Fed Flags Hedge Fund Borrowing as a Vulnerability in Financial System

Federal Reserve Chair Jerome Powell. (Alex Wong / Getty Images)

Key Points

• Hedge-fund leverage is at its highest level since regulators began tracking data over a decade ago.
• The Federal Reserve noted increased leverage across various strategies, supporting significant positions in markets like Treasury securities and equities.
• Total hedge fund assets reached $12.5 trillion in the first quarter, with an average annual growth rate of 8.7% since 1997.

Leverage among hedge funds is the highest it has been since regulators started tracking the data more than a decade ago, a dynamic the Federal Reserve noted Friday as part of a broader set of vulnerabilities it is monitoring within the U.S. financial system.

The central bank said while the banking system “remained sound and resilient,” risks tied to financial leverage levels were notable. It pointed specifically to borrowing by hedge funds and life insurers.

“The use of leverage over the past couple of years has increased across a range of strategies and supported significant positions in key markets, such as Treasury securities, interest rate derivatives, and equities,” the report said. The largest funds were generally the most leveraged, it said.

It is common for sophisticated hedge funds to borrow money in order to build up big bets across asset types and markets. Doing so can help to boost returns.

But funds unwinding those large positions have the power to move markets and amplify swings in asset prices. That creates a risk that moves by one fund can lead to broader market volatility and losses.

Total hedge fund assets in the first quarter stood at $12.5 trillion, the Fed noted, while bank and credit union assets were $28.6 trillion as of the second quarter. Hedge funds’ and banks’ overall assets have grown at an average annual rate of 8.7% and 5.5% since 1997, respectively.

The report was based on hedge fund borrowing in the first quarter of 2025. It drew on public data available since 2013, when the Securities and Exchange Commission started recording hedge funds’ activity through what is known as “Form PF,” for private fund.

The Fed noted elsewhere in its report that banks’ lending to nonbank financial institutions “continued to grow at a robust pace.”

That type of lending—it refers to banks’ loans to entities as varied as private-equity firms, mortgage lenders, and real estate investment trusts—has come under intense scrutiny. This year, two high-profile bankruptcies spooked investors as they contend with the increasingly intertwined worlds of banking and private capital.

The collapses of subprime auto lender Tricolor Holdings and the large auto-parts supplier First Brands “so far appear to be isolated events,” the Fed said Friday in its report, without referring to them by name.

Still, the report said, “these examples highlight that unexpected losses could arise from opaque off-balance-sheet funding arrangements that may be used by certain privately held firms.”

In 2018, the Fed started publishing reports focused on the financial system’s stability twice per year. The latest one was released in April.

Write to Rebecca Ungarino at rebecca.ungarino@barrons.com