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Working Paper
Sovereigns versus Banks: Credit, Crises, and Consequences
Two separate narratives have emerged in the wake of the Global Financial Crisis. One speaks of private financial excess and the key role of the banking system in leveraging and deleveraging the economy. The other emphasizes the public sector balance sheet over the private and worries about the risks of lax fiscal policies. However, the two may interact in important and understudied ways. This paper studies the co-evolution of public and private sector debt in advanced countries since 1870. We find that in advanced economies financial stability risks have come from private sector credit booms ...
Report
Financial Stability Considerations for Monetary Policy: Theoretical Mechanisms
This paper reviews the theoretical literature at the intersection of macroeconomics and finance to draw lessons on the connection between vulnerabilities in the financial system and the macroeconomy, and on how monetary policy affects that connection. This literature finds that financial vulnerabilities are inherent to financial systems and tend to be procyclical. Moreover, financial vulnerabilities amplify the effects of adverse shocks to the economy, so that even a small shock to fundamentals or a small revision of beliefs can create a self-reinforcing feedback loop that impairs credit ...
Report
Good news is bad news: leverage cycles and sudden stops
We show that a model with imperfectly forecastable changes in future productivity and an occasionally binding collateral constraint can match a set of stylized facts about ?sudden stop? events. ?Good? news about future productivity raises leverage during times of expansion, increasing the probability that the constraint binds, and a sudden stop occurs, in future periods. The economy exhibits a boom period in the run-up to the sudden stop, with output, consumption, and investment all above trend, consistent with the data. During the sudden stop, the nonlinear effects of the constraint induce ...
Discussion Paper
The Growth of Murky Finance
Building upon previous posts in this series that discussed individual banks, we examine the historical growth of the entire financial sector, relative to the rest of the economy. This sector’s historically large share of the economy today (see chart below) and its role in disrupting the functioning of the real economy during the recent financial crisis have led to questions about the social value of costly financial services. While new regulations such as the Dodd-Frank Act impose restrictions on financial activities and increase their costs, especially those of large firms, our paper ...
Discussion Paper
Banking System Vulnerability: 2022 Update
To assess the vulnerability of the U.S. financial system, it is important to monitor leverage and funding risks—both individually and in tandem. In this post, we provide an update of four analytical models aimed at capturing different aspects of banking system vulnerability with data through 2022:Q2, assessing how these vulnerabilities have changed since last year. The four models were introduced in a Liberty Street Economics post in 2018 and have been updated annually since then.
Working Paper
The Firm Size-Leverage Relationship and Its Implications for Entry and Business Concentration
Larger firms (by sales or employment) have higher leverage. This pattern is explained using a model in which firms produce multiple varieties, acquire new varieties from their inventors, and borrow against the future cash flow of the firm with the option to default. A variety can die with a constant probability, implying that firms with more varieties (bigger firms) have a lower variance of sales growth and, in equilibrium, higher leverage. In this setup, a drop in the risk-free rate increases the value of an acquisition more for bigger firms because of their higher leverage: They can (and ...
Journal Article
Two Years into COVID, What’s the State of U.S. Businesses?
More than two years after the outbreak of COVID-19, concerns remain that U.S. businesses are substantially more vulnerable and less productive than in the past. Using extensive data on private and public firms allows for a detailed assessment of these concerns. According to a number of performance measures, businesses borrowing from large U.S. banks appear relatively healthy, increased leverage is concentrated among safer companies rather than riskier ones, and probabilities of default are close to pre-crisis levels.
Journal Article
Components of U.S. financial sector growth, 1950-2013
The U.S. financial sector grew steadily as a share of the total business sector from 1959 until the recent financial crisis, when the trend reversed. In this article, the authors develop measures based on firm-level data to estimate the size of the financial sector and its subsectors relative to the total business (financial and nonfinancial) sector over time. The analysis further sheds light on how these size measures are affected by a firm?s choice of financing (whether public or private), firm size, industry type, use of leverage, and regulation. The authors find that the relative size of ...
Working Paper
Endogenous Option Pricing
We show that a structural model of firm decisions can produce very flexible implied volatility surfaces: upward and downward sloping, u-shaped. A calibrated version of the model is able to match many unconditional financial characteristics of the average option-able stock, and can help explain how, contrary to simple economic intuition, more valuable growth and contraction options are associated with a more negatively sloped implied volatility curve (i.e., a more negatively skewed implied distribution).
Report
A Leverage-Based Measure of Financial Instability
The size and the leverage of financial market investors and the elasticity of demand of unlevered investors define MinMaSS, the smallest market size that can support a given degree of leverage. The financial system’s potential for financial crises can be measured by the stability ratio, the fraction of total market size to MinMaSS. We use that financial stability metric to gauge the buildup of vulnerability in the run-up to the 1998 Long-Term Capital Management crisis and argue that policymakers could have detected the potential for the crisis.