Many financial institutions use leverage to expand their ability to invest or trade in financial assets and to increase their return on equity. A firm can use leverage through a number of strategies, including by using debt to finance an asset or entering into derivatives. Greater financial leverage, as measured by lower proportions of capital relative to assets, can increase the firm’s market risk, because leverage magnifies gains and losses relative to equity. Leverage also can increase a firm’s liquidity risk, because a leveraged firm may be forced to sell assets under adverse market conditions to reduce its exposure. Although commonly used as a leverage measure, the ratio of assets to equity captures only on-balance sheet assets and treats all assets as equally risky. Moreover, the ratio of assets to equity helps to measure the extent to which a change in total assets would affect equity but provides no information on the probability of such a change occurring. Finally, a leveraged position may not be more risky than a non- leveraged position, when other aspects of the position are not equal. For example, a non-leveraged position in a highly risky asset could be more risky than a leveraged position in a low risk asset. During the 1980s, banking regulators became concerned that simple leverage measures—such as the ratio of assets to equity or debt to equity—required too much capital for less-risky assets and not enough for riskier assets and that such measures did not require capital for growing portfolios of off-balance sheet items. In response to these concerns, the Basel Committee on Banking Supervision adopted Basel I, an international framework for risk-based capital that required banks to meet minimum risk-based capital ratios, in 1988. By 1992, U.S. regulators had fully implemented Basel I; and in 1996, they and supervisors from other Basel Committee member countries amended the framework to include explicit capital requirements for market risk from trading activity (called the Market Risk Amendment). In response to the views of bankers and many regulators that innovation in financial markets and advances in risk management have revealed limitations in the existing Basel I risk-based capital framework, especially for large, complex banks, the Basel Committee released the Basel II international accord in 2004. Since then, individual countries have been implementing national rules based on the principles and detailed framework. In a prior report, we discussed the status of efforts by U.S. regulators to implement the Basel II accord. Studies we reviewed suggest that leverage within the financial sector increased before the crisis and that subsequent deleveraging by financial institutions could have contributed to the recent crisis. The causes of the recent financial crisis are complex and multifaceted and remain subject to debate and ongoing research. Given our mandate, our review of the economic literature focused narrowly on deleveraging as one of the potential economic mechanisms contributing to the crisis. The studies we reviewed do not provide definitive findings about the role of deleveraging relative to other mechanisms, and we relied on our interpretation and reasoning to develop insights from the studies we reviewed. Leverage steadily increased in the financial sector before the crisis began around mid-2007 and created vulnerabilities that increased the severity of the crisis, according to studies we reviewed. As mentioned earlier, leverage can take many different forms, and no single measure of leverage exists. In that regard, the studies we reviewed generally identified a range of sources that aided in the buildup of leverage before the crisis. One such source was the reliance on short-term funding by financial institutions, which made them vulnerable to a decline in the availability of such credit. Another source of leverage was special purpose entities (SPE), which some banks created to buy and hold mortgage-related and other assets that the banks did not want to hold on their balance sheets. SPEs often borrowed by issuing shorter-term instruments, exposing them to the risk of not being able to renew their debt. Other sources of leverage included collateralized debt obligations (CDOs) and credit default swaps, a type of OTC derivative. For securities firms, hedge funds, and other financial intermediaries that operate mainly through the capital markets, their balance sheet leverage, or ratio of total assets to equity, tends to be procyclical. Historically, such institutions tended to increase their leverage when asset prices rose and decrease their leverage when asset prices fell. Consistent with this trend, the ratio of assets to equity for five large broker-dealer holding companies, in aggregate, increased from an average ratio of around 22 to 1 in 2002 to around 30 to 1 in 2007 (see fig. 1). In contrast, the ratio of assets to equity for five large bank holding companies, in aggregate, was relatively flat during this period (see fig. 2). As discussed in the background, the ratio of assets to equity as a measure of leverage treats all assets as equally risky and does not capture off- balance sheet risks. As their mortgage-related and other losses grew after the onset of the crisis, banks, securities firms, hedge