Leverage and risk

Someone in the office asked me about leverage in reference to the global financial crisis and how governments can induce commercial banks to lend money.  So I did a little bit of research about it.

Leverage is a general financial term that refers to a variety of ways to multiply profits.  For most cases this means borrowing.  Leverage also means multiplying risk.  So say you have enough money to buy one cow for 400,000 tugriks.  Instead of buying one, you decide to borrow 3,600,000 tugriks from your bank and buy ten.  Now you can make ten times more milk from your cows.  At the same time, you become vulnerable to ten times more risk... if the winter is very cold, which is very possible in Mongolia, then you could lose all ten cows.  You could be left with no cows, no money and you owe the bank 3,600,000 tugriks.  

Now consider the financial crisis.  During the boom years banks used mortgage backed securities to leverage their profits.  But they undervalued risk and did not maintain enough equity capital to act as a buffer in the event of a crisis in the market.  In fact, instead of keeping significant amounts of capital they bought insurance to cover the possibility of large scale defaults.  When the housing crisis hit, insurance companies like AIG were not able to cover the large volume of filings from the banks.  Many banks did not have enough capital to survive and either failed or needed large scale bailouts to stay afloat.  Now that the crisis is over banks are choosing to grow their capital reserves instead of lend out money.  They now have to factor in the possibility of a financial crisis in their spread sheets.  The government has tried to induce lending using quantitative easing (this is the process of lowing interest rates in order to allow banks to barrow cheaply from the government)  but banks continue to be reluctant to take advantage of the low interest rates and leverage their profits.