What is Deleveraging?

Deleveraging is a process that is employed by financial institutions, businesses and governments to reduce the amount of financial leverage currently in place. This is usually accomplished by paying off or otherwise reducing the amount of borrowed capital. The deleverage activity usually takes place when the purpose for borrowing the capital does not result in the growth predicted and steps must be taken to minimize the negative impact.

One of the best examples of deleveraging is found in the business world. A company will often seek to finance a growth project by borrowing capital from a bank or group of banks. This is often seen as a wiser option than liquidating existing financial assets. The idea is that the growth project will begin to operate at a profit within a projected period in time and eventually pay off the cost of the loan without ever touching the core assets of the company.

If the growth project does not yield the anticipated results, the company must begin to undergo a period of deleveraging. During this period, the company will take steps to pay off the loans associated with the borrowed capital. This often means making use of the core assets of the company in order to retire the debt. As a result, the overall value of the company is decreased rather than increased by the attempt at growth.

Deleveraging functions as a means to retire the debt with as little damage to the company as possible. While investors may consider deleveraging as a sign of failure, the process may actually function as a way of preventing the business from falling into deeper financial trouble and eventually putting the core operation at risk. From this perspective, deleveraging can be viewed as a means of minimizing the damage caused by the failed growth attempt.

Governments and banking institutions may also employ this basic process of deleveraging as well. With governments, retiring debt that was incurred as part of some attempt to improve the infrastructure of the local, state, or federal jurisdiction is often a means of preventing more money from being invested in a project that is ultimately doomed to fail. With banks, deleveraging is a means of putting an end to an investment attempt that did not yield the results projected. While in all cases the retirement of the debt does impact the overall assets held by the entity, deleveraging does bring an end to the drain on resources that would otherwise continue.