Leverage is a financial term typically used to express the borrowings an individual or business takes on, in the hope of magnifying investment returns. For instance, if someone is absolutely convinced that investing in Company X stock will generate great returns, he or she could buy shares on margin. Purchasing $2,000 of Company X stock could be financed with $1,000 in cash and borrowing $1,000 from a broker. If the stock magically doubles after a year, you could sell the overall position for $4,000. After paying the broker the $1,000 you borrowed (plus interest), approximately $3,000 would remain. In effect, you’ll have turned the initial $1,000 cash outlay into $3,000 by applying 2:1 leverage, which turns a 100% return into 200% (before subtracting borrowing costs).
While this example is rosy, the clear downside of leverage is that losses can be magnified as well. If Company X performs poorly and its stock drops by 50%, the $2,000 position would fall to $1,000, and your entire equity investment of $1,000 would be wiped out (since the lender would collect the remaining $1,000). Despite the stock falling 50%, your investment would decline by 100%, which is where 2:1 leverage would be regrettable.
Banks need to use leverage in order to generate enough profitability to be sustainable. A bank’s assets consist of loans it makes to businesses and individual borrowers. A traditional bank’s liabilities mostly consist of borrowings that are federally-insured deposits made by individuals and businesses.
For individuals, assets would equate to money deposited at a bank, and liabilities would equate to debt we have incurred. But for lenders, this gets flipped, and a bank’s fundamental business model is to charge more in interest for loans it provides (e.g., construction, commercial real estate, agricultural, multifamily, individual mortgages, consumer) than the interest it pays to borrowers on deposit accounts (e.g., CDs, money market, savings, checking).
When banks use deposits from you and me to fund loans, they are applying leverage. For simplicity, let’s say you decide to start a bank tomorrow and have $100 million of capital. Without using leverage, you could lend at most $100 million (actually less because the government requires banks to keep reserves). Let’s say those loans would pay an average interest rate of 6%. The bank would receive about $6 million per year in interest income, and its ability to lend more money would be very limited until many loans reach maturity where the entire principal is paid back. In this scenario, your bank would not be profitable because of all its expenses such as maintaining branches, personnel, computer systems, and ATMs. Not to mention the fact that some loans could go bad, reducing the collected interest and wiping out a substantial portion of the initial loan.
Therefore, banks must apply leverage to make more loans, and this can be accomplished by using low-cost deposits. In this interest rate environment, your bank could borrow $900 million of deposits at 2%, and lend that money to borrowers at 6%. Now instead of having $100 million of capital fund $100 million in loans, the capital can be used to run the company and serve as a cushion in case some borrowers are unable to fully pay back their loans. In this scenario, $900 million of loans would generate $54 million in interest income, and the $900 million of deposits would cost your bank $18 million in interest expense, resulting in a $36 million differential.
In this example, having 10:1 leverage allowed for net interest income of $36 million, compared with only $6 million when no leverage was employed. Of course in the real world, there are plenty of other considerations that dictate a bank’s profitability, such as:
· Losses from nonperforming loans
· Alternate sources of borrowing
· Fee income
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