LSF Research Working Paper Series

In this paper we study the relationship between leverage and risk in commercial banking market. We employ a panel data set that consists of the biggest US commercial banks and which extends from 2002 to 2010 thus covering both the years before the outbreak of the current financial crisis as well as those followed. We make clear distinctions among different leverage types like onand off-balance sheet leverage as well as shortand long-term leverage, which have never been made in the relevant literature. Our findings provide evidence that excessive leverage, both explicit and hidden off-the-balance sheet, rendered large banks vulnerable to financial shocks thus contributing to the fragility of the whole banking industry. In a similar vein, a direct link between shortand long-term leverage with risk is reported before the crisis, showing that leverage has been one of the key factors responsible for the serious liquidity shortages that were revealed after 2007 when the crisis erupted. We also demonstrate that banks which concentrate on traditional banking activities typically carry less risk exposure than those that are involved with modern financial instruments. Overall, our results provide a better understanding of the role of leverage in destabilizing the whole system whereas at the same time contribute to the current discussion on the resilience of the banking sector through the strengthening of the existing regulatory framework.