What Is the Connection Between Financial Leverage and Risk?
Leverage generally refers to the ratio of total assets and bank capital (owner's equity) in the balance sheet. Leverage is an indicator of the company's liability risk, which reflects the company's ability to repay from the side. The reciprocal of the leverage ratio is the leverage multiple. Generally speaking, the leverage ratio of investment banks is relatively high. Merrill Lynch's leverage ratio was 28 times in 2007, and Morgan Stanley's leverage ratio was 33 times in 2007.
- Advantages of leverage
- The main advantages of introducing leverage as a supplement to capital regulation are:
- The first is to reflect the role of real money contributed by shareholders to protect depositors and resist risks, which is conducive to maintaining the minimum level of capital adequacy of banks and ensuring that banks have a certain level of high-quality capital (common shares and retained profits).
- Second, it can avoid the complexity of weighted risk capital adequacy ratio and reduce capital arbitrage space. The lessons of this financial crisis show that under the framework of the new capital agreement, if commercial banks take advantage of the complexity of the new capital agreement to conduct regulatory arbitrage, it will seriously affect the bank's capital level. Relevant data show that some banks' core capital adequacy ratios and leverage ratios have diverged. At the end of 2008, Credit Suisse's core capital adequacy ratio was 13.1%, but its leverage ratio was only 2.9%; UBS core capital adequacy ratio was 11.5%, and its leverage ratio was only 2.6%. By introducing leverage, you can avoid overly complex measurement issues and control the risks of risk measurement.
- The third is to help control the excessive growth of the bank's balance sheet. Through the introduction of leverage, the scale of capital expansion is controlled within a certain multiple of the bank's tangible capital, which is conducive to controlling the excessive growth of the balance sheet of commercial banks.
- Disadvantages of leverage
- Leverage also has its inherent flaws:
- One is for different risks
- It is precisely based on the above characteristics of the financial institution's balance sheet that when changes in asset prices reflect changes in net assets, financial institutions will actively adjust their net worth. The leverage ratio of financial institutions shows obvious procyclical characteristics: the following figure reflects the correlation between the leverage ratio and total assets of the top five investment banks in the United States. It can be seen that changes in leverage ratios of financial institutions are positively related to changes in balance sheet size.
- Figure a
- Under the interaction of leverage adjustment and asset price changes, the volatility of the financial cycle is easily amplified. When asset prices rise, as financial institutions adopt market-priced accounting methods, balance sheets are strengthened, and leverage ratios are reduced, financial institutions are generally reluctant to hold excessive equity capital (because it will cause earnings per share to fall), they will Efforts to restore the leverage to its original position. Therefore, it is necessary to purchase assets in order to increase the leverage ratio. The increase in demand for assets will cause its prices to rise further (see Figure a). Conversely, when asset prices fall, the leverage ratio rises. At this time, it is necessary to sell assets to reduce the leverage ratio. This behavior may exacerbate the decline in asset prices (see Figure b) [3] .