Leverage and risk in U.S. commercial banking in the light of the current financial crisis.

Abstract

In this paper we study the relationship between leverage and risk in US commercial banking market. We employ a representative panel data set of systemically important banks that extends from 2002 to 2009 thus covering both the years before the outbreak of the current financial crisis and those that followed. Several alternative variables are used to capture both on- and off-balance-sheet leverage as well as short-term leverage. Regarding risk, it is proxied by two measures: the systemic risk potential and banks’ overall risk. Our findings indicate reliably that both on- and off-balance-sheet leverage contributes to (systemic) risk, which implies that large banks do not maintain a level of leverage that could allow for equity capital to act fully as a buffer, absorbing losses and enabling the business to continue in case of financial distress. In a similar vein, a direct link between short-term leverage and risk is reported, showing that leverage is one of the main factors responsible for the serious bank liquidity shortages that were revealed in the current crisis. We also find that those banks that concentrate on traditional banking activities typically carry less risk exposure than those that are involved with new financial instruments. The latter finding could play a role in the current discussion about a possible revival of the Glass-Steagall Act. Overall, our results provide a better understanding of the main causes of the present crisis and contribute to the discussion on the reinforcement of the existing regulatory framework.