Monday, May 05, 2008

Leveraged Banking

I have just read an article by David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil K Kashyap (University of Chicago), Hyun Song Shin (Princeton) called Leveraged Losses: Lessons from the Mortgage Market Meltdown. Their estimate that total mortgage credit losses will be about $US400 billlion has become the accepted wisdom. I was more interested in what they have to say about leverage.

The balance sheet perspective gives new insights into the nature of financial contagion in the modern, market-based financial system. Aggregate liquidity can be understood as the rate of growth of aggregate balance sheets. When financial intermediaries’ balance sheets are generally strong, their leverage is too low. The financial intermediaries hold surplus capital, and they will attempt to find ways in which they can employ their surplus capital. In a loose analogy with manufacturing firms, we may see the financial system as having “surplus capacity”. For such surplus capacity to be utilized, the intermediaries must expand their balance sheets. On the liabilities side, they take on more short-term debt. On the asset side, they search for potential borrowers that they can lend to. Aggregate liquidity is intimately tied to how hard the financial intermediaries search for borrowers. With regard to the subprime mortgage market in the United States, we have seen that when balance sheets are expanding fast enough, even borrowers who do not have the means to repay are granted credit - so intense is the urge to employ surplus capital. The seeds of the subsequent downturn in the credit cycle are thus sown.
I cannot understand why we want a financial system based on leverage. It does not have to be that way. See Money.

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