Board of Governors of the Federal Reserve System

3. Leverage in the Financial Sector

Vulnerabilities associated with financial leverage remained notable

The banking system, overall, remained sound and resilient. Measures of regulatory capital for banks increased further over the first half of 2024, and indicators of profitability were near average levels. However, fair value losses on banks' fixed-rate assets as of the start of November remained sizable, the fair value of banks' assets continued to be sensitive to movements in long-term interest rates, and some banks still had concentrated exposures to loans backed by CRE.

Outside the banking sector, leverage at broker-dealers was stable near historically low levels, but uncertainties around dealers' intermediation capacity during periods of market stress remained a vulnerability to Treasury markets. Life insurers' leverage was little changed and continued to hold a significant share of illiquid and risky assets. In the first quarter of 2024, measures of hedge fund leverage that account for hedge fund size were at or near the highest level observed since the data became available in 2013.

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 solid

Measures of bank profitability over the first half of 2024 were within typical ranges, and third-quarter earnings reports showed that overall profitability remained robust. Banks' average rate on interest-earning assets continued to sit well above the average interest rate paid on liabilities as of the second quarter of 2024 (figure 3.1). The gap between the two rates, known as the net interest margin, narrowed slightly in the first half of 2024 relative to its levels in 2023. The narrowing reflected some further pass-through to bank funding rates of higher rates on short-term instruments that outpaced the pass-through to interest rates on assets.

Measures of banks' regulatory capital increased further

The common equity Tier 1 (CET1) ratio—a regulatory risk-based measure of bank capital adequacy—increased further during the first half of 2024 across all bank-size categories (figure 3.2). CET1 ratios for global systemically important banks (G-SIBs) and for the other bank holding companies group (those not considered G-SIBs or large non–G-SIBs) reached the highest levels recorded in the past decade, while the average CET1 ratio for large non–G-SIBs has surpassed pre-pandemic levels. Third-quarter earnings reports suggest that most banks further increased their regulatory capital positions.

Fair value losses in fixed-rate assets remained sizable, and the sensitivity of the values of those assets to interest rates remained high

As interest rates rose from pandemic lows over 2022 and the first part of 2023, the fair value of banks' fixed-rate assets declined substantially. However, with interest rates leveling off in recent quarters, these declines started to moderate, and fair values were basically flat, on net, during the first half of 2024. At the end of the second quarter of 2024, the fair value of banks' available-for-sale (AFS) and held-to-maturity (HTM) portfolios were below their book values by $203 billion and $308 billion, respectively (figure 3.3).

The tangible common equity (TCE) ratio, which corresponds to the ratio of TCE to total tangible assets, is an alternative measure of bank capital. The TCE 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 the CET1 ratio, the TCE ratio does not account for the riskiness of assets but does include fair value declines on AFS securities for all banks. The TCE ratio moved up across all bank-size categories in the second quarter of 2024, reflecting increased bank capital from retained earnings during this period and a slight improvement in the fair value of the AFS securities portfolio (figure 3.4).

While most banks have reduced their exposure to interest rate risk over the past year, primarily by shortening the average maturity of their securities portfolios, some banks' vulnerability to changes in interest rates remained higher than normal. Interest rates declined significantly in the third quarter but reversed much of that decline in October. As a result, reflecting the continued elevated sensitivity of fixed-rate asset values to interest rates, fair value losses by the beginning of November likely were only modestly below their levels at the end of the second quarter.

Credit quality at banks remained sound overall despite some pockets of concern

By the end of the second quarter of 2024, banks' overall credit quality was sound. Third-quarter earnings showed that credit quality was little changed but that some segments of CRE continued to be a watchpoint. The aggregate bank-loan delinquency rate remained at historically low levels, despite being a notch higher than the record lows observed at the end of 2022. Contributing to the low aggregate delinquency rate are the low delinquency rates on residential real estate and commercial and industrial (C&I) loans. In the case of C&I loans, the quality of the loans is solid, as borrower leverage for all outstanding bank C&I loans is relatively low (figure 3.5) and recent SLOOS responses indicate that, after tightening over most of 2022 and 2023, credit standards for C&I loans have been little changed this year (figure 3.6). However, the delinquency rates for credit card and auto loans are somewhat elevated and increased further in the first half of 2024. Of note, exposures in credit card loans remained concentrated in a few large banks that are subject to regular stress testing and are therefore expected to be better prepared to manage losses in their loan portfolios.

