February, 2009

Understanding Capital and Leverage in the Financial Markets Debacle of ’07–’08

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As policy makers discuss the causes of the current financial crisis, and possible tools to prevent such crises, the terms "capital" and "leverage" are often used. Evidently, large financial institutions that are highly leveraged can cause a financial panic. Prudential regulators can calibrate appropriate mechanisms to put adequate limits on leverage positions of such firms. In addressing the financial debacle of 2007–2008, it is imperative to understand these concepts, and how they should affect the roles that prudential regulation can play in maintaining stability in the financial system.