<p>The point @EnergyNumbers raises is correct, and it's easy to understand from an intuitive standpoint: One of the key roles of financial intermediaries is to match the demand for liabilities of a given tenor to the demand for assets of a given tenor. </p>

<p>Financial intermediation allows maturity mismatches to exist in non-finance sectors of the economy by taking the opposite position. To do this, though, financial intermediaries such as banks must have far higher leverage than firms in the rest of the economy.</p>

<p>Consider, for a moment, the tenors of assets that consumers hold: outside of retirement investments (for consumers who are far from retirement age), most consumers have long-dated liabilities (mortgage loans, student loans, etc.), and short-dated assets (bank deposits, money market fund holdings, etc.). This mismatch exists for good reasons. On the liability side, for example, it's not insane for someone to want to own a house and consume housing services before having 100% of the cash necessary to purchase one outright. This sort of consumption smoothing, where one with a long horizon for future earnings brings forward a fraction of their lifetime consumption, is generally considered to be optimal behavior from a utility standpoint. </p>

<p>At the same time, on the asset side, consumers have to be able to smooth shocks to their income, and thus having short-dated, liquid assets, like bank deposits, is also optimal. If you're a consumer who holds all his extra cash in equities, you're going to be really sad when the stock market tanks at the same time that you lose your job and need to cash out of the stock market to cover your expenses for the next few months.</p>

<p>Similarly, non-financial firms have the same sort of demand for assets of particular tenors— they need a certain amount of cash for liquidity management, but at the same time, they want to be able to invest in capital projects (purchase equipment, etc.) that will pay off over a long time horizon. </p>

<p>Of course, in a closed system, the tenor of assets has to equal the tenor of liabilities. So how do we balance this? Financial firms take the other side of these trades, accepting significant maturity mismatches.</p>

<p>Non-financial firms are able to do engage in productive investments by making a deal with financial firms in which the non-financial firms give up a share of their future production in the form of interest payments in exchange for long-dated liabilities. Similarly, consumers are able to engage in consumption smoothing by giving up a share of their future labor income to financial firms in exchange for long-dated liabilities. The financial firms, for their part, end up holding a lot of long-dated assets, while being funded to a great extent by short-dated liabilities (such as bank deposits and money market fund holdings through the wholesale funding market). Financial firms make their money on the spread between maturities (the "carry")— the whole "borrow at 3%, lend at 6%, be at the tee by 3pm" thing.</p>

<p>This has a couple of implications:</p>

<ol>
<li><p>The amount of liabilities financial firms must hold relative to assets is a function both of the demand for assets and liabilities of differing tenors in the rest of the economy (i.e., the maturity mismatch in the rest of the economy) and of <em>the size of the financial intermediation sector relative to the rest of the economy</em>. The smaller financial intermediation is relative to the rest of the economy, the higher the leverage necessary in financial firms to rebalance maturity mismatches elsewhere.</p></li>
<li><p>The existence of significant maturity mismatches in finance means that liquidity risk is concentrated in financial firms, which could lead to bank runs. This is <a href="https://economics.stackexchange.com/questions/5308/what-is-the-necessity-of-the-fdic-in-the-us-banking-system">why deposit insurance is used</a>, and also why banks are given access to the Fed's discount window.</p></li>
</ol>

CC BY-SA 3.0
2015-06-16T15:47:59.607Z
2015-06-16T15:47:59.607Z
2017-04-13T12:51:38.253Z
dismalscience
<p>For this discussion one should use debt to equity, since we are talking about leverage.</p>

<p>In 2008, banks were leveraged 12 to 25 times their equity, 2500%, 25 parts debt, 1 part equity.</p>

<p>Your 30% is actually 30 parts debt to 70 parts equity, or 0.4 parts debt 1 part equity.</p>

<p>A dramatic difference.</p>

<p>Industry does not have a supporting government guaranteeing liquidity. Industry cannot lend and borrow from their competitors while interbank lending is allowed.</p>

<p>Industry does not have a FDIC which tricks consumer into thinking lending to banks is safe.</p>

<p>Industrial capitalism is one thing, but financial capitalism, which gets all the flack, is only possible due to the intervention of the state.</p>

<p>Banks are up to 60 times more powerful than any industry, so all industries combined thanks to the institution of government backed Central Banks etc etc etc. </p>

