Leverage
Also called: Financial leverage · Topic: Banking Regulation, NPAs and Financial Stability · NCERT: Beyond NCERT
Meaning
Leverage means using borrowed money to pay for assets. Banks are highly leveraged: most of their money comes from deposits, and only a small part is the owners' own capital. Leverage magnifies both gains and losses. When assets earn well, owners gain a lot on their small capital. When assets lose value, the loss comes straight out of that thin capital, and it can wipe it out. This is why regulators limit how much banks can borrow against their capital.
Example
Take a bank with Rs 100 of assets and only Rs 8 of capital. The rest is borrowed from depositors. An 8% loss on its assets wipes out all its capital.
Don't confuse with
- Leverage ratio: this is a Basel III rule, not the general idea. It equals Tier 1 capital ÷ total exposure, with no risk weights. India requires 4% for D-SIBs (domestic systemically important banks) and 3.5% for other banks, against Basel's 3%. It acts as a simple backstop in case risk weights are gamed.
Related concepts
- Basel norms
- Basel I
- Basel II
- Three pillars of Basel
- Capital adequacy ratio
- Risk-weighted assets
- Tier 1 capital
- Common Equity Tier 1
- Additional Tier 1 capital
- Tier 2 capital