In the aggregate, the delinquency rate on CRE loans held on banks' books was still at historically low levels at the end of the second quarter, especially among regional and community banks. Over the past several quarters, however, delinquency rates at larger banks have been showing a modest upward trend. These increases reflect significant deterioration in the credit quality of certain components of some banks' CRE portfolios. Most notably, delinquency rates in CRE loans backed by office properties increased further at large banks in the first half of 2024, as the adjustment to new patterns of work continued to put downward pressure on prices and operating income of office buildings. The delinquency rate on CRE loans backed by multifamily properties has remained low, reflecting the conservative CRE bank lending standards of recent years, but developments in this sector also pose some concern, as rental market fundamentals, such as vacancy rates and rent growth, have been deteriorating. The Supervision and Regulation Report discusses ways that supervisors are monitoring and addressing these risks with banks.⁸

Leverage at broker-dealers remained low

Risks posed to the financial system by broker-dealer leverage remained low on balance. Despite ticking up in recent quarters, the ratio of assets to equity stood near historically low levels by the end of the first half of 2024, as dealers increased equity to keep up with an expansion in assets (figure 3.7). Dealers' profits were up year-over-year and were slightly above pre-pandemic levels (figure 3.8). The most recent data on broker-dealers' trading profits continued to show a relatively even distribution of the shares of profits coming from equity; fixed income, rates, and credit; and other lines of business (figure 3.9). Dealers' intermediation activity increased to record highs, driven mainly by higher Treasury positions and secured financing amid rising volumes of outstanding Treasury securities and elevated Treasury issuance. Nonetheless, during periods of market stress, broker-dealers may not be able to meet increased intermediation demand, as their capacity to intermediate may become reduced due to internal risk limits, a factor that has been a structural vulnerability for the Treasury market.

In both the June and September 2024 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), dealers reported that use of financial leverage and terms on securities financing transactions and over-the-counter derivatives remained approximately unchanged.⁹ Responses to special questions in the June survey indicated that most dealers increased capacity to provide financing collateralized by Treasury securities in the past two years. Those moves responded to increased demand for Treasury financing from customers, and dealers expect those demands to increase further in the near future. For those dealers offering the enhanced service of immediate execution in Treasury securities markets, about half responded that they increased their capacity during the same period, while the other half kept their capacity unchanged. For the September SCOOS special questions, respondents indicated significant use of volatility strategies and products across most client classes, most notably by hedge funds. In terms of net positions, hedge funds tended to have a net-long volatility exposure, whereas mutual funds and exchange-traded funds tended to have net-short volatility positions.¹⁰ The use of net-short volatility strategies has the potential to make volatility artificially lower during calmer times and amplify large volatility shocks due to funds quickly unwinding their positions to limit their losses.

Insurance company leverage was little changed

Relative to the previous report, leverage at life insurers moved sideways and continued to be above average relative to the values that prevailed in the previous 15 years, while leverage at property and casualty (P&C) insurers remained at historically low levels (figure 3.10).¹¹ Life insurers continued to allocate a substantial percentage of assets to risky and less liquid instruments, such as leveraged loans, collateralized loan obligations (CLOs), high-yield corporate bonds, privately placed corporate bonds, and alternative investments. Moreover, life insurance companies have material direct exposures to commercial mortgages and are large holders of commercial mortgage-backed securities (CMBS). This exposure to illiquid and risky assets makes life insurers vulnerable to an array of adverse shocks, including that of an economic downturn or of a significant further deterioration of the CRE market.

Hedge funds' leverage was at or near its highest level in available data

Comprehensive data collected through SEC Form PF indicated that measures of leverage averaged across all hedge funds were at or near the highest level observed since these data became available in 2013. Relative to the previous report, 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, but which does not account for netting of offsetting exposures. On-balance-sheet leverage at the largest funds remained elevated at about 15-to-1 in the first quarter of 2024, despite having declined in the most recent reading (figure 3.12). Leverage for the group of hedge funds ranked 15 to 50 increased notably in the first quarter of 2024, with their ratio reaching around 10-to-1, a level that is at the high end of the range since 2013. Small haircuts on Treasury collateral in some markets where many funds obtain short-term financing contributed to these high levels of leverage.¹² More recent data from the September SCOOS suggested that hedge fund leverage was stable, on net, as dealers reported the use of financial leverage by their hedge fund clients remained largely unchanged between May and August 2024.

Of note, about one-fourth of dealers reported in the SCOOS that leverage at trading real estate investment trusts (REITs) had increased somewhat between May and August (figure 3.13).¹³ While this development warrants monitoring, the relatively small size of the trading REIT sector should limit spillovers from this sector to broader financial markets.

