Leverage: A Research Agenda for SIFIs

Jorge A. Chan-Lau, André O Santos, Liliana Schumacher, Karim Youssef, Luisa Zanforlin and Federico Galizia

This article was first published as a chapter in Managing Systemic Exposure, by Risk Books.

Leverage played a major role in the run up to the subprime lending crisis. Deposit- and non-deposit-taking financial institutions used leverage to progressively increase positions in risky assets. The trend was further magnified by rapid off-balance-sheet asset growth, often via vehicles that were highly leveraged and not consolidated. Financial innovations also played their part, with the creation of products with very high and little understood embedded leverage that significantly exposed these instruments and their investors to shifts in market sentiment and liquidity.

Deleveraging further magnified the initial shock once the crisis set in. Within the financial sector, banks tightened loan standards, cut costs, sold assets and raised capital – thereby reducing the supply of credit to the economy. The deleveraging process forced asset sales by non-bank financial intermediaries, thus further depressing the value of assets held within the financial sector. It applied to both domestic and cross-border positions, thus putting pressures on emerging market assets. The depressing effect on