Natural Rate of Leverage

"Unfortunately, the further you run from your sins, the more exhausted you are when they catch up to you...and they do."
--Dalton Russell (Inside Man)

Bank leverage generally runs 10:1 or more. This means that banks only hold about ten cents of every dollar deposited. The rest is loaned out or invested.

This amount of leverage is not natural and would not persist in unhampered markets. The only way systemic leverage could be this high is by edict and intervention. Government permits banks to operate with only a fraction of equity and bails out the system when inevitable margin calls (read: bank runs) materialize.

This does not imply that unhampered markets would operate with no leverage. Money would still be loaned or invested in projects deemed worthwhile.

However, the source of those loans would be commodity credit instead of bank credit. Commodity credit comes from real savings-commodities that have been set aside and not consumed. Bank credit is only loosely tied to savings. If a bank has $100 of savings in deposits, then it is legally permitted to create $900 (or more) of credit out of thin air.

The natural amount of leverage in unhampered markets is likely to approximate the general savings rate. The more savings, the more commodity credit available to lend out or invest. Moreover, banks could withstand large amounts of withdrawals from depositors without being rendered insolvent.

Leverage much higher than the savings rate is unlikely to persist in unhampered markets because bank runs driven by depositors nervous about the prospects of not being able to withdraw their funds would generate bankruptcies. Without the back stop of government-sponsored bailouts, people would more prudently vet alternatives for depositing their savings and institutions would more prudently select lending projects.

As such, claims that unhampered markets create conditions of bank instability are clearly misguided. In unhampered markets, bank leverage is low and regulated by buyers and sellers in the market. In hampered markets, bank leverage is high and regulated by bureaucrats.