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In
finance Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...
, leverage, also known as gearing, is any technique involving borrowing funds to buy an
investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...
. Financial leverage is named after a
lever A lever is a simple machine consisting of a beam (structure), beam or rigid rod pivoted at a fixed hinge, or '':wikt:fulcrum, fulcrum''. A lever is a rigid body capable of rotating on a point on itself. On the basis of the locations of fulcrum, l ...
in physics, which amplifies a small input force into a greater output force. Financial leverage uses borrowed money to augment the available capital, thus increasing the funds available for (perhaps risky) investment. If successful this may generate large amounts of
profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit (real property), a nonpossessory inter ...
. However, if unsuccessful, there is a risk of not being able to pay back the borrowed money. Normally, a lender will set a limit on how much risk it is prepared to take, and will set a limit on how much leverage it will permit. It would often require the acquired asset to be provided as collateral security for the loan. Leverage can arise in a number of situations. Securities like options and futures are effectively leveraged bets between parties where the principal is implicitly borrowed and lent at interest rates of very short treasury bills.Mock, E. J., R. E. Schultz, R. G. Schultz, and D. H. Shuckett, Basic Financial Management (1968). Equity owners of businesses leverage their investment by having the business borrow a portion of its needed financing. The more it borrows, the less equity it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result. Businesses leverage their operations by using fixed cost inputs when revenues are expected to be variable. An increase in
revenue In accounting, revenue is the total amount of income generated by the sale of product (business), goods and services related to the primary operations of a business. Commercial revenue may also be referred to as sales or as turnover. Some compan ...
will result in a larger increase in
operating profit In accountancy, accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit (accounting), profit that includes all incomes and expenses (operating and Non-operating income, non-operating) except interest expense ...
.
Hedge fund A hedge fund is a Pooling (resource management), pooled investment fund that holds Market liquidity, liquid assets and that makes use of complex trader (finance), trading and risk management techniques to aim to improve investment performance and ...
s may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.


History

Before the 1980s, quantitative limits on bank leverage were rare. Banks in most countries had a
reserve requirement Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the Bank reserves, commercial bank's reserve, is generally determined ...
, a fraction of deposits that was required to be held in liquid form, generally precious metals or government notes or deposits. This does not limit leverage. A
capital requirement A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital ...
is a fraction of assets that is required to be funded in the form of equity or equity-like securities. Although these two are often confused, they are in fact opposite. A reserve requirement is a fraction of certain liabilities (from the right hand side of the balance sheet) that must be held as a certain kind of asset (from the left hand side of the balance sheet). A capital requirement is a fraction of assets (from the left hand side of the balance sheet) that must be held as a certain kind of liability or equity (from the right hand side of the balance sheet). Before the 1980s, regulators typically imposed judgmental capital requirements, a bank was supposed to be "adequately capitalized," but these were not objective rules.Ong, Michael K., The Basel Handbook: A Guide for Financial Practitioners, Risk Books (December 2003) National regulators began imposing formal capital requirements in the 1980s, and by 1988 most large multinational banks were held to the Basel I standard. Basel I categorized assets into five risk buckets, and mandated minimum capital requirements for each. This limits accounting leverage. If a bank is required to hold 8% capital against an asset, that is the same as an accounting leverage limit of 1/.08 or 12.5 to 1.Saita, Francesco, Value at Risk and Bank Capital Management: Risk Adjusted Performances, Capital Management and Capital Allocation Decision Making, Academic Press (February 3, 2007) While Basel I is generally credited with improving bank risk management it suffered from two main defects. It did not require capital for all off-balance sheet risks (there was a clumsy provisions for derivatives, but not for certain other off-balance sheet exposures) and it encouraged banks to pick the riskiest assets in each bucket (for example, the capital requirement was the same for all corporate loans, whether to solid companies or ones near bankruptcy, and the requirement for government loans was zero). Work on Basel II began in the early 1990s and it was implemented in stages beginning in 2005. Basel II attempted to limit economic leverage rather than accounting leverage. It required advanced banks to estimate the risk of their positions and allocate capital accordingly. While this is much more rational in theory, it is more subject to estimation error, both honest and opportunitistic. The poor performance of many banks during the
Subprime mortgage crisis The American subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010, contributing to the 2008 financial crisis. It led to a severe economic recession, with millions becoming unemployed and many busines ...
led to calls to reimpose leverage limits, by which most people meant accounting leverage limits, if they understood the distinction at all. However, in view of the problems with Basel I, it seems likely that some hybrid of accounting and notional leverage will be used, and the leverage limits will be imposed in addition to, not instead of, Basel II economic leverage limits.


