Question

What is meant by the "paradox of leverage?"

Answer 1

Modern Economies rely on heavily on borrowing to make investments. In economic terms, borrowing is called leverage or financial leverage which basically means the amount of debt that an entity uses to buy more assets.

The more debt financing a company uses, the higher its leverage. A high degree of financial leverage means high- interest payments, which negatively affect the Company's bottom- line earnings per share.

When a bank experience a loss, it tends to reduce their leverage ( debt) - that is to deleverage - by selling its assets and issuing securities to enlarge it's equity. However when too many banks try to deleverage in that way simultaneously, it becomes counterproductive; falling prices, which means more losses, less equity and higher leverage ratio. This is called" The Paradox of Leverage"..

It is like, a situation where everyone is trying to reduce debts and improve their balance sheet all at once; but this process of paying off debts created problem for the economy- such as shortage of Liquidity and fall in consumer spending.

If it is seen from personal point of view, it is good to reduce personal debts and improve financial position. But, if everyone does it at the same time it can lead to a financial problems.