Yet Another Type of Rapidly Growing NDFI Loan
And not the type that's been getting attention of late, but will
I’ve noted that the entirety of U.S. banks’ loan growth this year has gone to nondepository financial institutions (NDFIs) such as broker-dealers, hedge funds, private equity/credit funds, securitization vehicles and subprime auto lenders (link). The recent collapses of Tricolor and First Brands and other NDFI-related loan disclosures (see Zions Bank and Western Alliance) have focused attention on the substantial risks associated with the rapid growth of these types of loans.
That said, these loan problems ultimately involved “real economy” companies selling auto parts, used cars, etc. (As longtime readers know, I’ve been writing about the weakness in the real economy aside from AI spending for over a year.) By contrast, a substantial amount of NDFI lending goes directly to the financial sector via broker-dealers, and that type of NDFI activity has ballooned over the past three years as evidenced by high primary dealer leverage (primary dealers account for a large fraction of the total activity of all securities dealers), record-high margin debt provided by broker-dealers, record-high primary dealer repurchase agreement (repo) lending, and record-high hedge fund borrowing/leverage.
For perspective, banks’ repo loans are growing by ~20% YoY; primary dealers’ repo loans are growing by ~20% YoY; margin debt provided by broker-dealers is growing by ~40% YoY as of September; and hedge fund borrowing has grown at an average rate of 30% YoY over the past two years. While securities financing is growing by 20-40%, the IMF expects U.S. GDP to grow by just 2% this year. Why is one growing wildly disproportionately to the other? It’s apparent that the growth in securities financing has been far more beneficial to asset prices than to the real economy.
Indeed, the buildup in financial sector leverage has likely fueled enormous asset price appreciation post-COVID, with many asset classes at or near record highs. Up to now, the heavy NDFI lending to the financial sector has been a largely virtuous cycle: (1) banks earn a high return on equity on NDFI loans given the low risk weights attached to those loans; (2) private credit firms and hedge funds, among other NDFIs, grow rapidly aided by those loans; (3) the substantial growth of private credit firms and hedge funds pushes up asset prices, which increases the amount of equity that can be leveraged; and (4) higher asset prices and therefore equity creates more demand for NDFI loans. I write “largely” virtuous because the 2021 collapse of the large family office Archegos caused a great deal of damage among banks and broker-dealers (see Credit Suisse), and that episode highlights what can and does happen amid periods of high financial leverage. And the risks that have built up in recent years stemming from mushrooming NDFI lending are apparent to regulators, even if regulators aren’t doing much about them.
At the center of this virtuous cycle has been the U.S. repo market, whose gross size is a whopping $12 trillion according to Fed researchers. I mention it not only because some of banks’ NDFI loans go to broker-dealers that make repo loans (primarily to hedge funds), but also because repo itself is banks’ fastest-growing asset besides NDFI loans. In other words, bank-affiliated broker-dealers have been making a rapidly growing amount of repo loans, and so too are the commercial banks themselves.
As can be seen below, banks’ total asset growth is just over 4% YoY. Excluding NDFI loans and repo, though, asset growth was just 1.1% YoY as of the most recent week. In other words, most of banks’ asset growth is going toward NDFI lending in various forms.
You may be wondering what “fed funds sold & RRPs” are in the charts above. It’s an asset line item in the Fed’s weekly H.8 release called “total federal funds sold and reverse RPs.” It includes fed funds sold to, and reverse repos (RRPs) with, commercial banks, broker-dealers, and others, including the Federal Home Loan Banks (FHLBs). The fed funds market is a small fraction of the size of the repo market, averaging just over $100 billion of daily trading volume this year compared to in excess of $4.5 trillion of overnight and open-dated repo volume; Dallas Fed president Lorie Logan mentioned this a month ago in her case for changing the Fed’s operating target rate (link). The fed funds market is dominated by the U.S. branches of foreign banks borrowing from FHLBs to capitalize on an interest on reserve balances (IORB)-related arbitrage opportunity that the Fed has given them; I wrote about this issue here. Banks also lend in the fed funds market, but at low volumes because they can earn the IORB rate. As Ms. Logan wrote, “FHLBs make the vast majority of fed funds loans…Fed funds loans that redistribute funds between domestic banks are uncommon.”
The key in the last paragraph to understanding the fed funds sold vs. RRPs issue is that foreign banks are borrowing from FHLBs; that’s a liability rather than an asset for the foreign banks in the fed funds market. And as Ms. Logan noted, domestic banks aren’t making many fed funds loans. Consequently, I assume that the bulk of the “total federal funds sold and reverse RPs” asset line item in the H.8 is RRPs.
And why are banks’ repo loans growing by more than 20% YoY? Repo rates are rising as funding conditions tighten (the Fed’s ON RRP facility is effectively down to zero and bank reserves recently fell below $3 trillion, such that the combination of the two is $1.25 trillion lower than at the beginning of 2024), which makes repo lending more attractive. Specifically, repo rates recently rose above IORB, the rate that banks can earn by parking cash at the Fed. The higher repo rates go, the more expensive it becomes for broker-dealers and by extension hedge funds to finance their securities trades. In other words, asset price/financial speculation becomes more expensive.
Virtuous cycles in financial markets have a limited shelf life, as we’ve seen on many occasions. The rapid growth in repo & margin lending/securities financing will turn into the opposite, with predictable effects on asset prices.
The content in As the Consumer Turns newsletters should not be construed as investment advice offered by Adam Josephson. This market commentary is for informational purposes only and is not meant to constitute a recommendation of any particular investment, security, portfolio of securities, transaction or investment strategy. The views expressed in this commentary should not be taken as advice to buy, sell or hold any security. To the extent any content published as part of this commentary may be deemed to be investment advice, such information isn’t tailored to the investment needs of any particular person. No chart or graph provided should be used to determine which securities to buy or sell.