Banking: Introduction to Leverage

This article explains the concept of leverage from a bank's perspective. It talks about what leverage is, and why it is good and bad. It also explains the relation between leverage and insolvency.

Leveraging is a key part of banking. Banks enable leveraging for individuals and institutions. Leverage is also called gearing. Leverage simply means how much of their assets are funded through debt. Higher leverage means the debt relative to each dollar of equity is higher.

For example, let’s say a bank has an equity of $300, and total assets of $1000. There is leverage in their balance sheet because they have used the depositors money to give loans to borrowers. One measure of leverage is Assets:Equity, which is 10:3 in this example.

How much leverage?

How much leverage is desirable then? A firm can avail cheaper funding of its assets by opting for a certain amount of debt. Since debt is tax-deductible, leveraging within limits can be useful for a firm. However over leveraging can prove to be dangerous to a firm. This is especially true when a firm cannot service its debts through its existing cash flow from its assets. This can result in writing off of some part of the equity of shareholders or a complete sell-out of the firm. There is a point beyond which taking debt is dangerous. There is a line beyond which the benefits of tax-advantages overrule the risk of bankruptcy.

Similarly, banks too are leveraged though their gearing is far higher than a firm. If a firm has a leverage ratio of 50:50, debt to equity, in banks it can be as high as 95:5. Banks collect household savings and other surplus funds and provide firms access to these funds, enabling better investment and at reasonable cost. Naturally, there is a risk when banks are so highly leveraged.

In order to counter this risk, governments have regulations about banks maintaining minimum requirements of capital, and liquidity. Banks are expected to maintain risk management measures, audits and several internal controls to monitor their debt/equity ratio.

Measures to Control Leverage

Two of the measures to control leverage are capital adequacy requirements and minimum leverage ratios. Capital adequacy ratio measures if the bank has sufficient capital relative to the risk being undertaken for various business activities. It is measured by dividing the core capital (Tier I and Tier II) of the bank, with its Risk Weighted Assets.

$$