Leverage: definition(s) and practical uses

Leverage is a term familiar in finance, both corporate and private investors use it in some cases. You come across it in many fields, including real estate, investment and the stock market. Banking regulations are no exception, with the leverage ratio. Here are the answers to the classic questions surrounding this concept.

What is leverage in general?

Broadly speaking, leverage is a technique used to increase a company’s capacity to invest and grow through debt. The aim is to use debt to make a profitable investment, where the gains exceed the cost of the loan. In this case, the leverage effect is said to be positive. If the financial cost of the operation exceeds the economic return generated, the leverage effect is negative. This results in losses rather than gains. This practice therefore involves risks and the possibility of losing all the capital.

What are the different types of leverage?

The concept of leverage is used in many areas. To put it simply, why wait to invest if you can get into debt more quickly, with a multiplier effect on profitability? This financial management technique can be found in

  • in trading or the stock market: a trader invests much more money than he has in equity. This approach increases risk and should be reserved for those who understand what is at stake and have the financial capacity;
  • in companies: they invest by taking out a loan rather than on the basis of their equity alone (bootstrapping);
  • in banks: banks lend the money raised via customer deposits, thus creating a leverage effect;
  • in real estate: an individual buys a home on credit. They make savings over the term of the loan, compared with staying in rented accommodation or waiting until they can fully self-finance their investment.

How can you use debt leverage to invest?

Here is an example of a leveraged financial transaction:

  1. investing CHF 1,000 in financial products such as equities ;
  2. choose 4:1 leverage, which increases the position to four times the amount invested, in this case CHF 4,000;
  3. if the share price rises by 20%, the position increases from CHF 4,000 to CHF 4,800, i.e. a positive result of CHF 800, for an initial investment of CHF 1,000;
  4. conversely, if the share price falls by 25%, the loss is CHF 1,000 on an initial investment of CHF 1,000.

In point 4, the position is said to be liquidated and the investor loses all his initial capital. This is why only people with the technical skills and financial capacity to take the risk invest in leveraged products.

What is the leverage ratio (LR) in financial regulations?

Banking regulations use the concept of the leverage ratio (LR). This concept is one of the key regulatory ratios for Swiss banks.

Capital requirements are part of Pillar 1 of the Basel regulations. The capital ratio corresponds to a calculation of risk-weighted assets. Over time, regulators have tightened the constraints with the introduction of the leverage ratio. The aim is to also have a capital ratio that is not risk-weighted.

This leverage ratio is established as a percentage of total exposures. It is the ratio of assets to adjusted capital. It is a way of limiting the absolute amount of leverage possible.

What legislation governs the leverage ratio (LR) in Switzerland?

As a result of Switzerland’s adoption of Basel III final, the resulting amendment to the Capital Adequacy Ordinance will come into force in 2025. The Federal Council adopted this amendment to the OFR on 29 November 2023. As a result, the definition of the leverage ratio, which has until now been set out in Art. 46 of the OFR, has been transferred to Art. 4, para. 1, lit. i.

What about the LR in Swiss banks?

As founder of the RegTech e-Reg solution, and based on his own experience, Enrico Giacoletto gives his views on the leverage ratio. He believes that, generally speaking, for an average Swiss bank, this is a limiting factor when customer deposits are high:

  • due to market tensions ;
  • and/or when interest rates are low.

On the other hand, when interest rates are higher, the leverage ratio is less of a limiting factor for a bank’s balance sheet. As customers invest their deposits, the size of the balance sheet generally falls. It is then the liquidity ratio or LCR that can limit certain activities.