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There are many euphemisms for debt – like ‘credit’, ‘finance’ and, for all you Gordon Brown fans out there, ‘investment’.  In certain business circles, however, the term of choice is ‘leverage’.

To be fair, it isn’t an entirely meaningless word, evoking, as it does, the use of debt to minimise the equity portion of a money making venture and thereby maximising any return on capital. 

In a hugely informative piece for the London Review of Books, Donald Mackenzie explains the  principle of leverage in terms of the equity you might have in a house or flat. For any given increase in the property’s value,  the lower your equity, the higher the return:

  • “Being in the equivalent of that position as a senior banker can be very attractive when your performance is judged – as, alarmingly, it still is – by your bank’s return on equity. The easiest way to boost that return is to ‘lever up’, as people in finance put it: to increase the ratio of the bank’s debt to the equity it holds.”

But there’s a catch:

  • “…the magic of leverage works both ways. If you have only 5 per cent equity in your flat, even a small decline in house prices – anything more than 5 per cent – plunges you into negative equity.”

And that, following the credit crunch, is what happened to so many of our banks. The value of the loans they’d made declined by more than the value of their equity:

  • “Between June 2007 and June 2009, the first phase of the global banking crisis, the aggregate market value of the assets of the UK’s big banks fell… by 5.3 per cent. That was enough to push Lloyds and RBS over the brink and take Barclays uncomfortably close to it.”

Donald Mackenzie tells us that, just prior to the crisis, RBS’s equity levels were at 4.5%, while Lloyds’ were at 3.3% – not enough to weather the storm and avoid the bail-out.  Once upon a time it would be have been a different story:

  • “The UK’s banking system a hundred years ago would have been shaken but could have survived: the financial historian David Sheppard has calculated that the system’s average level of equity in 1908 was 11.2 per cent.”

Who was responsible for the erosion of this vital safeguard? Well, the bankers, most obviously – but then bankers are prone to doing all sorts of silly things and it is the job of governments to impose sensible limits, which they failed to do. 

In fact, the state has made things worse. For instance, by being ready and willing to bail out those who lend to banks (depositors), but not those who own them (shareholders), governments have distorted the relative costs of debt and equity. To compound this effect, corporate interest repayments are typically tax deductible, unlike dividend payments.

Then there was the farce of an 1988 Basel Accord on Capital Adequacy, which tried to set out a minimum capital requirement for banks. As Mackenzie describes at some length, the loopholes were of staggering dimensions. For instance, certain investments were deemed to be so safe that no capital was required to match them. It tells you all you need to know that these ‘zero-rated’ investments included Greek government bonds.

Today, it makes sense to get equity levels back up to where they should be – but where is the capital going to come from? Well, there is one rather tempting potential source:

  • “Banks continually leak money, especially via bonuses to staff and dividends to shareholders… the dividends paid out by US banks in 2007 and 2008 amounted to around half the bailout funds they needed just a few months later… If profitable banks replaced cash bonuses and dividends with new shares they would, over a period of a decade or so, bolster their equity levels considerably.”

Of course, this would mean forcing bankers to tie up their bonuses in the shares of the banks they work for – which, if nothing else, would give them a long-term stake in the stability of the banking system.

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