Question

A leverage ratio is any one of several financial measurements that look at how much capital a firm holds in relation to its total assets. For our purposes we define the bank's leverage ratio as equity capital divided by total assets.*

Go to the St. Louis Federal Reserve FRED database, and find data on assets less liabilities, i.e. bank capital (RALACBM027SBOG), and total assets of commercial banks(TLAACBM027SBOG). Starting in January 1995, for each monthly observation, calculate the bank leverage ratio. Create a line graph of the leverage ratio over time. (All of this can be done on their web site, spend the time and learn how.) All else being equal, what can you conclude about leverage and moral hazard in commercial banks over the time considered?

Just to show how nebulous the definition of the leverage ratio, the inverse of this ratio is also called a leverage ratio in other contexts.

Answer 1

The leverage ratio is the ratio of banks assets and its capital. The higher the leverage ratio is the higher is the risk of default and thus bank run for a bank.

The figure below gives the leverage ratio of US bank over time since January 1995From 2008 the leverage ratio of the bank has skyrocked and its constant at this level until now. This implies the risk of default is constant at the current level. The equity loan works as mortgage for those who do not have capital asset. The equity loan enables the borrower to borrow against the equity. Thus, if the person defaults on the loan he will lose the equity. Thus it is highly subject to moral hazard.