The must-know basics of financial system deleveraging

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The “Great Deleveraging” that never happened: The US debt problem (Part 2 of 5)

(Continued from Part 1)

But over the past six years, the economy has been slowly but steadily reducing the debt burden. And like all myths, there is a kernel of truth. The U.S. financial system has indeed made significant strides in reducing leverage and U.S. banks are better capitalized.

Market Realist – Leverage ratios show you a bank’s ratios of lending to equity. Extremely high leverage usually shows a buildup of immense financial risk, as you saw in the financial crisis of 2008. Lehman Brothers had a leverage ratio as high as 30.7 times in 1 when it was declared bankrupt. Bear Sterns had a leverage ratio of 36 times to 1.

Market Realist – After the financial crisis of 2008, the financial sector was forced to deleverage. The graph above shows how the national financial conditions leverage subindex shot up in 2007–2008 and plummeted after.

The index is constructed to have an average value of zero and a standard deviation of 1 over a period extending back to 1973. Any positive values of the leverage subindex show that the leverage conditions are tighter than average. Negative values show that conditions are looser than average. The above graph shows how the leverage subindex was at its peak in 2007–2008, as conditions were extremely tight, and came down after, showing how deleveraging loosened the conditions.

Excess leverage means an excessive debt burden. During troubled times, that can magnify vulnerability to financial shocks and can even cause banks to go under. Excessive leverage was one of the primary reasons premier financial institutions like AIG, Lehman Brothers, Fannie Mae, and Merrill Lynch collapsed.

Recognizing the need for reform in capital adequacy measures to protect financial institutions from the ill effects of over-leveraging, Basel III norms have introduced a new ratio in their regulations. The leverage ratio, as introduced by Basel III, expects banks to maintain a leverage ratio in excess of 3%. A leverage ratio of 3% means that for every $1 of capital that a bank holds in reserve, it can lend $33.

U.S. regulators have enforced stricter laws than Basel III norms to help deleverage the financial system. As per a new leverage ratio brought into effect by the Federal Deposit Insurance Corp. and the Federal Reserve, the eight biggest systemically important U.S. banks have to maintain a leverage ratio of 5%. FDIC-insured bank subsidiaries need to maintain a leverage ratio of 6% minimum. A leverage ratio of 5% would mean that for every $1 of capital that a bank holds in reserve, the bank can lend only $20. This means a need for higher capital in reserve to meet the requirements.

Market Realist – The graph above shows the leverage ratios of U.S. globally and systemically important banks as of July 2013. These are greatly reduced from the peaks you saw in 2007–2008.

KBW estimated that the eight banks faced a collective shortfall of about $47.7 billion to meet the 5% threshold proposed by the FDIC and the Fed. The Bank of New York Mellon Corp. (BK) would be the worst affected, as it faces the broadest gap as a percentage of its existing capital. The move targets globally and systemically important banks like Bank of America (BAC), Wells Fargo (WFC), JP Morgan Chase (JPM), Citigroup (C), and Goldman Sachs (GS).

Read the next part of this series to see whether this deleveraging is limited to the financial sector.

Continue to Part 3

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