I read this blog entry by the BBC's business editor Robert Peston in which he considers a study that shows that the banking sector's out performance of the rest of the financial sector since 1985 was due almost entirely down to an increase in leverage (which has now been wiped out in the current financial crisis). Instead of generating a higher return on gross assets they instead increased "the ratio between bank's gross assets and its stock of shareholders' equity". Leverage in other words. A far more riskier strategy but when the economy is booming, a simple way to increase returns for shareholder's.
To put it another way, you could say that banks increased their profits, not by investing in ways more in accordance with the market's most urgent ends, but by betting on the upwards trend of asset prices continuing.
Peston proposes the following :
Regulators should impose a legally binding maximum - and at a relatively modest level - for the ratio of a bank's gross assets to its equity, the leverage multiple, to restrict bankers' freedom to gamble.
This sounds something like a required reserve ratio (RRR) but it's not the same is it? Because the RRR regulates the ratio of it's reserve of deposits to it's issued credit. In the UK, the RRR is zero.
Does anyone know how this relates to the fractional reserve banking? Would it be possible for a full reserve bank to use leverage in the same way to boost it's shareholder returns? Is leveraging something that needs to be regulated? And if not, how would a free market avoid the problem of over leveraging?
It depends on where that leverage is coming from. Did it come from legitimate savings, or was it through monetary inflation?
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I think I can begin to answer my own question. Leveraging has nothing to do with FRB because increasing the leveraging ratio does not increase the money in circulation. The ratio of demand deposits held in reserve is unaffected.
So the question is what causes excessive leveraging and what are the market forces that should keep it in check and where were they leading up to the current financial crisis? Is this market failure that needs to be regulated?
Could an expansionary monetary policy lead to excessive leveraging? It seems to me that if the interest rate on the loan markets was significantly lower than what many are prepared to pay to borrow money, leveraging is a good idea because the margins will be good. A form of arbitrage in other words. Precisely what we would expect to see then if the central bank were inflating the money supply via the loan markets. A tigher monetary policy should lead to banks being far more conservative in their attitude towards leveraging.
In a free market scenario, with the absense of an expansionary monetary policy, any discrepancies in interest rates in the loan markets should be quickly eliminated by the process of arbitrage. If this is true, it is not regulation of leveraging the banks need, but an end to expansionary monetary policy.
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