Leverage in the Financial System

Manmohan Singh and Zohair Alam

Traditional metrics of leverage in the financial sector have important shortcomings. Leverage metrics commonly used in the literature are primarily based on bank balance sheet data (to be precise, “on-balance sheet” data), even though recent Basel rules propose to pick up several off-balance sheet transactions for their monitoring reports. All such measures are similar in their construction, relying on the aggregation of balance sheet data only. These measures do not fully capture the bank – nonbank nexus, since the size of nonbank funding to banks is not readily available in standard bank databases. The thrust of this Chapter is that leverage is consistently underestimated.

INTRODUCTION

Omission of off-balance sheet items in the standard measures implies a substantial underestimation of the financial system’s leverage. Adrian and Shin (2009, unpublished) suggest that leverage has two components: leverage from balance sheets of banks and leverage from the interconnectedness within the system – see Chapter 2 and Annex 2.1). We focus on the latter component – leverage arising from the interconnectedness within the financial system – and show that it is large, rising, and not