Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Tue, 07 Feb 2006

Leverage in banks and derivatives

Commenting on my blog about an Economist column on CDOs, Ajay Shah wrote in his blog that the comparison between derivatives and banks is equally instructive when looking at leverage. He points out that leverage in banking is more than in derivatives and correctly argues that the (inverse of the) capital adequacy ratio is not the correct measure of leverage for a like-for-like comparison with derivatives leverage.

I completely agree with Ajay on this. I present below a few like-for-like comparisons of varying levels of sophistication all of which point to the same reality that banks embody high levels of risk:

Posted at 15:38 on Tue, 07 Feb 2006     1 comments     permanent link


kumar wrote on Tue, 21 Feb 2006 08:47

Re: Leverage in banks and derivatives

Repected prof. Varma This has been an interesting discussion and I would like to add the following: - apparently derivatives may have lesser leverage than banks the important point is the volatility of underlying in the derivatives is quite high vis a vis bank assets. (One may rise the issue that volatility of banking assets is unknown as they are not traded I have no definite answer) - Prof. Shah advocates modelling and computer engineering as corner stones for the successful risk management in derivative markets I feel he is only partially correct in the light of an article in FAJ Nov/Dec 2005 by Henry Kaufman where he lists some of the pitfalls of MTM, Quant models etc and is a nice reading.