Fundamentally, Assets = Liabilities + Equity. The assets each have risk factors associated with them. With respect to liabilities, the simplest example of a liability is debt but for financial institutions, customer deposits are also liabilities. Leverage is defined as riskiness of portfolio with the simple explanation being that one can lose more than their Equity; here Hindy defines leverage as maximum loss. Leverage can magnify the magnitude of both losses and gains. The last concept is liquidity, defined as how fast can you transform an asset to cash. In general, traded securities are most liquid while private investments or real estate are illiquid.
In financial markets, most investment companies will mark to market their assets, which means at the end of the day, the value of the assets are marked to the current market price. They must do this because shareholders, lenders, and regulators need to have an accurate depiction of the company's value.
For a leveraged institution, if there is a drop in asset values, there will be an even greater decrease in the value of shareholders equity due to leverage. Sometimes the drop in value is so extreme that the institution needs to sell assets or raise equity to be compliant with risk limits or regulation. This initiates a vicious cycle where the institution can potentially fail. In Cypress, banks invested deposits in risky assets such as Greek Bonds, which fell in value, thus wiping out the equity and some deposits. In the United States, the government enacted deposit insurance, where banks pay a small premium each year to insure their deposits.
Systemic Institutions
Regulators can designate certain banks, insurers or even funds as "systemically important." To illustrate, Long-term Capital was an example of a systemically important institution. The fund required leverage in trading their arbitrage strategies in order to increase returns since each arbitrage trade only captured a very small spread. When LTCM was near failing, the Federal Reserve asked banks to inject equity into the hedge fund and slowly wind down positions. Else, the action of unwinding the funds positions could cause a significant disruption in financial markets since banks might hold similar positions as well.
Are Banks Well Capitalized?
One topic always up for debate is whether or not financial institutions mark to market their assets accurately. Certain U.S. banks (for example Bank of America) still trade below book value while having normalized yearly earnings of $2/share, leading value investors to point out that the value of their assets and loans might be inflated. In a past quarterly letter, David Einhorn of Greenlight theorized that the Fed wanted to create the current environment where banks slowly earn returns in order to bolster capital because certain banks might not have enough equity to withstand losses if they truly marked their assets to current market. This also explains the Fed’s yearly Comprehensive Capital Analysis and Review (CCAR) process whereby the government decides whether banks are well-capitalized enough to return extra capital back to shareholders in the form of buybacks and dividends. While most banks want to be able to pass CCAR in order to impress upon the market that they have strong balance sheets, regulators also want to make sure that banks have enough capital to withstand another crisis.
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