While financial institutions have been trying to reduce leverage since the credit crisis began about a year ago, the overall financial system is more leveraged than it was before the crisis erupted.
The process of deleveraging, which could take years, will reduce the ability of institutional investors to produce appetizing returns. But some large players in the private equity and hedge fund worlds could actually benefit from a less crowded playing field as other firms are forced out of business.
“The financial crisis showed that financial leverage had become dangerously high, and the universal assumption was that leverage would have to come down,” J.P. Morgan wrote in a research note published June 24.
“So far, this has not occurred: The crisis also destroyed some $400 billion in equity capital, which made leverage across the financial system higher, not lower. Financial institutions, including many asset managers, are scrambling to get back to leverage positions of a year ago,” the research note continued.
Companies can reduce leverage, which J.P. Morgan defines as the degree to which debt is used instead of equity to fund an asset or an activity, in one of two ways. They can sell assets to repay debt, in the process reducing the size of their balance sheets, or they can boost capital by retaining earnings or issuing new equity.
Although the financial sector has raised more than $300 billion in new capital over the past year, the total increase in capital has been insufficient to bring leverage down to pre-crisis levels.
“Reducing systemwide leverage will be an arduous process,” J.P. Morgan wrote. “In the short run, the financial system as a whole is incapable of shrinking its balance sheet. For that, financial institutions need either to raise capital more quickly than they are writing down assets or else wait for the debt to mature.”
