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leverage

ENGR.ECONOMIC ANALYSIS
ENGR.ECONOMIC ANALYSIS
14th Edition
ISBN:9780190931919
Author:NEWNAN
Publisher:NEWNAN
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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DARNELL: Hi, Felix. I would like to ask you about leverage. The Professor was talking about the advantages and disadvantage of banks using leverage. From what I understand, high bank leverage was one of the key ingredients in the housing bubble and the financial crisis that followed. What I do not understand is that, if leverage is so risky, why wouldn't the government just forbid banks from using leverage at all and thus eliminate the possibility of such a crisis in the future? FELIX: Darnell, this is not an easy question. Regulators and bankers are still searching for strategies that would benefit both investors and bank customers. I'll try to help you understand the trade-off of using leverage versus abandoning it completely. But first, let's make sure you understand what leverage is. DARNELL: In banking, leverage means that banks can use Increase the potential return on reserves to purchase assets that offer higher returns and thus deposits reserves stockholders' equity FELIX: Consider a bank that has $8,000,000 in deposits an es. Suppose it lends out $7,200,000. What are the bank's total deposits assets and stockholders' equity? DARNELL: This bank has $8,200,000 in assets, and stockholders' equity is s FELIX: Now, suppose the bank's deposits carry an average annual interest rate of 4%, whereas its loans yield 8%. This means that the bank earns $7,200,000 x 0.08 = $576,000 on loans and must pay only $8,000,000 x 0.04 = $320,000 in interest on deposits. To sum up, the bank "borrowed" dollar deposits from its customers to return $576,000 – $320,000 = $256,000per year in profit for its stockholders. DARNELL: I see. This implies that the bank offers a return of on its equity of $200,000. Quite impressive! FELIX: Yes, the investors should be excited to get such a return! However, what if there is an increase in defaults, so that the bank's assets (loans) fall in value by, say, 10%, or $7,200,000 x 0.1 = $720,0002 The value of loans outstanding would decline to $7,200,000 – $720,000 = $6,480,000 and total assets would be $1,000,000 + $6,480,000 = $7,480,000 consequentily, the stockholders' equity will decline to $7,480,000 – $8,000,000 = -$520,00Q DARNELL: But this means that the bank's shareholders lost of the original equity of $200,000! FELIX: Now, let's see whether it would really help if the bank used no leverage, that is, if it operated without borrowing from customer deposits. All it would be able to loan out is its equity of $200,000, which would earn just $200,000 x 0.08 = $16,000. Given a 4% interest rate on deposits, the bank's profit would be $16,000 – $320,000 = -$304,000 with such low expected returns, the bank would not exist in the first place, as investors would undoubtedly go somewhere else. Thus leverage is essential to a bank's profitability, but it also carries significant risk.
Transcribed Image Text:DARNELL: Hi, Felix. I would like to ask you about leverage. The Professor was talking about the advantages and disadvantage of banks using leverage. From what I understand, high bank leverage was one of the key ingredients in the housing bubble and the financial crisis that followed. What I do not understand is that, if leverage is so risky, why wouldn't the government just forbid banks from using leverage at all and thus eliminate the possibility of such a crisis in the future? FELIX: Darnell, this is not an easy question. Regulators and bankers are still searching for strategies that would benefit both investors and bank customers. I'll try to help you understand the trade-off of using leverage versus abandoning it completely. But first, let's make sure you understand what leverage is. DARNELL: In banking, leverage means that banks can use Increase the potential return on reserves to purchase assets that offer higher returns and thus deposits reserves stockholders' equity FELIX: Consider a bank that has $8,000,000 in deposits an es. Suppose it lends out $7,200,000. What are the bank's total deposits assets and stockholders' equity? DARNELL: This bank has $8,200,000 in assets, and stockholders' equity is s FELIX: Now, suppose the bank's deposits carry an average annual interest rate of 4%, whereas its loans yield 8%. This means that the bank earns $7,200,000 x 0.08 = $576,000 on loans and must pay only $8,000,000 x 0.04 = $320,000 in interest on deposits. To sum up, the bank "borrowed" dollar deposits from its customers to return $576,000 – $320,000 = $256,000per year in profit for its stockholders. DARNELL: I see. This implies that the bank offers a return of on its equity of $200,000. Quite impressive! FELIX: Yes, the investors should be excited to get such a return! However, what if there is an increase in defaults, so that the bank's assets (loans) fall in value by, say, 10%, or $7,200,000 x 0.1 = $720,0002 The value of loans outstanding would decline to $7,200,000 – $720,000 = $6,480,000 and total assets would be $1,000,000 + $6,480,000 = $7,480,000 consequentily, the stockholders' equity will decline to $7,480,000 – $8,000,000 = -$520,00Q DARNELL: But this means that the bank's shareholders lost of the original equity of $200,000! FELIX: Now, let's see whether it would really help if the bank used no leverage, that is, if it operated without borrowing from customer deposits. All it would be able to loan out is its equity of $200,000, which would earn just $200,000 x 0.08 = $16,000. Given a 4% interest rate on deposits, the bank's profit would be $16,000 – $320,000 = -$304,000 with such low expected returns, the bank would not exist in the first place, as investors would undoubtedly go somewhere else. Thus leverage is essential to a bank's profitability, but it also carries significant risk.
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