Investment funds’ financial leverage – material and systemic?

Prepared by Emanuele Franceschi, Simon Kördel and Oscar Schwartz Blicke

This box discusses the financial leverage that euro area investment funds take on through repurchase transactions and margin lending. As shown in Article 2, investment funds can take on synthetic leverage using derivatives. Financial and synthetic leverage can both pose risks for financial stability. In addition, investment funds are subject to lighter regulation than banks, and some business models, such as hedge funds, inherently take on more risk and are leveraged by design. In recent years, the footprint of investment funds, and in particular that of hedge funds, has increased considerably.^[1] Therefore, it is important to analyse the extent of the financial leverage that investment funds take on. While Articles 2 and 4 address investment funds’ leverage via repo and synthetic leverage, this box includes margin lending leverage and takes a wider view, beyond alternative investment funds. This box also assesses how systemic leveraged investment funds are, drawing on network analysis.

Repurchase agreements and margin lending represent two types of collateralised loans that allow for leverage to be built up. Repurchase agreements involve a temporary exchange of cash against collateral discounted by a haircut,^[2] with the trade usually reversed within a short period of time. Interest on the borrowed cash is included in the repurchase amount. Margin lending allows a borrower to use a portfolio as collateral to (i) borrow cash, (ii) borrow funds to purchase securities or (iii) borrow securities to sell short through a broker-dealer.^[3] Repo transactions are usually subject to fixed terms. Conversely, margin lending is usually a floating rate loan without a fixed term maturity. In addition, while repo leverage is restricted by haircuts, margin lending leverage is restricted by portfolio margin requirements.

Investment funds’ borrowing has increased over the past two years, with most financial leverage sourced from non-euro area banks in foreign currencies. Investment funds mainly borrow from non-euro area banks, although lender characteristics differs depending on the particular type of fund (Chart A, panel a). Funds borrow slightly more than 53% of their funds through their repo transactions in pounds sterling, about 32% in euro and 14% in US dollars. The significant role of the pound is partly due to the liability-driven investment fund business model, such as those that were at the origin of the September 2022 turmoil. For margin lending, the US dollar is the predominant borrowing currency, accounting for 78% of cash borrowing. For repo transactions, the denomination of the funds borrowed correlates almost perfectly with the denomination of the assets that are used as collateral (correlation of about 0.98), partially offsetting the exchange rate risk.^[4] Highly leveraged funds are therefore a potential channel for the transmission and amplification of external shocks.

Chart A

Investment funds’ lenders and funds’ leverage ratios

a) Borrowing by fund type and by lender sector and jurisdiction

b) Funds’ leverage vs net asset value

Investment funds increasingly lend to euro area banks and could potentially pass on shocks to the banking sector, triggering further instability. With decreasing excess liquidity, a liquidity shock pushing euro area funds to deleverage and cut their lending could affect banks, which in the very short term can only partially replace repo funding, especially from investment funds.^[5]

Overall, financial leverage is low on average, although pockets of high leverage exist in some segments, particularly hedge funds. Leveraged repo borrowing funds have comparatively small net asset values, while margin lending funds show the opposite relationship, albeit at low leverage levels (Chart A, panel b). In addition, lender networks grow with the total amount of borrowing (Chart B, panel a), which may reduce concentration risk. Meanwhile, no fund appears central to the network of borrowing funds and lending counterparties, a situation which further restricts the knock-on effects of excess leverage (Chart B, panel b).

Pockets of high leverage in the non-bank financial intermediation (NBFI) sector warrant close monitoring and further policy work. As investment funds have become more relevant in the financial sector, risk from excessive leverage in investment funds should be closely monitored and addressed. If market stress forces investment funds to deleverage, this could increase counterparty credit risk and amplify asset price movements.^[6] While financial leverage appears modest on average (Chart A, panel b), this analysis shows that it is often sourced in non-euro currencies, from non-euro area lenders, highlighting the risks from external shocks. In addition, investment funds’ herding behaviour may amplify systemic risk. Our results thus underline the need for further work on policies to contain risks from NBFI leverage, such as the efforts currently undertaken by the Financial Stability Board.

Chart B

Centrality measures of repo borrowing and margin lending

a) Funds’ number of lenders vs borrowing volumes	b) Borrower centrality vs number of lenders

References

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Ferrara, F.M., Linzert, T., Nguyen, B., Rahmouni-Rousseau, I., Skrzypińska, M. and Vaz Cruz, L., “Hedge funds: good or bad for market functioning? ”, The ECB Blog, ECB, 23 September 2024.

Fortune, P., “Margin Requirements, Margin Loans, and Margin Rates: Practice and Principles”, New England Economic Review, 2000, pp. 19-44.

Geanakoplos, J., “The leverage cycle”, Cowles Foundation Discussion Paper, No 1715R, January 2010.

Lenoci, F.D., Letizia, E., “Classifying Counterparty Sector in EMIR Data” in Consoli, S., Reforgiato Recupero, D., Saisana, M. (eds.), Data Science for Economics and Finance, 2021, pp. 117-143.