funds, and other financial institutions have attempted to deleverage and reduce their risk. Deleveraging can cover a range of strategies, including raising new equity, reducing dividend payouts, diversifying sources of funds, selling assets, and reducing lending. After the crisis began, U.S. banks and securities firms initially deleveraged by raising more than $200 billion in new capital from private sources and sovereign wealth funds. However, raising capital began to be increasingly difficult in the subsequent period, and financial institutions have deleveraged by selling assets, including financial instruments and noncore businesses. For example, in the fourth quarter of 2008, broker-dealers reduced assets by nearly $785 billion and banks reduced bank credit by nearly $84 billion. Some studies we reviewed highlighted the possibility that deleveraging through asset sales by financial institutions could trigger downward spirals in asset prices and contribute to a financial crisis. In times of market stress, a sharp decline in an asset’s price can become self- sustaining and lead to a financial market crisis. Following a sharp decline in an asset’s price, investors normally will buy the asset after they deem its price has dropped enough and help stabilize the market, but in times of crisis, investors are unable or unwilling to buy the asset. As the asset’s price declines, more investors sell and push the price lower. For leveraged institutions holding the asset, the impact of their losses on capital will be magnified. To lower their leverage or risk, the institutions may sell more of their assets, which can cause the asset’s price to drop even more and induce another round of selling. In other words, when market liquidity is low, namely in times of market stress, asset sales establish lower market prices and result in financial institutions marking down their positions— potentially creating a reinforcing cycle of deleveraging. In the extreme, this downward asset spiral could cause the asset’s price to be set below its fundamental value, or at a “fire sale” price. In addition, a decline in a financial asset’s price could trigger sales when the asset is used as collateral for a loan. In such a case, the borrower could be required to post additional collateral for its loan, but if the borrower could not do so, the lender could take ownership of the collateral and then sell it, which could cause the asset’s price to decline further. Importantly, other theories that do not involve asset spirals caused by deleveraging through asset sales provide possible explanations for the sharp price declines in mortgage-related securities and other financial instruments. Moreover, as the crisis is complex, no single theory likely is to explain in full what occurred or necessarily rule out other explanations. First, given the default characteristics of the mortgages underlying their related securities and falling housing prices, low market prices may result from asset prices reverting to more reasonable values after a period of overvaluation. Second, the low prices of mortgage-related securities and other financial instruments may have resulted from the uncertainty surrounding their true value. This theory holds that investors may lack the information needed to distinguish between the good and bad securities and, as a result, discount the prices of the good securities. These two theories and the deleveraging hypothesis may provide some insight into how the financial crisis has unfolded and are not mutually exclusive. Nonetheless, at this juncture, it is difficult to determine whether a return to fundamentals, uncertainty, or forced asset sales played a larger causal role. In addition, some studies we reviewed suggested that deleveraging by restricting new lending could contribute to the crisis by slowing economic growth. In short, the concern is that banks, because of their leverage, will need to cut back their lending by a multiple of their credit losses to restore their balance sheets or capital-to-asset ratios. The contraction in bank lending can lead to a decline in consumption and investment spending, which reduces business and household incomes and negatively affects the real economy. Moreover, rapidly declining asset prices can inhibit the ability of borrowers to raise money in the securities markets. Officials from federal financial regulators, two securities firms, a bank, and a credit rating agency whom we interviewed had mixed views about the effects of deleveraging by financial institutions in the recent crisis. Nearly all of the officials told us that large banks and securities firms generally have sought to reduce their risk exposures since late 2007, partly in response to liquidity pressures. The institutions have used a number of strategies to deleverage, including raising new capital; curtailing certain lines of business; and selling assets, including trading assets, loans, and noncore businesses. Regulatory officials said that hedge funds and other asset managers also deleveraged by selling assets to meet redemptions or margin calls. According to officials at a securities firm, raising capital and selling financial assets was easier in the beginning of the recent crisis, but both became harder to do as the crisis continued.