Wednesday, September 9, 2009

The New Normal - Financial Leverage

The new normal

In March this year the McKinsey Quarterly published an article entitled The New Normal. In it they said:

Obviously, there will be significantly less financial leverage in the
system. But it is important to realize that the rise in leverage leading up to
the crisis had two sources. The first was a legitimate increase in debt due
to financial innovation—new instruments and ways of doing business that reduced risk and added value to the economy. The second was a credit bubble
fueled by misaligned incentives, irresponsible risk taking, lax oversight, and
fraud. … it is clear that the future will reveal significantly lower levels of
leverage
…”

I think this prognosis is overly influenced by unusual factors impacting the correction we are currently experiencing. A big part of the problem rests with the impact on bank capital from the losses around credit default swaps and their related mortgage backed securities. The banks’ capital determines how much leverage they can put into the market. But that capital will get rebuilt pretty quickly.

Certainly there will be less foolish lending once credit becomes available. On the consumer side, I think we will return to a fairly highly leveraged economy. And from a business perspective, I think we will once again see ample credit available where credit is needed.

The McKinsey article is at:http://www.mckinseyquarterly.com/Strategy/Strategic_Thinking/The_new_normal_2326?gp=1
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