The Role of Leverage in the Current Financial Crisis
THE ROLE OF LEVERAGE IN THE CURRENT FINANCIAL CRISIS
The United States of America is in the middle of the worst financial crisis in more than 75 years. To date, federal regulators and authorities have taken unprecedented steps to stop the complicated situation of the financial services sector by committing trillions of dollars of taxpayer funds to rescue financial institutions and restore order to credit markets. Although the current crisis has spread across a broad range of financial instruments, it was initially triggered by defaults on U.S. subprime mortgage loans, many of which had been packaged and sold as securities to buyers in the United States and around the world. With financial institutions from many countries participating in these activities, the resulting turmoil has affected financial markets globally and has spurred coordinated action by world leaders in an attempt to protect savings and restore the health of the markets.
The buildup of leverage during a market expansion and the rush to reduce leverage or “deleverage,” when market conditions deteriorated was common to this and other financial crises. Leverage traditionally has referred to the use of debt, instead of equity, to fund an asset and been measured by the ratio of total assets to equity on the balance sheet. But, as we can see in the current crisis, leverage also can be used to increase an exposure to a financial asset without using debt, such as by using derivatives. In that regard, leverage can be defined broadly as the ratio between some measure of risk exposure and capital that can be used to absorb unexpected losses from the exposure. However, because leverage can be achieved through many different strategies, no single measure can capture all aspects of leverage. Federal financial regulators are responsible for establishing regulations that restrict the use of leverage by financial institutions under their authority and supervising their institutions’ compliance with such
The United States of America is in the middle of the worst financial crisis in more than 75 years. To date, federal regulators and authorities have taken unprecedented steps to stop the complicated situation of the financial services sector by committing trillions of dollars of taxpayer funds to rescue financial institutions and restore order to credit markets. Although the current crisis has spread across a broad range of financial instruments, it was initially triggered by defaults on U.S. subprime mortgage loans, many of which had been packaged and sold as securities to buyers in the United States and around the world. With financial institutions from many countries participating in these activities, the resulting turmoil has affected financial markets globally and has spurred coordinated action by world leaders in an attempt to protect savings and restore the health of the markets.
The buildup of leverage during a market expansion and the rush to reduce leverage or “deleverage,” when market conditions deteriorated was common to this and other financial crises. Leverage traditionally has referred to the use of debt, instead of equity, to fund an asset and been measured by the ratio of total assets to equity on the balance sheet. But, as we can see in the current crisis, leverage also can be used to increase an exposure to a financial asset without using debt, such as by using derivatives. In that regard, leverage can be defined broadly as the ratio between some measure of risk exposure and capital that can be used to absorb unexpected losses from the exposure. However, because leverage can be achieved through many different strategies, no single measure can capture all aspects of leverage. Federal financial regulators are responsible for establishing regulations that restrict the use of leverage by financial institutions under their authority and supervising their institutions’ compliance with such
Bibliography: Acharya, V. and P. Schnabl. “How Banks Played the Leverage “Game”?” in Acharya, V. and Richardson, M. (Eds.). Restoring Financial Stability: How to Repair a Failed System. John Wiley and Sons. Chapter 2. 2009. Federal Deposit Insurance Corporation (FDIC). Supervisory Insights. From the Examiner’s Desk… Community Bank Leverage Strategies: Short-term Rewards and Long- term Risks. July 16, 2009 Federal Reserve Bank of New York. Assets, Liabilities, and the Leverage of Financial Institutions. July 16, 2009 International Monetary Fund (IMF). “Financial Stress and Deleveraging: Macrofinancial Implications and Policy.” Global Financial Stability Report. Washington, D.C.: October 2008. Leverage. July 16, 2009 < http://www.wikinvest.com/wiki/Leverage> Leverage the Financial Crisis. July 17, 2009 Leverage 101: The Real Cause of the financial Crisis. July 19,2009 United States Government Accountability Office (GAO). Troubled Asset Relief Program: March 2009 Status of Efforts to Address Transparency and Accountability Issues, GAO-09-504 (Washington, D.C.: Mar. 31, 2009).