ABSTRACT
The role of leverage that played in aggravating the credit crunch in the current crisis has been gaining much attention in research. A financial institution’s leverage is defined as the size of its total assets to equity (or, net worth, the term often used later in this book). The leverage of the financial market exhibits strong procyclicality: it rises sharply in the boom, but falls heavily in the bust. As Adrian and Shin (2010) pointed out, this reflects the financial firms’ active management on their balance sheets – otherwise, if one firm’s balance sheet doesn’t respond to the business cycle, the firm’s leverage ratio should be counter-cyclical: falling in the boom since its net worth increases, and vice versa. Therefore, the leverage ratio is a crucial indicator of the firm’s investment and risk management, as well as a key to understanding the financial institutions’ risk taking incentive, helping the regulators see through the murky veil of their daily activities.
