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How leveraged were banks prior to the Global Financial Crisis?

Level:
A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 27 May 2023

How highly leveraged were banks prior to the global financial crisis?

What is the leverage ratio?

Prior to the global financial crisis of 2008, many banks had become highly leveraged, meaning they had a significant amount of debt relative to their equity or capital. The exact level of leverage varied between banks, but there were several factors that contributed to the high levels of leverage across the financial system:

  1. Mortgage-backed securities: One major factor was the creation and widespread use of complex financial products, such as mortgage-backed securities (MBS). These securities were pools of mortgages that were packaged and sold to investors. Banks held significant amounts of these MBS on their balance sheets, and they used short-term borrowing to finance these investments.
  2. Securitization and off-balance-sheet activities: Banks engaged in securitization, which involved bundling loans, including mortgages, into tradable securities. By moving these assets off their balance sheets and selling them to investors, banks were able to reduce their capital requirements and free up funds for further lending. This process allowed banks to leverage their balance sheets even more.
  3. Shadow banking system: Another contributing factor was the growth of the shadow banking system, which refers to non-bank financial institutions that perform bank-like activities, such as lending and borrowing. These institutions were less regulated than traditional banks and operated with higher levels of leverage, often relying on short-term funding markets.
  4. Low interest rates and lax regulations: Low interest rates prevailing in the early 2000s encouraged borrowing, leading to increased leverage. Additionally, regulatory oversight and risk management standards were relaxed or insufficient in some cases, allowing banks to take on more risk without appropriate safeguards.

The combination of these factors resulted in banks and financial institutions having high levels of debt relative to their capital. This high leverage made them more vulnerable to economic downturns and declines in the value of the assets they held, particularly in the mortgage market. When the housing bubble burst and the subprime mortgage market collapsed, it triggered a chain reaction that exposed the fragility of the highly leveraged financial system, leading to the global financial crisis.

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