The bonsai and the gardener: using flow data to better assess financial sector leverage

This paper discusses the concept of leverage, its components and how to measure and monitor it. It proposes an innovative approach to assessing leverage based on flows using the concept of a marginal leverage ratio, which reveals the leverage related to new activities, as a valuable supplement to the traditional absolute leverage ratio.

The marginal leverage ratio can be used as an early warning tool to signal potential episodes of excessive leverage and to understand if, and how, banks deleverage. Besides capturing the leveraging-deleveraging cycles better than the absolute leverage ratio, the marginal leverage ratio provides an indication of risks that a stable absolute leverage ratio can conceal.