Leverage (finance)

Sometimes people borrow money to buy things. This is called leverage. It is like using a tool to lift heavy things. Using borrowed money can help you make more profit. This can be a good thing. But it can also be very risky. If things go wrong, you may not pay it back. A lender might set rules to keep things safe. They may ask for something to hold onto. This helps them if you cannot pay. Using leverage is a big choice for people and businesses.

In finance, leverage is a way to use borrowed money. It helps people buy more than they could with their own cash. The name comes from a lever in science. A lever helps you lift heavy things with a small push. Leverage does something similar with money. It can make profits much larger if things go well.

However, leverage can also make losses much larger. If an investment loses value, you might not be able to pay the money back. This is a big risk. To stay safe, lenders often set limits. They may also ask for collateral. This is an asset, like a house, that they can keep if you cannot pay.

In the past, banks had fewer rules about leverage. In the 1980s, new rules called Basel I began. These rules set limits to keep banks safe. Later, the Basel II rules came in 2005. These rules tried to look at real risk. In 2008, a large financial crisis happened. Many people blamed excessive leverage for this event. For example, the firm Lehman Brothers used a lot of leverage. They had many assets but very little of their own money. This made them very risky when markets changed.

In the world of money, leverage is a way to use borrowed funds to buy an investment. The word comes from physics, where a lever helps a small force move a large object. Financial leverage works in a similar way by using borrowed money to grow available capital. This allows a person or a company to invest more than they could with just their own cash. If the investment is successful, it can lead to very large profits. However, this method is also risky because the money must be paid back.

There are several ways that leverage works in different parts of finance. Business owners use it by having their company borrow money to help pay for things. This means the owners need less of their own money to start or grow. Hedge funds might use leverage by borrowing money from the cash they get from short sales. Some people even use special tools called options or futures to make leveraged bets. In these cases, the money is borrowed for a very short time.

Rules for how much money banks can borrow have changed over many years. Before the 1980s, most countries did not have strict rules about bank leverage. Instead, they used reserve requirements, which meant banks had to keep some cash or gold ready. In the 1980s, regulators began setting formal capital requirements to keep banks safer. By 1988, most large international banks followed the Basel I standard. This rule put assets into five different buckets based on how much risk they held.

Newer rules like Basel II were started in the early 1990s and began in 2005. These rules tried to look at economic leverage instead of just accounting numbers. However, many people believe that too much leverage helped cause the 2008 financial crisis. During that time, many people and companies had much more debt than they could afford. A famous example was the firm Lehman Brothers. In its final reports, Lehman Brothers showed accounting leverage of 31.4 times. This meant they had $691 billion in assets but only $22 billion in their own equity.

Understanding leverage helps us see how risk and reward are connected. Adding leverage to an investment always adds more risk to the situation. If an investment's value drops, the person using leverage might lose money much faster. This can lead to a situation called bankruptcy if they cannot pay the debt. Yet, some companies use leverage to modernize or expand into new places. This can sometimes make them safer by helping them grow in different ways. It is all about how much risk a person is willing to take.

In the field of finance, leverage is a technique that involves borrowing funds to purchase an investment. The term is borrowed from physics, where a lever amplifies a small input force into a much larger output force. In a financial context, leverage uses borrowed money to augment available capital. This process increases the total funds available for investment. If the investment is successful, it can generate large amounts of profit. However, leverage also brings significant risk. If an investment fails, the borrower may be unable to pay back the borrowed money. To manage this, lenders often set limits on how much leverage they will permit. They may also require the acquired asset to be provided as collateral security for the loan.

Leverage operates through several distinct mechanisms depending on the situation. In corporate finance, equity owners leverage their investments by having a business borrow a portion of its needed financing. This means the business requires less equity, so any profits or losses are shared among a smaller base. Consequently, these results become proportionately larger. Businesses also use operating leverage by using fixed cost inputs when they expect revenues to be variable. In this case, an increase in revenue results in a larger increase in operating profit. Other groups, such as hedge funds, may leverage assets by financing portfolios with cash proceeds from the short sale of other positions. Additionally, securities like options and futures act as effectively leveraged bets between parties.

There are three primary ways to define and measure leverage: accounting, notional, and economic. Accounting leverage is calculated by dividing total assets by the total assets minus total liabilities. Notional leverage is more expansive, calculated by dividing the total notional amount of assets plus the total notional amount of liabilities by equity. Finally, economic leverage measures the volatility of equity divided by the volatility of an unlevered investment in the same assets. For example, a party might use a derivative like an interest rate swap to change the nature of a bond. While this swap might be ignored in accounting leverage, it would be included in notional leverage. However, because the swap can reduce risk, the economic leverage might actually be near zero.

History shows that the regulation of leverage has evolved significantly over time. Before the 1980s, quantitative limits on bank leverage were quite rare. Most countries used reserve requirements, which forced banks to hold a fraction of deposits in liquid forms like precious metals or government notes. However, reserve requirements do not actually limit leverage. Regulators instead used judgmental capital requirements, where a bank was simply expected to be "adequately capitalized." This was not an objective rule. In the 1980s, national regulators began imposing formal capital requirements. By 1988, most large multinational banks followed the Basel I standard. This standard categorized assets into five risk buckets and mandated minimum capital requirements for each to limit accounting leverage.

As banking grew more complex, new standards were developed to address the flaws of previous rules. Basel I was criticized because it did not require capital for all off-balance sheet risks. It also encouraged banks to pick the riskiest assets within each risk bucket. Because of these issues, work on Basel II began in the early 1990s, with implementation starting in 2005. Basel II attempted to limit economic leverage rather than just accounting leverage. It required advanced banks to estimate the risk of their positions and allocate capital accordingly. While this was more rational in theory, it became more subject to both honest and opportunistic estimation errors.

The 2008 financial crisis highlighted the dangers of excessive leverage in the global economy. During this period, many consumers held high levels of debt relative to their wages and collateral. When home prices fell and interest rates rose, many borrowers could no longer afford their payments. Financial institutions were also highly levered. A notable example was Lehman Brothers. In its last annual financial statements, Lehman Brothers showed accounting leverage of 31.4 times. This was calculated by dividing $691 billion in assets by $22 billion in stockholders' equity. A bankruptcy examiner later determined the true accounting leverage was even higher due to dubious accounting treatments.

Lehman Brothers also demonstrated the massive difference between accounting and notional leverage. While its accounting leverage was 31.4, its notional leverage was more than twice as high. This was due to off-balance sheet transactions, including $738 billion in notional derivatives. The company also had significant exposures to special purpose entities and structured investment vehicles. Even though Lehman emphasized its "net leverage" of 16.1 by excluding certain low-risk assets, the total exposure was vast. This crisis led to calls for new leverage limits. Many experts believe future regulations will use a hybrid of accounting and notional leverage limits to prevent similar collapses.

Understanding the relationship between leverage and risk is essential for any financial analysis. Adding leverage to a specific asset always increases its risk profile. For instance, an investor buying stock on a 50% margin will lose 40% if the stock price declines by 20%. This can lead to rapid ruin if the underlying asset value decline is even temporary. However, leverage does not always make a company or investment riskier in every context. A company might use borrowed money to modernize or expand internationally. This diversification can create profits that offset the added risk. In some cases, highly levered hedge funds may even have less return volatility than unlevered bond funds.