High Leverage as the Precipitate of the Next Financial Crisis

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Introduction

Many scholars are of the opinion that leverage is vital for funding growth and development but when it exceeds some limit, it causes dangerous unintended consequences. Adrian and shin (2010) ,Acharya, Shnabl & Suarez (2013), Goel, Song and Thakor (2014), Shleifer and Vishny (2010), Mian and Sufi (2010) and other notable scholars have held high leverage culpable as a major contributor of 2007 -2009 financial crisis. Leamer (2007) goes a step further claiming that all of U.S recessions after second world war have been caused in one way or another by high leverage.

There is an emerging acceptance that there is laxity among financial regulators during economic booms and this allows banks to lend risky loans thereby increasing leverage in non-financial institutions and household consumer. This, among other weakness such as a lack of consensus on the right leverage ratio for firms are some weaknesses that needs to be addressed before the day of reckoning approaches. Thus, the aim of this essay is to show theoretically and empirically how high leverage will cause the next financial crisis.

 Why high leverage will cause the next financial crisis

Theoretical Analysis

The leverage cycle theory

As per the leverage cycle theory, in boom times leverage are too high and in bad times leverage becomes too low. As a result asset prices are high in boom times whereas in crisis they are low (Geanakoplos,2009). How does this theory manifest itself? Leverage increases contagion danger in banking systems and exacerbates transmission of risks to the rest of the economy from financial system in a number of ways;

First, excessive leverage give rise to cycles of credit and asset prices contributing to macroeconomic booms and bursts i.e. asset bubbles and crashes. These bubbles are driven by flawed assumption of fundamental value and also by competitive pressures, hence have potential to cause extensive economic damage when they burst (Adrian and Shin 2010). As Delis, Tran and Tsionas (2011) have shown, leverage tends to increase during good economic times when banks finance loans that are risky and recedes during economic contraction times. Thus, assets in the market becomes inflated during market booms causing investors’ appetite for loans to increase and to amplify speculation. Price growth at these high rates, however may not be compatible with overall potential of real economic expansion (Delis, Tran and Tsionas 2011).

A very good and recent example of the above case is the housing bubble of 2007 -2009 , where after the bubble burst, oversupply reduced the prices of real estates and value of homeowners houses (Duca, Muellbauer and Murphy, 2010). As a result, mortgage-holders housing loan was higher than their residence was worth. Additionally, during the peak of the asset bubble, a lot of investors willing to tap into profits from the mortgage become more leveraged as they took more loans that were secured with little down payments and which had variable repayment rates (Duca, Muellbauer and Murphy,2009a and 2009b). Lax borrowing conditions made it possible for consumers to be highly leveraged as the took more loans. This left them at the mercy of these adjustable interest rates. When interest rates were raised, consumers risk premiums rose further damaging their indebtedness (Demirguc-Kunt, Evanoff and Kauffman,2011). This resulted in defaults and short sales as mortgage buyers tried either to deleverage or declare bankruptcy. Depressed housing economy resulted in assets prices that were lower and more tightened credit access made the situation worse (Dennis,2012; Duke, 2012; Madigan,2012). This housing market downturn exported worsened financial conditions beyond its sector and resulted to reduced demand of goods in the whole economy.

Second, leverage causes procyclicality due to the compound effect caused by increased borrowing on asset prices. It follows that negative effects caused by leverage are felt keenly during the times of financial distress (Shleifer and Vishyny 2011). Keen investors knows that highly levered institutions capital reserves will be drained off in the time of negligible price falls of the assets. Thus, during a crisis, a bank that is highly leveraged looses confidence of investors earlier than less leveraged banks. Financial system is thus left vulnerable to market panic episodes, where deflation of asset prices and fire sales quickly causes mass insolvencies (Gennaioli, Scheifler and Vishny 2010)

The debt overhang theory

Another significant drawback caused by excessive leverage is debt overhang.

As per this theory, when a firm is excessively leveraged, there reaches a point where it cannot borrow more capital, at this point the firm is regarded to be in debt overhang. The debt becomes so large that all  its earnings goes to pay off the debt instead of funding new investment projects leading to an even higher potential for default.

Avgouleas (2015) espouses that debt overhang prevents companies from borrowing and consequently banks from lending capital to finance investments inspite of those investments guarantee to produce returns. This is caused by past excessive borrowing and fragile capital structures. Firms that are highly leveraged therefore pass up investments opportunities that are valuable. Worthwhile investment opportunities are sacrificed in favor of asset sales. When the bank is highly leveraged it is unable to extend credit to borrowers that are worthwhile. This reduces the volume of funding to finance projects which in turn hurts the economy. Thus, banks that are highly leveraged make poor financial decisions ( Hanson,Kashyap and Stein 2011). Fatih and Arif (2013) also maintain that highly leveraged firms faces difficulty of borrowing to finance regular expenditure and their working capital. Similarly they argue that an increase in leverage dampen their performance also in terms of new finance access and additionally in times of financial crisis an increase in leverage causes severe impacts on their growth.

