Question

1. Explain how financial leverage at investment banks differ from financial leverage at more traditional commercial banks. What is the benefit of this leverage? What are the primary risks associated with the financial manager?

Answer 1

The concept of Financial leverage in commercial banks is slightly different form that in investment banks because commercial banks can write down only that portion of its assets which is financed by its capital otherwise the money of its bond and deposit holders will be in danger there is a ratio to measure the level of leverage in commercial banks which is known as leverage ratio( total debt to capital ratio)this ratio should not be higher then a particular metric so its Federal reserve 's responsibility to keep it in check through regulatory capital requirements and leverage banckmarks. Now why these banks borrow if there is so much issues with it ,because for banks it is comparatively difficult to raise capital but easy to borrow and moreover debt has its own benefits which we will discuss later in this answer but because of these regulations commercial banks can't reap full benifits of leveraging. Now in investment banks there is no such regulation hence they can use leverage to harrness its benifits in full.

As far the benifits of leverage is concerned ,as its name suggests it leverages or magnifies the returns lets understand it with an example suppose there are two persons A and B both have $100000 as their own capital.but A borrows $1000000 from C at 7 % interest now A is having a fund of $1100000 and B is having a fund of $100000. They both put their money in businesses which belong to the same industry that provides a return of 10% .now lets calculate their profits

For A:

Return from business =10%of1100000=110000

Interest paid to C at 7%of 1000000=70000

Profit= 110000-70000=35000

For B:

Return from business =10% of 100000=10000

As we can see A has used leverage which magnified its returns.

Second benifit of debt is it provides you with Tax shield( saves tax)

But apart from the benifits discussed above, there are also some risk attached with leverage which a financial manager faces.excessive leverage can lead to threat on solvency because if the business and its assets are not providing sufficient returns,the economy is not doing well and there is huge amount of debt outstanding in books which is creating a huge pile of interest.so because of low returns these interest will not be paid or to pay this company has to borrow more funds which will lead the company to run in bankruptcy cost.and also after a particular amount of leverage the size of interest become so big that it eats up the benefits of tax shield hence there should always be an optimal amout of leverage.