Mar 5, 2014

Leverage in financial crises

Leverage is a double-edged sword. One acute edge increases returns and amplifies price bubbles, another enlarges losses. When key financial institutions take on too much leverage, even a seemingly localized financial distress can result in a knock-out effect of the entire financial system.

Panic of 1907
In 1906, the ratio of cash reserves to deposits at trust companies - institutions at the heart of the crisis - was 3 percent (Moen & Tallman,1992). Given that trusts' depositors were not secured by a lender of last resort, the ratio of cash reserves to deposits can be translated into a leverage ratio of 33-to-1. In other words, a 3% withdrawal of deposits would have wiped out trusts' capital and sent them to bankruptcy. In 1907, just before the October stock market crash, the ratio of cash reserves to deposits was 8 percent, translating into a leverage ratio of 12.5-to-1. While the leverage ratio in October was much more conservative than the ratio of 2006, it was too late to contain the rising tide of panic.