Federal Reserve Bank of New York
Intermediary leverage cycles and financial stability
We present a theory of financial intermediary leverage cycles within a dynamic model of the macroeconomy. Intermediaries face risk-based funding constraints that give rise to procyclical leverage and a procyclical share of intermediated credit. The pricing of risk varies as a function of intermediary leverage, and asset return exposures to intermediary leverage shocks earn a positive risk premium. Relative to an economy with constant leverage, financial intermediaries generate higher consumption growth and lower consumption volatility in normal times, at the cost of endogenous systemic financial risk. The severity of systemic crisis depends on two state variables: intermediaries’ leverage and net worth. Regulations that tighten funding constraints affect the systemic risk-return tradeoff by lowering the likelihood of systemic crises at the cost of higher pricing of risk.
Cite this item
Tobias Adrian & Nina Boyarchenko, Intermediary leverage cycles and financial stability, Federal Reserve Bank of New York, Staff Reports 567, 2012, revised 01 Feb 2015.
- E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- G00 - Financial Economics - - General - - - General
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
Keywords: financial stability; macro-finance; macroprudential; capital regulation; dynamic equilibrium models; asset pricing
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