Joint FSF-CGFS Working Group - The role of valuation and leverage in procyclicality
This report explores the link between leverage and valuation in the light of the recent experience of market stress. Prior to the crisis, traditional balance sheet measures of leverage did not give an unambiguous signal of higher risk during the boom years of 2003-07. While balance sheet leverage increased at European banks and US investment banks, and for the household sector in many countries, there was not a widespread increase for other banks or the corporate sector.
Nevertheless, a break in the trend in leverage seems to have occurred around 2003-04 as leverage and risk started to build up in less visible ways, and this set the stage for the crisis:
the leverage and risk embedded in structured credit products increased, making traditional measures of balance sheet leverage less meaningful;
assets held in highly leveraged off-balance sheet vehicles increased dramatically;
maturity mismatches, and exposure to funding liquidity risk, increased as offbalance sheet vehicles and some large financial institutions funded a growing amount of long-term assets with short-term liabilities in wholesale markets.
Since the crisis broke in mid-2007, part of this build-up of leverage and risk has reversed, at times with disruptive consequences. Over a longer time period, and as a result of a range of market and regulatory developments, fair value measurement has come to be more widely used for financial reporting purposes. At the same time, mark-to-market valuation techniques have become more widely used for risk management purposes.
Although it was not well understood during the boom, it has now become clear that these two developments - the increase in leverage and risk during 2003-07 and the spread of marketsensitive valuation techniques - are related. While market practices related to marketsensitive valuation techniques have existed for some time, their growth appears to have created a risk to financial stability. In short, these market practices appear to have contributed to an increase in the procyclicality of leverage in the financial system. Continue reading