Real Leverage

Real and reported leverage

In the esoteric world of financial markets why is leverage so important? Because for banks it’s the very thing that can increase the magnitude of profits. That’s very attractive if your remuneration is linked to these profits. But excessive leverage increases the probability of bankruptcy. The cost of which is not borne by those who benefit in the good times. Few would dispute this is a conflict of interest. The problem is that restricting leverage is notoriously difficult. There is a world of difference between reported leverage and real leverage. Let’s see why.

Leverage is sometimes referred to as gearing. If you ride a bicycle you will be familiar with the principle. Pedaling at the same rate and selecting a higher gear increases speed. But you work harder. This can also be applied to financial markets. But here leverage really is far less straight forward. 

In simple terms a business with $100 of equity and $200 of debt has a leverage ratio of 2:1 or 200%. So what’s the point of leverage? Take a company’s operating profit, deduct the interest and taxes and you have the sum due to shareholders. So if a company borrows to invest in its business and as a result increases profit, more is available to the equity owners. Earnings per share rise and in theory so should the stock value. This sounds good. A company could increase its leverage and improve the stock holder’s return. But it’s not without risk. Higher leverage implies higher interest costs. These must be met before dividend payments. Failure to do so risks bankruptcy. Leverage is therefore a double edged sword. It increases the possibility of both risk and return. 

How dealers leverage 

So just how do you get leverage in a dealing room and what are the implications?

Consider a very simple business with just loans and deposits. Borrowed money is lent out. There are three main ways dealers can turn a profit.

The first is borrowing short term and lending long term. After hedging any interest rate mismatches the dealer is left with a liquidity premium that is booked to the P&L. Only if the funding cannot be refinanced at an acceptable rate will the dealer lose. 

The second is by taking market risk. If the dealer lends at a fixed rate and borrows at a variable rate falling interest rates will lead to gains.

The third is by taking credit risk. By investing in more risky assets the dealer will pick up the credit spread. This is booked to the P&L. Only if the investment defaults will the dealer lose a proportion of capital.

So how much capital supports these activities? On the face of it none! It’s all borrowed money but that’s not the end of the story. The bank will have capital in the form of equity and reserves. How much is being used by the dealer?

Capital ratios 

In simple terms under the original Bank of International Settlements capital requirements if the dealer lent $10m to a company the capital requirement was:

$10m x 100% x 8% = $800,000

If the loan was to another bank the amount was:

$10m x 100% x 8% x 20% = $160,000

In effect regulators said “We are concerned that banks may over leverage themselves and create systemic risk. To prevent this we will insist on an appropriate capital adequacy ratio. When a bank does business it must put aside capital to support that business and cover any loss that it may incur on that business”.

In theory this caps the amount of leverage the bank can take. Every $1 capital could support $12.5 of corporate loans or $62.5 of bank loans. But does it cap risk taking?

No! The bank could decide to increase market risk in its trading books. The bank could ignore the credit risk and buy more risky assets. The bank could borrow even shorter term money and lend for longer periods. This is precisely what happened but when you add relatively recent innovations the gap between real and reported leverage widened. Why is this?

Derivatives 

One of the big problems with borrowing and lending is that you need cash to do it. And if you want to benefit from leverage cash just complicates the process. Surely there is a limit on how much you can safely borrow? Why not use derivatives instead?

In the 1980s and 90s it was assumed derivatives allowed the efficient hedging of risk and thereby made the financial system safer. In the following decade reality was that derivatives far from being used to reduce risk were in many cases being used to substantially increase it.  

Traders, under pressure to make money, incentivised with bonuses, decided derivatives were the answer. A bet on markets needs almost no cash. Furthermore the regulatory capital requirements for trading books were low (after all in the world of mark-to-market losses were immediate and value at risk hadn’t been challenged). Facilitated by derivatives trading the real leverage of trading books was much greater than the reported leverage.  It’s just what you needed in a rising market.

Structured credit

At the same time structured credit provided more opportunities. The process of slicing loan portfolios into low, medium and high risk tranches made it easier to confuse real and reported leverage. Using the new capital models and historic data it was  now possible to show that holding the triple AAA tranches required negligible capital. After all the credit risk was virtually nil wasn’t it? The real leverage simply goes unnoticed.

Off balance sheet financing

Buy selling structured credit assets to a specially incorporated company banks went a step further. The triple AAA assets in the company had a duration of 3 to 5 years. By financing them with short term commercial paper carrying an A1/P1 rating, banks went full circle. Borrowing short and lending long only this time it’s not on the banks books is it? Well that depends. If the assets defaulted can the originating bank walk away? Not if it has a legal obligation to fund the venture in times of stress. But until that happens the assets aren’t on the bank’s balance sheet. It’s just another opportunity to increase risk without a commensurate rise in capital. How much risk did sponsoring banks have? We didn’t know so how could you determine the real leverage of their business? 

Helped by relatively low global interest rates and stable economics greed overcame fear. Every year these strategies made money. Requests to increase limits sanctioned further risk taking and even higher real leverage. Banks made profits from their usual activities (maturity transformation, trading and credit intermediation) only this time the degree of leverage being run was under the radar. Only when things fell was it possible to see the extent to which firms were really exposed. The valuation losses and margin calls were far in excess of the capital supporting their businesses.

Leverage ratios 

In this context you can see why leverage is so controversial. Bankers have traditionally employed it but the difference between reported leverage and real leverage surprised everyone. The asymmetry of risk encouraged bank boards to push risk limits.

Apply this to the whole banking system and you have a recipe for risk taking. In good years traders and boards are paid phenomenally well. In bad years they may lose their job. In very bad years the firm may suffer fatal losses only to be picked-up by the tax payer because of the systemic risk they pose.

On the face of it restricting leverage by banks is a “good thing” and it is likely that regulators will apply some form of maximum leverage ratio for banks. But the subjective nature of risk will make it difficult to determine the real leverage of a bank. Those who really know the questions to ask work for the firm and they will continue to benefit from leverage albeit that remuneration may be “deferred”.

First Published by Barbican Consulting Limited 2009