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The simultaneous unwinding of leveraged positions can trigger financial market turbulence. Although balance-sheet measures of leverage are available, it is useful to construct a measure of leverage that incorporates both on- and off-balance-sheet activities. This paper provides measures of leverage implicit in derivative contracts by decomposing the contracts into cash market equivalent components. A leverage ratio can then be calculated for this replicating portfolio, which consists of own funds (equity) and borrowed funds equivalents (debt). Methods for aggregating leverage by institution and by markets are presented. The interaction between leverage and risk is discussed, and a modified capital adequacy ratio is calculated, which captures off-balance-sheet exposure.

Leverage has been singled out as one of the most important factors in the buildup of financial conditions that enabled a single event – the unilateral Russian debt moratorium – to trigger the financial crisis in the fall of 1998, permeating even the deepest and most liquid financial markets in the world (e.g., International Monetary Fund, 1999). The crisis in mature markets has been partially attributed to the rapid and simultaneous unwinding of leveraged positions triggered by adverse price movements. It can further be argued that the ability of highly leveraged institutions to accumulate leverage off the balance sheet and thus their ability to elude the scrutiny of supervisors and the counterparty due diligence process contributed to the vanishing liquidity in normally highly liquid markets. Market participants were caught by surprise when their competitors desired to unwind their leveraged positions all at the same time because they did not know the extent of leveraged positions of everyone else in the market.1 The President's Working Group (1999) concluded that the central public policy issue raised by the near collapse of the long-term capital management hedge fund is how to constrain leverage more effectively and called for an appropriate measurement of leverage and risk. While a controversy surrounds the issue of constraining leverage, observers agree that traditional on-balance-sheet measures do not accurately depict the degree of an institution's leverage because a significant degree of leverage is assumed through off-balance-sheet activities, which are not fully reflected on the balance sheet.

Counterparty due diligence,market level surveillance and prudential supervision at the level of individual institutions are currently constrained by the lack of a measure for off-balance-sheet leverage. The regulatory costs associated with assuming leverage on-the-balance sheet have prompted institutions to take on leverage through off-balance-sheet operations. To judge potential defaults and to determine the potential for financial market turbulence it is necessary to gain an understanding of overall leverage,incorpo rating both, onand off-balance-sheet activities. This paper presents a method of measuring the degree of leverage implicit in selected derivative contracts by decomposing the contract and mapping the replicating portfolio into equity and debt components. The resulting measure differs from commonly used measures of leverage implicit in derivative contracts,su ch as the ratio of notional value over market value. Specifically,the analysis shows that data on current notional amounts need to be collected to measure the economic exposure of an institution more accurately. Evidence that approximates the degree of total leverage indicates a substantial degree of off-balance-sheet leveraging,parti cularly among a few internationally active financial institutions. Changes in the total leverage indicator correspond to anecdotal evidence of leveraging and deleveraging activities of U.S. banks,underscori ng the informational content of the indicator. The substantial off-balance-sheet leveraging activities and the limitations of current capital adequacy requirements for derivatives call for an appropriate capitalization measure that accurately captures total exposure, on- and off-balance-sheet. Approximating such a modified capitalization measure suggests that there could be large discrepancies with traditional capitalization ratios.