JPMorgan Chase, Wells Fargo, Bank of America and other systemically important U.S. banks are now financing $2.423 trillion in leveraged bets on Wall Street, according to new industry self-reported figures.
The Financial Industry Regulatory Authority (FINRA) says major banks’ total margins to hedge funds have hit a new record, according to data from March 2013.
Both US and foreign banks provide a high degree of leverage in US markets, with foreign systemically important banks financing an additional $1.544 trillion in margin debt.
Margin debt played a major role in the 2008 financial crisis, as shown in a 2014 study by the Federal Reserve Bank of San Francisco.
“Hedge funds are perhaps the most important transmitters of shocks during crises, more important than commercial banks or investment banks…
Hedge funds are opaque and have high leverage. If highly leveraged hedge funds are forced to liquidate assets at sales prices, these asset classes could suffer heavy losses. This could lead to further defaults or threaten systemically important institutions, not only directly as counterparties or creditors, but also indirectly through asset price adjustments.
One channel for this risk is the so-called loss and margin spiral. In this scenario, a hedge fund is forced to liquidate assets to raise cash to meet margin calls. The sale of these assets increases the supply in the market, causing prices to fall, especially when market liquidity is low. This in turn leads to higher margins on other financial institutions, creating a downward spiral.”
Lawmakers have addressed margin debt in several ways in the wake of the 2008 financial crisis.
New legislation imposed stricter leverage and capital requirements on banks, while limiting their ability to trade on their own account using their own capital.
In addition, the Dodd-Frank Act required financial firms to use clearinghouses that provide collateral and act as intermediaries on both sides of the transaction, a process designed to increase transparency and reduce the risk of one party defaulting .
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