Sunday, November 20, 2011 2 comments ++[ CLICK TO COMMENT ]++

Why do European companies have higher leverage? Anyone know?

I don't have the answer to the question of the blog post, so does anyone have any idea why European companies tend to have higher leverage than American companies?

I remember noticing this when I briefly looked at US-listed European companies a few years ago. This is just one example and one should be careful with extrapolating off one example but, just compare a company like Diageo (DEO) to Brown Forman (BF/B).

In any case, the leverage issue is starting to pop up in news these days because European banks tend to have higher leverage than American companies. In an opinion piece for Bloomberg, Simon Johnson remarks (bolds by me),

By any measure, Deutsche Bank is a giant. Its assets at the end of September totaled 2.28 trillion euros (according to the bank’s own website), or $3.08 trillion. In the latest ranking from The Banker, which uses 2010 data, Deutsche was the second-largest bank in the world by assets, behind only BNP Paribas SA.

The German bank, however, is thinly capitalized. Its total equity at the end of the third quarter was only 51.9 billion euros, implying a leverage ratio (total assets divided by equity) of almost 44. This is up from the second quarter, when leverage was about 36 (assets were 1.849 trillion euros and capital was 51.678 euros.)

Even by modern standards, this is very high leverage. JPMorgan Chase & Co. has a balance sheet about 20 percent smaller than Deutsche Bank’s, but more than twice as much Tier 1 capital, an important indicator of a bank’s financial strength. Bank of America Corp., whose weakness is a serious worry in the U.S. today, has twice Deutsche’s capital. (These comparisons use The Banker’s ranking of the top 25 banks.)

Globally, Deutsche’s capital ratios are relatively healthy, judging by the banking industry’s standard measures. At the end of the third quarter, its Tier 1 capital ratio was 13.8 percent (up from 12.3 percent at the end of 2010) and its core Tier 1, which excludes hybrid debt that can convert into equity, was 10.1 percent.

How does such a highly leveraged bank become “well-capitalized”? The answer is that “risk-weighted assets” were 337.6 billion euros as of Sept. 30. But what is a low risk-weight asset in the European context today? Incredibly, it is sovereign debt, which of course is far from riskless at the moment.

Perhaps Deutsche Bank holds mostly German government debt, which still has safe-haven value. But it’s likely that Deutsche also holds a significant amount of Italian and French government bonds.

Again, this is just one example and one shouldn't blindly extrapolate it to all banks; but it does show the nature of leverage in Europe. One of the best-run banks in Europe, Deutche Bank, appears to have a leverage of around 44. Depending on how your counted, even Lehman Brothers and Bear Stearns weren't that high (although investment bank operations tend to be more riskier). American banks with cloud over them, like Bank of America and Citigroup only have a leverage between 10 to 15 right now (how you count, or mark, the assets impacts these numbers but they don't explain the huge gap between 44x leverage and 15x).

The ironic thing is that American investors, particularly private equity investors, get blamed in America for overloading companies with debt and increasing risk, yet companies as a whole appear to have much lower debt levels in America than in Europe.

So, does anyone have a theory on why European companies, financial as well as non-financial, tend to have higher leverage than in America? Does anyone know if differences in accounting schemes (say how preferred shares or certain types of convertible debt are counted) may explain this? Or is there some cultural element that explains how you can carry higher debt levels?

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2 Response to Why do European companies have higher leverage? Anyone know?

November 21, 2011 at 2:06 AM

for banks the reason is quite simple: Difference in accounting standards.

Under US GAAP banks can net out most of their derivative exposure whereas European banks haveto show derivatives on a gross basis.

This is explained for instance here:

November 21, 2011 at 8:43 PM

Thanks memyselfandi007. I'll study this deeper and maybe post additional thoughts.

Glad to see some knowledgeable folks reading this blog :)

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