The Fed Board of Governors released the May Financial Stability report to give a status update on the resilience of the financial system today. There is one section in particular, “Leverage in the Financial Sector”, that paints a tale of two sectors: the financial and non-financial and their differences in leverage.
Currently, banks and bank holding companies are roughly 11% equity financed. This figure is up from past decades, put is still far below the estimated optimum of around 20%. Even so, the Fed’s report is optimistic at this decline in leverage:
Leverage at financial firms remained low relative to historical levels, as regulatory reforms enacted after the financial crisis continue to support the resilience of key financial institutions . Regulators require that banks—especially the largest banks—meet much higher standards in the amount and quality of capital on their balance sheets and in the ways they assess and manage their financial risks.
It is interesting to compare this decrease in bank leverage to non-banks (sometimes called the “real economy”).
As the above chart shows, firms that borrow from the largest banks have seen a steady rise in their debt relative to assets at the same time those large banks have de-leveraged. Though the rise in leverage in non-bank firms is something to keep an eye on, the degree of leverage is still dwarfed by that of the financial sector.
The Fed seems comfortable with the current leverage of the financial sector, so the rise in business leverage isn’t necessarily indicative of any larger systematic threats.
It’s difficult to imagine a system where banks aren’t more leveraged than their counterparts in the “real economy,” but the above figure is an important reminder of not only how leveraged the financial sector is in general, but how unique this state of affairs is relative to the rest of the economy.