From Archimedes to Our Days: The Leverage
Leverage is a physical principle discovered by the renowned Greek mathematician Archimedes in the 3rd century BC. In other words, leverage allows the amplification of applied force to lift a weight that would otherwise be too heavy to lift with a single force.
In finance, leverage operates in a similar manner: investors can use it to amplify their gains, just as leverage enables lifting a heavier load. By taking on debt to invest more than they would be able to with their own funds, investors can potentially increase their returns. However, this also entails greater risk, as it amplifies losses as well. The risks associated with excessive leverage have been demonstrated by various crises, such as the one in 2008.
The Biggest Financial Crisis
The 2008 financial crisis is connected to a series of events starting from the 1990s. In 1999, the Glass-Steagall Act was repealed, allowing commercial and investment banks to engage in a wide range of financial activities, including the bundling of subprime loans. With the merger of commercial and investment banks, citizens' savings became a source of funding for banking activities. These savings were used to provide loans, including subprime loans, which were granted to individuals with low creditworthiness or poor credit history. As a result, banks were able to generate significant profits through interest income from subprime loans.
With easy access to credit, many people purchased multiple real estate units, driving up prices. However, when the real estate market began to decline and subprime borrowers could no longer meet their mortgage payments, panic ensued, leading to a full-blown crisis.
The Effects of Bank Leverage and Duration Mismatch
Bank leverage was one of the factors contributing to the subprime crisis. It should be noted that subprime mortgages were packaged into securities known as "Collateralized Debt Obligations" (CDOs) and sold to investors. In the context of the subprime crisis, bank leverage contributed to a significant duration mismatch. Banks had invested in CDOs and other financial instruments tied to subprime loans, which were long-term assets. However, to finance these investments, banks had used customer deposits and other short-term funds, which were short-term liabilities.
This duration mismatch became a problem when the real estate market started to collapse, and subprime borrowers began to default on their mortgages. As the value of collateralized debt obligations plummeted, banks found themselves with low-quality long-term assets and short-term liabilities that needed to be repaid. Banks were unable to quickly sell their deteriorating investments to obtain enough liquidity to cover their short-term loans. This resulted in a chain of defaults and forced asset sales, further fueling the crisis and negatively impacting the entire global financial system.
The Current Scenario
As of this date, the main problem associated with bank leverage still revolves around systemic risk in the financial system. Financial regulatory authorities have sought to address this issue by introducing new measures to limit bank leverage.
However, it is important to recognize that bank leverage is an important financial tool that allows banks to fulfill their crucial role in the economy by providing loans and facilitating investments. The challenge lies in finding a balance between responsible use of financial leverage and mitigating systemic risks. The use of leverage cannot be completely eliminated, as it is the heart of modern finance. In a scenario with a rapid increase in the cost of debt, leverage may no longer be a dream, but can turn into a nightmare. In recent months, some banks have experienced difficulties and even failures due to factors such as rising interest rates or market instability, once again highlighting the risks associated with excessive use of leverage.