CC BY-SA 3.0
2015-06-16T11:38:15.780Z
2015-06-16T13:39:47.053Z
2015-06-16T13:39:47.053Z
Stephen
<p>I've been reading a little about the capital structure of banks. For example, in this working paper, &quot;Financing as a Supply Chain: The Capital Structure of Banks and Borrowers&quot; by Gornall and Strebulaev (accessed 2014), it mentions this:</p>
<blockquote>
<p>There is disagreement on the causes and effects of high bank leverage; however, there is no disagreement that banks and other financial institutions are indeed highly indebted. The average leverage of U.S. banks, measured as the ratio of debt to assets, has been in the range of 87%-95% over the past 80 years. At the same time, the average leverage of public U.S. non-financials, measured in the same way, has been in the range of 20%-30% over a long period, below the predictions of many models. This dramatic difference in financial structure is puzzling at first glance.</p>
<p>In this paper, we explain this gap by modeling the interaction between a bank's debt decisions and the debt decisions of that bank's borrowers....</p>
</blockquote>
<p>I am unfamiliar with this literature. I'm wondering, what other explanation exist in the literature to explain the difference in the average leverage between banks and non-financials?</p>

CC BY-SA 3.0
2015-01-24T19:47:23.677Z
Isn't leverage the raison d'etre of a bank? What am I missing?
410 gone
CC BY-SA 3.0
2015-01-24T20:05:26.060Z
@EnergyNumbers Yes exactly. Via maturity transformation, principally.
Rusan Kax
CC BY-SA 3.0
2015-01-24T20:49:33.377Z
@EnergyNumbers I don't see how your comment is pertinent. Any firm (including banks) are principally financed trough either debt or equity. Companies choose how much of their funds they will raise through issuing debt and how much by issuing equity (selling stock). The question is, why aren't banks more equity financed than they are?
jmbejara
CC BY-SA 3.0
2015-01-24T20:58:40.973Z
ok, I'm missing something. But I still don't know what. The question seems akin to asking why steelworks buy so much iron compared to non-steel industries. Banks take deposits: that's what makes them banks. Just as turning iron into steel is what makes a steelworks a steelworks.
410 gone
CC BY-SA 3.0
2015-01-26T20:47:32.827Z
I'm unfamiliar with the literature myself. I think this will help. It gives a little overview of the literature. Later I might look for a better literature review. http://www.philadelphiafed.org/research-and-data/publications/business-review/2011/q2/brq211_can-we-explain-banks-capital-structures.pdf
jmbejara
CC BY-SA 3.0
2015-01-26T23:17:28.417Z
Strictly speaking, just because banks transform duration doesn't mean that they have to take the duration risk onto their balance sheet. They could sell that risk through swap hedging or securitization. If they do hold onto that risk, why they do so is an excellent question.
BKay
<banking><corporate-finance><regulation><capital-structure>
How do we explain the difference in average leverage between banks and non-financial firms?
jmbejara
# How do we explain the difference in average leverage between banks and non-financial firms?

(Asked by: username_0 on 2015-01-24)

I've been reading a little about the capital structure of banks. For example, in this working paper, "Financing as a Supply Chain: The Capital Structure of Banks and Borrowers" by Gornall and Strebulaev (accessed 2014), it mentions this:

> There is disagreement on the causes and effects of high bank leverage; however, there is no disagreement that banks and other financial institutions are indeed highly indebted. The average leverage of U.S. banks, measured as the ratio of debt to assets, has been in the range of 87%-95% over the past 80 years. At the same time, the average leverage of public U.S. non-financials, measured in the same way, has been in the range of 20%-30% over a long period, below the predictions of many models. This dramatic difference in financial structure is puzzling at first glance.
>
> In this paper, we explain this gap by modeling the interaction between a bank's debt decisions and the debt decisions of that bank's borrowers....

I am unfamiliar with this literature. I'm wondering, what other explanation exist in the literature to explain the difference in the average leverage between banks and non-financials?

**Tags:** banking, corporate-finance, regulation, capital-structure
> **Comments:**
> **username_1**: Isn't leverage the raison d'etre of a bank? What am I missing?  
> **username_2**: @EnergyNumbers Yes exactly. Via maturity transformation, principally.  
> **username_0**: @EnergyNumbers I don't see how your comment is pertinent. Any firm (including banks) are principally financed trough either debt or equity. Companies choose how much of their funds they will raise through issuing debt and how much by issuing equity (selling stock). The question is, why aren't banks more equity financed than they are?  
> **username_1**: ok, I'm missing something. But I still don't know what. The question seems akin to asking why steelworks buy so much iron compared to non-steel industries. Banks take deposits: that's what makes them banks. Just as turning iron into steel is what makes a steelworks a steelworks.  
> **username_0**: I'm unfamiliar with the literature myself. I think this will help. It gives a little overview of the literature. Later I might look for a better literature review. http://www.philadelphiafed.org/research-and-data/publications/business-review/2011/q2/brq211_can-we-explain-banks-capital-structures.pdf  
> **username_3**: Strictly speaking, just because banks transform duration doesn't mean that they have to take the duration risk onto their balance sheet. They could sell that risk through swap hedging or securitization. If they do hold onto that risk, why they do so is an excellent question.  

