The complexity of modern leverage is elevating financial system risks, beyond just the total amount of debt. Five key factors contribute to this increased risk: multiple layers of debt making true equity opaque, diverse lenders beyond traditional banks with varying credit standards, increasing reliance on asset values for debt servicing, a broader range of assets being leveraged (including illiquid ones), and embedded leverage like binary options that amplify losses disproportionately.
Modern leverage differs significantly from past forms, including simple borrowings for asset purchases. Examples of this complexity include private equity net asset value loans, where funds borrow against already leveraged businesses, creating multiple claims on underlying cash flows. The "shadow banking system," comprising institutional investors and various funds, now accounts for about 50 percent of global financial services assets, further diffusing risk through intricate financial chains.
Another concern is the shift from leveraging traditional assets to more speculative ones like infrastructure, start-ups, intellectual property, and even catastrophe bonds. These assets are harder to assess, complicating loan-to-value determinations and increasing potential for unforeseen losses. The article also highlights embedded leverage in instruments like junior securities in securitizations, where small numbers of defaults can lead to outsized losses for investors in riskier tranches.
The author, a former banker, points out that traditional regulatory tools like disclosure and capital requirements are insufficient to address this new landscape. Information often arrives too late, and the complex nature of modern leverage makes accurate risk modeling difficult. A significant portion of this exposure resides outside the regulated banking system, where oversight varies across jurisdictions. The article concludes that the economy's reliance on speculation, supported by governments and central banks, makes limiting leverage challenging, as innovators consistently outpace regulators.
Concerns about rising leverage are echoed by figures like Jamie Dimon, CEO of JPMorgan Chase, who warned about higher-than-expected losses on leveraged lending due to weakening credit standards. The $1.8 trillion private credit industry, in particular, is drawing scrutiny, with several large US funds restricting investor withdrawals due to fears of increasing losses on loans to heavily indebted companies. The Bank of England's Deputy Governor Sarah Breeden noted the rapid growth of private credit to $2.5 trillion in 15-20 years, highlighting its opacity, complexity, and interconnectedness with the broader financial system, drawing parallels to the global financial crisis.