In a nutshell, over-borrowing  during boom times leads to a halt on investments in the event of a downturn causing a liquidity asphyxia causing a sharp fall on asset prices, a view that is supported by Occhino and Pescatori (2010). These developments causes chain of effects on employment rates economic activity and saving ratios.

Empirical analysis

There is significant empirical evidence that high leverage has precipitated to financial crises and will likely cause another if some measures are not taken.

First, Jagannathan, Kapoor and Schaumburg (2013), carried out an extensive research to aimed to assess how per capita consumption grew in the U.S. They found out that it grew at a rate of $ 1,994 annually from 1980-1999, but amazingly jumped significantly to approximately $ 2,8,49 annually from 2001-2007. This increase happened despite the recession of March-November 2001.they also found out that from late 1990s, the value appreciation of average national home rose from 5% to 15% annually in 2006 where it collapsed in 2007 furthermore, They reported that average household consumption debt increased by 230% from 2000 to  2007. They found out that this consumption was financed by household debt. Additionally, before the crisis period S&P/Case-Shiller home price index rose from 100.77 in first quarter of 2000 to 186.07 in the same quarter of 2007. The scholars concluded that this high household consumption was financed by debt.

Second, a research by Mian and Sufi (2010) examined between household leverage and downturns in economic activities across U.S counties. Their research showed that an increase in household debt (leverage) before the financial crisis was linked to the recession of 2007-2009.

Third, Huang and Thakor (2015) sought out to examine how banks behave in boom times.they provided empirical evidence that if banks expect political pressure to offer loans that are politically favored, they reduce capital ( thereby increasing leverage) by increasing dividends. They went on to prove that there is more political pressure when banks have more capital and and thus healthy. This high leverage, they concluded, becomes dangerous when economic booms end and downturn kicks in. An almost similar study was carried out by Berger and Bowman (2013) and it showed that banks with less capital get less market percentage and during crises are less likely to survive.

The above standpoint can be illustrated by the case of Lehman Brothers whereby, in their last financial statement before the crisis, reported accounting leverage which was 31.4 times. Anton R. Valukas, a bankruptcy examiner, determined that the accounting leverage was morebut dubious accounting treatments made it possible to understate it.

Suggestions on future resolutions

As this essay has tried to show, high leverage is a major factor that contributes to financial crises. In this section I will try to show some measures that can be taken to mitigate the risk of  high leverage precipitating another financial crisis.

To start with, there is need to be an enforced capital requirement and leverage ratio. Gauthier Lehar and Souissi (2012) found out that a capital requirement that is probably designed can reduce by 25% the probability of a crisis. Similary, The Economist (1-18-2014) reports how the European banks were against the leverage ratio proposed under Basel 3. They were successful in watering down the new rules by for example some assets were to be excluded when calculating leverage ratio. As such, the new leverage requirements were loosened to allow big European banks pass 3% limit. If it were not for the committee’s help, three quarters of the biggest banks in Europe might have failed the test. In support of the above arguments, Admati Demarzo, Hellwig and Pfleiderer (2010) maintain that the Basel 3 agreements leverage % ratio should be enforced. They conclude that setting equity requirements higher than the levels that are currently on the market would benefit every economy.

Another solution is to review bail out regulations for banks. The rationale behind this is that the so called “too big to fail” banks have an assuarance guarantee of being bailed out and therefore they operate on riskier balance sheet (Tsesmelidakis and Merton 20120). Some tough new regulations need to be put in place and enforced in order for these banks to operate with larger capital base and not issue risky loans.

The third solution, is to properly time regulatory initiatives. Potential regulatory initiatives that are not properly timed, which ask highly leveraged banks to bolster capital by selling their assets during a downturn could inadvertently cause problems for the rest of other financial institutions. This is supported by Adrian and Shin (2010) who is of the opinion that this can cause market shock, or during a systematic disruption, exacerbate one.

Conclusion

Leverage is vital for funding growth and development but when it exceeds a certain limit, the benefits associated with it evaporates and it becomes dangerous to firms, consumers and the whole economy. As this essay has shown there are some loopholes that need to be addressed to avoid another financial crisis as it has done in the past. Laxity among regulators as we have seen during boom times, has always been a recipe for a crisis. We have seen that a lack of consensus on the right amount of capital requirements and leverage ratio among scholars and policy makers poses great danger on the economies. This essay has proposed that properly timed regulatory initiatives and enough capital requirements and an optimal leverage ratio for firms will go a long way in saving our economies from financial crisis

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