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## 2 answers

### Answer by username_4 on 2015-06-16. Score: 3

The point @EnergyNumbers raises is correct, and it's easy to understand from an intuitive standpoint: One of the key roles of financial intermediaries is to match the demand for liabilities of a given tenor to the demand for assets of a given tenor.

Financial intermediation allows maturity mismatches to exist in non-finance sectors of the economy by taking the opposite position. To do this, though, financial intermediaries such as banks must have far higher leverage than firms in the rest of the economy.

Consider, for a moment, the tenors of assets that consumers hold: outside of retirement investments (for consumers who are far from retirement age), most consumers have long-dated liabilities (mortgage loans, student loans, etc.), and short-dated assets (bank deposits, money market fund holdings, etc.). This mismatch exists for good reasons. On the liability side, for example, it's not insane for someone to want to own a house and consume housing services before having 100% of the cash necessary to purchase one outright. This sort of consumption smoothing, where one with a long horizon for future earnings brings forward a fraction of their lifetime consumption, is generally considered to be optimal behavior from a utility standpoint.

At the same time, on the asset side, consumers have to be able to smooth shocks to their income, and thus having short-dated, liquid assets, like bank deposits, is also optimal. If you're a consumer who holds all his extra cash in equities, you're going to be really sad when the stock market tanks at the same time that you lose your job and need to cash out of the stock market to cover your expenses for the next few months.

Similarly, non-financial firms have the same sort of demand for assets of particular tenors— they need a certain amount of cash for liquidity management, but at the same time, they want to be able to invest in capital projects (purchase equipment, etc.) that will pay off over a long time horizon.

Of course, in a closed system, the tenor of assets has to equal the tenor of liabilities. So how do we balance this? Financial firms take the other side of these trades, accepting significant maturity mismatches.

Non-financial firms are able to do engage in productive investments by making a deal with financial firms in which the non-financial firms give up a share of their future production in the form of interest payments in exchange for long-dated liabilities. Similarly, consumers are able to engage in consumption smoothing by giving up a share of their future labor income to financial firms in exchange for long-dated liabilities. The financial firms, for their part, end up holding a lot of long-dated assets, while being funded to a great extent by short-dated liabilities (such as bank deposits and money market fund holdings through the wholesale funding market). Financial firms make their money on the spread between maturities (the "carry")— the whole "borrow at 3%, lend at 6%, be at the tee by 3pm" thing.

This has a couple of implications:

1. The amount of liabilities financial firms must hold relative to assets is a function both of the demand for assets and liabilities of differing tenors in the rest of the economy (i.e., the maturity mismatch in the rest of the economy) and of *the size of the financial intermediation sector relative to the rest of the economy*. The smaller financial intermediation is relative to the rest of the economy, the higher the leverage necessary in financial firms to rebalance maturity mismatches elsewhere.
2. The existence of significant maturity mismatches in finance means that liquidity risk is concentrated in financial firms, which could lead to bank runs. This is [why deposit insurance is used](https://economics.stackexchange.com/questions/5308/what-is-the-necessity-of-the-fdic-in-the-us-banking-system), and also why banks are given access to the Fed's discount window.


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### Answer by username_5 on 2015-06-16. Score: -2

For this discussion one should use debt to equity, since we are talking about leverage.

In 2008, banks were leveraged 12 to 25 times their equity, 2500%, 25 parts debt, 1 part equity.

Your 30% is actually 30 parts debt to 70 parts equity, or 0.4 parts debt 1 part equity.

A dramatic difference.

Industry does not have a supporting government guaranteeing liquidity. Industry cannot lend and borrow from their competitors while interbank lending is allowed.

Industry does not have a FDIC which tricks consumer into thinking lending to banks is safe.

Industrial capitalism is one thing, but financial capitalism, which gets all the flack, is only possible due to the intervention of the state.

Banks are up to 60 times more powerful than any industry, so all industries combined thanks to the institution of government backed Central Banks etc etc etc.


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