Financial Fuss (10) - Leverage

Modern banks are highly leveraged. This has been normal practice since central banks became normal last century. Central banks are supposed to protect depositors, so most governments have allowed capital asset ratios to fall dramatically. Modern banks have capital asset ratios less than 8 percent. Some European banks have ratios as low as 2 percent. This was great for profits during the boom years, but the chickens are now coming home to roost.

Capital or shareholders equity provides a buffer if things go wrong. If borrowers default on loans, the hit is on bank capital. If a bank faces defaults on loans that are greater than its capital, it becomes insolvent, with loans exceeding deposits. When loan defaults exceed bank capital, deposits are eroded and the bank collapses. Many modern banks simply do not have sufficient capital to absorb the losses that they currently face.

Banks prefer to be highly leveraged, because this boosts profits. High leverage amplifies profits. High leverage also amplifies the losses. Strong capital is the best protection for depositors, but that has been forgotten.