Crime Against Humanity: the Holy GAAP, 28

When the bank grants a loan, the related credit is entered in its balance sheet as an asset. If the borrower fails to pay it back, in part or in full, the loss is booked as a write−down or a write−off of that asset. But… who’s going to bear the loss?
As I said, the bank owes its resources on the assets side of its balance sheet to the providers of those resources on the liabilities side of it, and there are two types of resource providers: owners and lenders. The resources provided by its owners constitute what is called its equity capital, or equity. Equity is the bank’s own capital, the bank belongs to its owners who put it up and these, together with ownership, took responsibility for the business risk as well.
So when a borrower fails to pay back a loan, it’s the bank’s equity to bear the loss, and the bank’s owners through it.

Then there is the concept of leverage ratio: in finance just like in mechanics, a lever is a servomechanism that enables one to add more force to one’s own. In the liabilities side of the bank’s balance sheet, the resources provided by the lenders are the additional force added to that of the owners; the total resources to equity capital is called leverage ratio: every 100 quids the bank loans, how many of them belong to its owners? The more the bank works with other people’s money, the higher is the leverage ratio.

On one hand, the equity capital of the bank is a guarantee for its lenders and customers: in case of impaired loans the losses are absorbed by the owners through it before being dumped on them. On the other hand, just like fractional reserve, the higher the leverage ratio the smaller the guarantee: given a bank with an equity of 1, if it loans 10 there is a leverage of 10 to 1, hence 10 percent of impaired loans will wipe out its equity; if it loans 100 instead, there is a leverage of 100 to 1, hence to wipe it out 1 percent of impaired losses will be enough.