Sources of risk for banks..

Corkbhoy8

I think banks main concern should be their leverage rather then there asset quality..what are peoples opinions on this. Im doing an assignment at the moment on this topic so just looking for peoples opinions..

Both are important and are inter-related, it's not a case of one or the other.

Corkbhoy8

im comparing bank of ireland and anglo irish bank..their leverage over the last few years etc..still only learning about the topic really..any insight?

Patrick Honohan has done a lot of work on this recently. http://www.tcd.ie/Economics/staff/phonohan/

I am not sure which paper it was in though.

nesf

For Ella yeah?

Both matter hugely as illegalheadbutt said. Do you have a good grasp of the downsides of leverage?

Corkbhoy8

ha are u a past economics grad??i dont really have a good grasp on it to be honest..seems like im reading a lot but not getting much down on paper!

nesf

Corkbhoy8 wrote: »

ha are u a past economics grad??i dont really have a good grasp on it to be honest..seems like im reading a lot but not getting much down on paper!

Think of it this way, leveraging allows you to make bigger bets than you would if you didn't borrow.

Say I've €10K and I want to invest it in something. Say my returns are 4% from this scheme, I'll get €400 from my investment and the €10K I invested back.

Now say I use this €10K as a guarantee against a loan of €20K. Assuming the same returns, if I invest the 20K, I'll get €800 back from my investment and I can pay back the €20K I borrowed. I just doubled my income by borrowing a little. (we're getting 0% loans here to keep it simple but so long as the interest on the loan is smaller than the interest you earn from your investment you make a profit).

The above is 2 times leverage. My net worth is €10K, but I'm investing twice that amount in the market. Investment banks in the States were over 30 times leveraged by 2007.


Now leverage does two things, it magnifies wins and it magnifies losses. So long as the market is moving with you, high leverage means you can make enormous profits. If the market moves against you, high leverage means that it'll wipe out large amounts of your capital (in the simply example above, if the investment lost only half its value it would wipe out all your capital since you'd have to use the €10K you put aside and the €10K left from selling the investment to pay off your loan. In contrast, if you weren't leveraged you'd only have lost €5K and would have €5K left).

I hope that helps.

Little article about a danger of leverage here: http://www.economist.com/finance/displaystory.cfm?story_id=E1_JGGTJDJ

Corkbhoy8

Thanks for yere help guys..i just need to start applying this to anglo irish bank and bank of ireland and ill be flying!:D