Leverage

Leverage in banking means using deposits and other borrowed funds to grow a bank’s assets beyond its own capital. It’s measured as the ratio of total assets to capital.

Suppose a bank has eight million dollars in capital and has access to ninety-two million dollars through deposits and other liabilities.

It now has one hundred million dollars to allocate—most of which typically goes toward lending—giving it a leverage ratio of 12.5. When borrowers repay their loans with interest, the bank earns returns on the full amount it lent, even though only eight million dollars was its own money.

But leverage also increases risk. If too many borrowers default, the bank might not have enough capital to absorb the losses, potentially leading to insolvency.

For instance, before the 2008 financial crisis, investment bank Lehman Brothers had a leverage ratio of thirty to one—about $30 in assets for every $1 of capital. When losses mounted, it lacked sufficient capital to survive.

That’s why regulators monitor bank leverage closely—to protect both depositors and the broader financial system.