GIVE ME A BANK AND I WILL LEVERAGE THAT TEN TIMES THE AMOUNT
By Melvin J. Howard
The basic building blocks of contemporary capital and money markets is just plain money that legal tender that can be used in the trade for all goods and services and in the repayment of all debts. Plain money is first created by the Federal Reserve ", first as bank reserves, and then later as currency or Federal Reserve Notes as the public demand more cold hard cash. Secondly, and where most money is created, the private commercial banks make about 10 times this amount as deposit or check account money simply through the loan creation process.
Ultimately the decisions on who gets access to credit and who gets it on reasonable terms is decided on the basis of what loans will bring in to the shareholders of banks a return on their invested capital at a level of around 15 to 20% in recent years. By this I mean that for every 1 dollar of stock or equity capital that a shareholder invests in a bank they will get back 1.20 after a year. This is called a 20% return on equity. While this is simply an accounting profit which is a purely abstract notion these profits will translate into wealth in the real sense of potential to buy goods and services, because everyone accepts the US dollar as legal tender good for all trade and in the repayment of all debts. Therefore it is ultimately driven by the profit targets desired by the major shareholders of banks, which is a very small segment of society.
On top of this money or basic debt markets sits more complex debt markets (outside the banking system) and, of course, the rest of the capital markets (or stock markets), where shareholders invest the US dollars they've accumulated in return for more of these dollars in the future. In the case of all entities that raise money on the public stock exchanges (known as publicly traded corporations) all company decisions will be primarily driven by the need to meet shareholder expectations in terms of required return on capital. Meeting shareholder expectation is necessary in order to retain access to the capital markets. Access to the capital markets is the "make or break", the very requirement for survival of a publicly traded company, and meeting shareholder expectations therefore drives all decision making. Consequently the other main parties of a corporation the employees and the customers and other effected public can have say in the corporation to the extent that they can influence the shareholders. The shareholders will be mostly concerned with percent return on investment.
Today banking works a bit differently, whereby the amount of leverage in the banking system is basically driven by capital requirements. Let us suppose you have a $100 to invest by either depositing your money in a bank or becoming a shareholder of a bank. If you just become a bank depositor you can earn 5% a year on your $100. But if you are a bank shareholder, you get to borrow additional money from the depositors and lend this money out at a higher rate, keeping the difference in interest rates for your own profit. Let's suppose that for every $100 of shareholder or equity capital a bank has, it can borrow $900 from its depositors and loan out the total $1,000 at a 7% interest rate. Then your profit as a shareholder is calculated as follows:
INCOME: 1000 * 7% = $70 from people that borrow from the bank less OUTGO: 5% * 900 = $45 to go back to depositors, whose money you just borrowed, as interest on their deposits. That leaves you with a clear $25 of profit on your $100 investment which is a 25% return on investment. That's much better than the $5 or 5% you would get as a depositor and the reason is quite simply, leverage. You could borrow 9 times your own capital investment to make a much larger return than you could have done with just your own money. I say that your leverage was 9, which is the ratio of debt to equity in your total investment.
But such leverage comes with many more risks than if you just invested your own $100. One obvious risk is that some of the $1,000 borrowed from the bank will not be paid back. If this amount is less than $100 plus any interest profits you make, then the loss simply hits your investment, but the bank still has enough money to pay back the depositors. But what happens if $100 or more, of the $1000 of bank loans don’t get paid back. Then the bank will be insolvent or bankrupt and some of the bank depositors will have lost their money. Well, unless there is a government intervention, that is. This is just the type of loss that can trigger a further series of loan defaults and thereby start a chain reaction of defaults, asset sales, lost confidence and mad panic, that can lead to financial collapse but in can be controlled.
It is clear that the higher the leverage, or multiple of your own investment, you can borrow from depositors to lend out then the higher your potential returns, but also the higher the risk of potential catastrophe. For example if the bank's leverage was now 19 instead of 9, they could borrow $1,900 from depositors added to your $100 investment. This huge leverage could bring a 45% return if nobody defaults on their bank loans and interest rates stay the same. But the risk of losing $100 in the larger pool of bank loans is now much greater and it's this loss that can cause bank failure.
On the other hand financial leverage lies at the heart of the development of modern societies. It is the great facilitator of our massive production and distribution of energy and goods, and our rapid technological advancement. Without such leverage there would not have been enough money to fuel the industrial revolution or the technological revolution as they happened. Without the confidence in this highly leveraged system you would not have the cooperation between people to get such big projects completed. Many people in the developed world would not want to give up their modern luxuries nor, in fact, could many even survive now without them.
