A common theme in finance — Pure play investment banks push into high leverage to achieve profit margins much higher than commercial banks could. Any Downside?
1) profit is magnified by leverage, so is loss. I guess Lehman collapsed under the weight of leverage.
2) Leverage always requires borrowing. In a credit crunch, cost-of-funding, i.e. borrowing cost could suddenly escalate for no apparent reason.
Leverage means borrow $1m to trade $20m worth of security. Leverage is a power tool in the hands of masters. In Goldman's case, the big share holders are the (skilled) partners. I guess these “masters” decided to push up leverage (with risk control in mind) to increase profit and return on their share holdings.
Investment banks achieved such leverage because they weren't highly regulated and restrained as commercial banks. In 2008, GS and MS abandoned that “freedom” due to Item 2) above. As nominal owners of commercial banks (i.e. bank-holding) , they could now borrow at a much lower rate, probably from the US central bank. I guess the amount they could borrow from government was about a trillion dollars for each bank. See http://www.newyorkfed.org/markets/pdcf_faq.html.
Commercial banks and universal banks typically borrow at the deposit rate — the rate on your regular savings accounts. In a credit crunch, these banks have trillions of deposit dollars to provide liquidity to themselves (banks), which means these banks could use the deposit dollars to pay creditors. Icing on the cake — in many countries, deposit dollars are insured by governments to protect consumers, and also to reassure depositors not to create a run on a bank.
With more regulation, leverage ratio must reduce, so does profit margin. However, I am not sure if GS or MS had lower profit margins as a result.
Another (related) form of leverage is margin trading and wide spread in
– listed option
– FX spot, options
– a lot of cash equity trades