Leverage

Leverage is the use of borrowed money, or of contracts that behave like borrowing, to hold or control more assets than an investor or institution could pay for with its own capital. A firm that funds a large balance sheet with a small slice of equity can earn a high return on that equity when asset values rise, but it also loses its capital quickly when they fall.

Leverage is closely tied to debt, yet the two are not the same: debt is the obligation, while leverage describes how large positions are relative to the capital that absorbs losses. Leverage can also be built without a loan, through derivatives such as futures and swaps. Regulators watch it because highly leveraged firms are the ones most likely to be forced into fire sales during a crisis.

Think of buying a house with a small down payment. If you put in a tenth of the price and borrow the rest, a modest rise in the house's value can double your own stake. A modest fall, though, can wipe your stake out entirely, and you still owe the lender every penny of the loan.

Financial firms do the same thing on a much larger scale and with assets that change price every second. The borrowed money works like a lever: a small push from the owner moves a heavy weight. The more a firm borrows against each dollar of its own money, the less room it has for mistakes.

Leverage multiplies returns because borrowed funds earn the asset's return while costing only the interest paid on them. When the asset yields more than the borrowing cost, the surplus flows to the equity holders; when it yields less, or loses value, the shortfall comes out of equity first. Common sources of leverage include:

• Bank deposits and bonds. A bank's deposits and wholesale borrowing are its main sources of leverage.
• Secured short-term borrowing. Funds and dealers finance securities through the repurchase agreement (repo) market, pledging the securities as collateral and receiving cash minus a haircut.
• Margin loans. A broker lends against a client's portfolio and issues a margin call if prices fall and the collateral no longer covers the loan.
• Embedded leverage. Options, futures and total return swaps give exposure to a large notional amount for a small upfront payment.

Leverage is measured in several ways, including debt to equity and assets to equity. For banks, the Basel III leverage ratio compares core capital with total exposure, without risk weights:

• $\text{Tier 1 capital}$ is the bank's highest-quality capital, mainly common equity and retained earnings.
• $\text{Total exposure measure}$ adds on-balance-sheet assets, derivative exposures, securities financing transactions and certain off-balance-sheet commitments.

Suppose a bank holds 9 billion dollars of Tier 1 capital against a total exposure of 250 billion dollars. Its leverage ratio is $9 \div 250 \times 100 = 3.6\%$, just above the 3% minimum. A loss of roughly 3.6% on its exposure would consume all of that capital.

Before 2008, bank rules relied mainly on risk-weighted regulatory capital, which let banks build large positions in assets judged low-risk. The Basel Committee on Banking Supervision responded with a simple, non-risk-based backstop in Basel III: a minimum leverage ratio of 3%, published as a standard in January 2014 and now a binding minimum in the consolidated Basel Framework. Global systemically important banks face an additional leverage buffer, and national authorities can set stricter versions, such as the US supplementary leverage ratio.

Leverage outside banks is harder to see and to cap. Hedge funds, investment funds and other parts of non-bank financial intermediation are mostly subject to disclosure and margin rules rather than direct leverage limits, which is one reason supervisors treat leverage as a central concern of macroprudential policy.

High leverage turns ordinary price falls into forced selling. When collateral values drop, lenders raise haircuts or demand more margin, borrowers sell assets to raise cash, and those sales push prices lower still. The pattern has repeated across several episodes:

• Long-Term Capital Management, 1998. The hedge fund ran a balance sheet many times larger than its capital, plus derivative positions with a notional value above 1 trillion dollars. After Russia's default, losses mounted so quickly that the Federal Reserve Bank of New York brokered a 3.6 billion dollar recapitalisation by a group of 14 banks and securities firms in September 1998.
• The 2008 financial crisis. Investment banks and off-balance-sheet vehicles funded long-term mortgage assets with short-term borrowing, so falling house prices quickly became a funding crisis.
• Archegos Capital Management, 2021. A family office built concentrated stock positions through total return swaps with several prime brokers; its collapse in March 2021 left those banks with losses of more than 10 billion dollars combined.

These cases show why leverage matters for shadow banking in particular: the lenders to a leveraged fund can pull funding as fast as depositors run from a bank.

No single leverage figure captures the whole picture. A plain leverage ratio treats a government bond and a risky loan alike, so it can push banks toward riskier assets that earn more per unit of capital. Risk-weighted measures have the opposite weakness, since the weights themselves can be wrong. Derivative and off-balance-sheet exposures are difficult to compare across firms, and leverage that sits with a fund's lenders, rather than the fund, may be invisible to any one supervisor. Analysts therefore read leverage ratios alongside liquidity and funding maturity.

• Bank for International Settlements: Basel III leverage ratio framework and disclosure requirements
• Board of Governors of the Federal Reserve System