The high level of leverage of hedge funds partly reflects elevated U.S. Treasury cash-futures basis trading activity

As of the first quarter of 2024, data from Form PF showed that net repurchase agreement borrowing, one measure of the Treasury cash-futures basis trade, edged down but still stood near historical highs. Two other indicators, the leveraged funds' short Treasury futures positions and a basis trade proxy from Treasury TRACE, also declined in the first quarter but then showed leverage increasing again between April and September.¹⁴ This highly leveraged trade 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. This trade was popular among hedge funds between mid-2018 and February 2020, and its subsequent unwinding contributed to the Treasury market turmoil in March 2020.

The volatility spike in early August, discussed earlier in the report, did not appear to have led to a significant unwinding of the basis trade. Instead, that spike appeared to be related to some highly leveraged hedge funds having to quickly deleverage other positions, largely to meet internal volatility targets rather than because of margin or funding pressures from creditors. During this event, liquidity in the Treasury market, as well as in other markets, deteriorated markedly, but market conditions improved rapidly following favorable data releases the following week. Nevertheless, this episode showed once again how high leverage can amplify adverse shocks.

Issuance of non-agency securities was strong

Non-agency securitization issuance—which increases the amount of leverage in the financial system—was strong in the first three quarters of 2024 and was on pace to reach the second-highest level observed in the past 15 years (figure 3.14).¹⁵ Credit spreads on most major securitized products generally decreased since the April report. The declines in the spreads were most pronounced for lower-rated tranches of CMBS deals, which suggested some improvement in investor sentiment regarding CRE. However, credit performance across securitized products backed by riskier loan collateral generally showed signs of further deterioration. For instance, the loan delinquency rate in CMBS deals continued to increase, standing at close to 4.5 percent at the end of August. For consumer asset-backed securities (ABS) deals, the delinquency rate for auto ABS deals continued to trend up for both prime and subprime borrowers. Similarly, the loan delinquency rate on credit card ABS deals increased, on balance, since the April report, standing at the end of August at just over 1.5 percent.

Bank lending to nonbank financial institutions increased slightly

Bank lending to nonbank financial institutions (NBFIs) can be informative about the amount of leverage used by NBFIs and shed light on the interconnectedness of these financial institutions with the banking system. After the strong growth of 2021 and 2022, the four-quarter growth rate of bank credit commitments to NBFIs stepped down substantially in 2023, and a similar lower pace of growth was observed through the end of the second quarter of 2024 (figure 3.15). The four-quarter growth in committed amounts was largely due to loans to structured finance vehicles—such as SPEs, CLOs, and ABS—and to open-end investment funds (figure 3.16). This growth was partially offset by declines in commitments to financial transactions processing and in commitments to REITs. Delinquency rates on banks' lending to NBFIs continued to be very low, but they have increased for real estate lenders and lessors in the second quarter of 2024 relative to 2023.

 

References

 

 8. The most recent Supervision and Regulation Report is available on the Federal Reserve Board's website at https://www.federalreserve.gov/publications/supervision-and-regulation-report.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. Buying volatility, or taking long positions in volatility, refers to taking positions that increase in value when volatility increases. Selling volatility, or taking short positions in volatility, refers to taking positions that decrease in value when volatility increases. Return to text

 11. The steep decline of P&C insurers' leverage in the second quarter results from AIG, which is considered a P&C insurer in our sample, having spun off its life insurance business in June. Return to text

 12. 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, September 8), https://doi.org/10.17016/2380-7172.3377, or Samuel Hempel, R. Jay Kahn, Robert Mann, and Mark Paddrik (2023), "Why Is So Much Repo Not Centrally Cleared?" OFR Brief 23-01 (Washington: Office of Financial Research, US Department of the Treasury, May 12), https://www.financialresearch.gov/the-ofr-blog/2023/05/12/why-is-so-much-repo-not-centrally-cleared/. Return to text

 13. A trading REIT, also known as a mortgage REIT, is a company that invests in mortgage-related assets such as mortgages, mortgage-backed securities, and mortgage servicing rights. A company that elects to be taxed as a REIT receives favorable tax treatment in exchange for concentrating its investments in real estate–related assets and distributing most of its taxable income to shareholders. Return to text

 14. For a discussion of the net repurchase agreement, Treasury futures, and TRACE proxy measure of the Treasury cash-futures basis trade, see Jonathan Glicoes, Benjamin Iorio, Phillip Monin, and Lubomir Petrasek (2024), "Quantifying Treasury Cash-Futures Basis Trades," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, March 8), https://www.federalreserve.gov/econres/notes/feds-notes/quantifying-treasury-cash-futures-basis-trades-20240308.html. Data and reports on Treasury futures positions are available on the Commodity Futures Trading Commission's website at https://www.cftc.gov/MarketReports/CommitmentsofTraders/index.htm. 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 CLOs (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