Leveraging

Big investment banks on Wall Street such as Lehman Brothers,
Merrill Lynch, and Morgan Stanley were until recently the most
prestigious financial corporations on Wall Street.  They made
huge investment bets with borrowed money, opened branches all
over the world, paid enormous salaries to their executives, and
in the process helped transform the financial landscape.

For so many years, it looked so rosy.  Nothing could go
wrong in this Shangri-La.  But these fortresses were built on
sand.  They were built on leveraging.  And, sooner or later, the
whole thing was destined to come tumbling down.

A $100 investment funded with you own money and earning $10
will provide you with a return of 10%.  But a U.S. investment
bank would typically borrow $95 and use just $5 of its own money;
by earning $10 they would double their original investment of $5.
This in a nutshell is what leveraging is all about.  You can make
enormous profits.  You can also take major risks since you’re
largely using somebody’s else money.  (The interest payable on
the money borrowed is ignored in this example).

But there are two sides to leveraging.  If the venture were
to lose $10, the investment bank would not only lose the $5 it
had invested, but also $5 of the borrowed money.  It wouldn’t
take too many such bad deals to exhaust its thin capital reserve.

Essentially, this is what happened to Bear Stearns and
Lehman Brothers.  They had bet heavily on risky securities tied
to the disastrous U.S. mortgage market.

By now you’ve figured that the above behavior is the reason
why these banks are called investment banks.  A regular bank will
mostly (but not exclusively) take deposits and provide loans to
prime borrowers.

In Canada (and most other industrialized nations) investment
banking (stock trading, packaging and selling securities, etc.)
is mostly done by the same commercial banks that provide you with
banking services through its numerous branches.

Commercial banks in Canada are regulated, and their leverage
(the amount of borrowed money they use to do business) is limited
to a fraction of that found in the lightly regulated U.S.
investment banks.

While Canadian banks can never earn the fabulous profits of
their counterpart in the U.S., they are exposed to much less risk
in bad years.

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