2008 financial crisis

The
2008 financial crisis The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...
, like many previous
financial crises A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with Bank run#Systemic banki ...
, was blamed in part on excessive leverage. Consumers in the United States and many other countries had high levels of debt relative to their wages and the value of collateral assets. When home prices fell, and debt interest rates reset higher, and business laid off employees, borrowers could no longer afford debt payments, and lenders could not recover their principal by selling collateral. Financial institutions were highly levered.
Lehman Brothers Lehman Brothers Inc. ( ) was an American global financial services firm founded in 1850. Before filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank in the United States (behind Goldman Sachs, Morgan Stanley, and Merril ...
, for example, in its last annual financial statements, showed accounting leverage of 31.4 times ($691 billion in assets divided by $22 billion in stockholders' equity).Lehman Brothers Holdings Inc Annual Report for year ended November 30, 2007
/ref> Bankruptcy examiner Anton R. Valukas determined that the true accounting leverage was higher: it had been understated due to dubious accounting treatments including the so-called
repo 105 Repo 105 is Lehman Brothers' name for an accounting maneuver that it used where a short-term repurchase agreement is classified as a sale. The cash obtained through this "sale" is then used to pay down debt, allowing the company to appear to redu ...
(allowed by
Ernst & Young EY, previously known as Ernst & Young, is a multinational corporation, multinational professional services partnership, network based in London, United Kingdom. Along with Deloitte, KPMG and PwC, it is one of the Big Four accounting firms, Big F ...
). Banks' notional leverage was more than twice as high, due to
off-balance sheet In accounting, "off-balance-sheet" (OBS), or incognito leverage, usually describes an asset, debt, or financing activity not on the company's balance sheet. Total return swaps are an example of an off-balance-sheet item. Some companies may have ...
transactions. At the end of 2007, Lehman had $738 billion of notional derivatives in addition to the assets above, plus significant off-balance sheet exposures to special purpose entities,
structured investment vehicle A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders ...
s and conduits, plus various lending commitments, contractual payments and contingent obligations. On the other hand, almost half of Lehman's balance sheet consisted of closely offsetting positions and very-low-risk assets, such as regulatory deposits. The company emphasized "net leverage", which excluded these assets. On that basis, Lehman held $373 billion of "net assets" and a "net leverage ratio" of 16.1.


Risk

While leverage magnifies profits when the returns from the asset more than offset the costs of borrowing, leverage may also magnify losses. A corporation that borrows too much money might face
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...
or default during a business downturn, while a less-leveraged corporation might survive. An investor who buys a stock on 50%
margin Margin may refer to: Physical or graphical edges *Margin (typography), the white space that surrounds the content of a page * Continental margin, the zone of the ocean floor that separates the thin oceanic crust from thick continental crust *Leaf ...
will lose 40% if the stock declines 20%; also in this case the involved subject might be unable to refund the incurred significant total loss. Risk may depend on the volatility in value of collateral assets. Brokers may demand additional funds when the value of securities held declines. Banks may decline to renew mortgages when the value of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to maintain the ongoing borrowing costs, loans may be called-in. This may happen exactly at a time when there is little market liquidity, i.e. a paucity of buyers, and sales by others are depressing prices. It means that as market price falls, leverage goes up in relation to the revised equity value, multiplying losses as prices continue to go down. This can lead to rapid ruin, for even if the underlying asset value decline is mild or temporary the debt-financing may be only short-term, and thus due for immediate repayment. The risk can be mitigated by negotiating the terms of leverage, by maintaining unused capacity for additional borrowing, and by leveraging only liquid assets which may rapidly be converted to cash. There is an implicit assumption in that account, however, which is that the underlying leveraged asset is the same as the unleveraged one. If a company borrows money to modernize, add to its product line or expand internationally, the extra trading profit from the additional diversification might more than offset the additional risk from leverage. Or if an investor uses a fraction of his or her portfolio to margin stock index futures (high risk) and puts the rest in a low-risk money-market fund, he or she might have the same volatility and expected return as an investor in an unlevered low-risk equity-index fund. Or if both long and short positions are held by a pairs-trading stock strategy the matching and off-setting economic leverage may lower overall risk levels. So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly levered hedge funds have less return volatility than unlevered bond funds, and normally heavily indebted low-risk public utilities are usually less risky stocks than unlevered high-risk
technology Technology is the application of Conceptual model, conceptual knowledge to achieve practical goals, especially in a reproducible way. The word ''technology'' can also mean the products resulting from such efforts, including both tangible too ...
companies.


