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Leverage and risk in US commercial banking in the light of the current financial crisis

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  • Nikolaos Papanikolaou

    ()
    (Luxembourg School of Finance, University of Luxembourg)

  • Christian Wolff

    ()
    (Luxembourg School of Finance, University of Luxembourg)

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    Abstract

    In this paper we study the relationship between leverage and risk in commercial banking market. We employ a panel data set that consists of the biggest US commercial banks and which extends from 2002 to 2010 thus covering both the years before the outbreak of the current financial crisis as well as those followed. We make clear distinctions among different leverage types like on- and off-balance sheet leverage as well as short- and long-term leverage, which have never been made in the relevant literature. Our findings provide evidence that excessive leverage, both explicit and hidden off-the-balance sheet, rendered large banks vulnerable to financial shocks thus contributing to the fragility of the whole banking industry. In a similar vein, a direct link between short- and long-term leverage with risk is reported before the crisis, showing that leverage has been one of the key factors responsible for the serious liquidity shortages that were revealed after 2007 when the crisis erupted. We also demonstrate that banks which concentrate on traditional banking activities typically carry less risk exposure than those that are involved with modern financial instruments. Overall, our results provide a better understanding of the role of leverage in destabilizing the whole system whereas at the same time contribute to the current discussion on the resilience of the banking sector through the strengthening of the existing regulatory framework.

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    Bibliographic Info

    Paper provided by Luxembourg School of Finance, University of Luxembourg in its series LSF Research Working Paper Series with number 10-12.

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    Date of creation: 2010
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    Handle: RePEc:crf:wpaper:10-12

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    Related research

    Keywords: financial crisis; risk; leverage; commercial banking;

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    Cited by:
    1. Gaston Giordana & Ingmar Schumacher, 2012. "An Empirical Study on the Impact of Basel III Standards on Banks? Default Risk: The Case of Luxembourg," BCL working papers 79, Central Bank of Luxembourg.
    2. Ojo, Marianne, 2010. "Preparing for Basel IV (whilst commending Basel III) : why liquidity risks still present a challenge to regulators in prudential supervision ( Part II)," MPRA Paper 32630, University Library of Munich, Germany.
    3. Mariana Laverde & Esteban Gómez & Miguel Ángel Morales Mosquera, . "Measuring Systemic Risk in the Colombian Financial System: Systemic Contingent Claims Approach," Temas de Estabilidad Financiera 060, Banco de la Republica de Colombia.
    4. Ojo, Marianne, 2012. "Bailouts and longer term refinancing operations (LTROs): when temporary cures generate longer term economic concerns," MPRA Paper 38483, University Library of Munich, Germany.

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