The Optimum Leverage Level of the Banking Sector

Abstract

Banks make profits from the difference between short-term and long-term loan interest rates. To issue loans, banks raise funds from capital markets. Since the long-term loan rate is relatively stable, but short-term interest is usually variable, there is an interest rate risk. Therefore, banks need information about the optimal leverage strategies based on the current economic situation. Recent studies on the economic crisis by many economists showed that the crisis was due to too much leveraging by “big banks”. This leveraging turns out to be close to Kelly’s optimal point. It is known that Kelly’s strategy does not address risk adequately. We used the return–drawdown ratio and inflection point of Kelly’s cumulative return curve in a finite investment horizon to derive more conservative leverage levels. Moreover, we carried out a sensitivity analysis to determine strategies during a period of interest rates increase, which is the most important and risky period to leverage. Thus, we brought theoretical results closer to practical applications. Furthermore, by using the sensitivity analysis method, banks can change the allocation sizes to loans with different maturities to mediate the risks corresponding to different monetary policy environments. This provides bank managers flexible tools in mitigating risk.