Definitions

The term leverage is used differently in
investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...
s and
corporate finance Corporate finance is an area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analy ...
, and has multiple definitions in each field.


Accounting leverage

Accounting leverage is total assets divided by the total
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...
s minus total liabilities.Weston, J. Fred and Eugene F. Brigham, Managerial Finance (1969).


Banking

Under
Basel III Basel III is the third of three Basel Accords, a framework that sets international standards and minimums for bank capital requirements, Stress test (financial), stress tests, liquidity regulations, and Leverage (finance), leverage, with the goa ...
,
bank A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...
s are expected to maintain a leverage ratio in excess of 3%. The ratio is defined as :: \frac. Here the exposure is defined broadly and includes
off-balance sheet In accounting, "off-balance-sheet" (OBS), or incognito leverage, usually describes an asset, debt, or financing activity not on the company's balance sheet. Total return swaps are an example of an off-balance-sheet item. Some companies may have ...
items and derivative "add-ons", whereas
Tier 1 capital Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view.By definition of Bank for International Settlements. It is composed of ''core capital'', which consists primarily of common stock and disclosed ...
is limited to the banks "core capital". See


Notional leverage

Notional leverage is total notional amount of assets plus total notional amount of liabilities divided by equity.Brigham, Eugene F., ''Fundamentals of Financial Management'' (1995).


Economic leverage

Economic leverage is volatility of equity divided by volatility of an unlevered investment in the same assets.Bodie, Zvi, Alex Kane and Alan J. Marcus, Investments, McGraw-Hill/Irwin (June 18, 2008) For example, assume a party buys $100 of a 10-year fixed-rate treasury bond and enters into a fixed-for-floating 10-year interest rate swap to convert the payments to floating rate. The derivative is
off-balance sheet In accounting, "off-balance-sheet" (OBS), or incognito leverage, usually describes an asset, debt, or financing activity not on the company's balance sheet. Total return swaps are an example of an off-balance-sheet item. Some companies may have ...
, so it is ignored for accounting leverage. Accounting leverage is therefore 1 to 1. The notional amount of the swap does count for notional leverage, so notional leverage is 2 to 1. The swap removes most of the economic risk of the treasury bond, so economic leverage is near zero.


Corporate finance

: \text = \frac : \text = \frac : \text = \text \times \text = \frac There are several ways to define operating leverage, the most common. is: : \begin \text & = \frac = \frac \end Financial leverage is usually defined as: : \text= \frac For outsiders, it is hard to calculate operating leverage as fixed and variable costs are usually not disclosed. In an attempt to estimate operating leverage, one can use the percentage change in
operating income In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. Operating income and opera ...
for a one-percent change in revenue. The product of the two is called total leverage, and estimates the percentage change in net income for a one-percent change in revenue. There are several variants of each of these definitions, and the financial statements are usually adjusted before the values are computed. Moreover, there are industry-specific conventions that differ somewhat from the treatment above.Darrat, Ali F.d and Tarun K. Mukherjee, "Inter-Industry Differences and the Impact of Operating and Financial Leverages on Equity Risk," Review of Financial Economics (Spring 1995), pp. 141–155.


See also

* Coupon leverage * Homemade leverage *
Leveraged buyout A leveraged buyout (LBO) is the acquisition of a company using a significant proportion of borrowed money (Leverage (finance), leverage) to fund the acquisition with the remainder of the purchase price funded with private equity. The assets of t ...
*
Margin (finance) In finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty (most often their broker or an exchange) to cover some or all of the credit risk the holder poses for the counterparty. This ri ...
* Operating leverage *
Repurchase agreement A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of secured short-term borrowing, usually, though not always using government securities as collateral. A contracting party sells a security to a lend ...


References


Further reading

# {{DEFAULTSORT:Leverage (Finance) Debt Financial risk management