBFIs continued to decline for nearly all counterparties in the fourth quarter of 2023.

 

References

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

 7. See Ayelen Banegas and Phillip Monin (2023), "Hedge Fund Treasury Exposures, Repo, and Margining," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, September8), https://doi.org/10.17016/2380-7172.3377. Return to text

 8. CFTC data and reports are available on the CFTC's website at https://www.cftc.gov/MarketReports/CommitmentsofTraders/index.htm. Return to text

 9. 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