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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).
Working Paper
The Transmission of Financial Shocks and Leverage of Financial Institutions: An Endogenous Regime-Switching Framework
We conduct a novel empirical analysis of the role of leverage of financial institutions for the transmission of financial shocks to the macroeconomy. For that purpose, we develop an endogenous regime-switching structural vector autoregressive model with time-varying transition probabilities that depend on the state of the economy. We propose new identification techniques for regime switching models.Recently developed theoretical models emphasize the role of bank balance sheets for the build-up of financial instabilities and the amplification of financial shocks. We build a market-based ...
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.
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 and Leverage Relationship and Its Implications for Entry and Concentration in a Low Interest Rate World
Larger firms (by sales or employment) have higher leverage. This pattern is explained using a model in which firms produce multiple varieties and borrow with the option to default against their future cash ow. A variety can die with a constant probability, implying that bigger firms (those with more varieties) have lower coefficient of variation of sales and higher leverage. A lower risk-free rate benefits bigger firms more as they are able to lever more and existing firms buy more of the new varieties arriving into the economy. This leads to lower startup rates and greater concentration of ...
Working Paper
Did High Leverage Render Small Businesses Vulnerable to the COVID-19 Shock?
Using supervisory data on small and mid-sized nonfinancial enterprises (SMEs), we find that those SMEs with higher leverage faced tighter constraints in accessing bank credit after the COVID-19 outbreak in spring 2020. Specifically, SMEs with higher pre-COVID leverage obtained a smaller volume of new loans and had to pay a higher spread on them during the pandemic period. Consistent with an inward shift in loan supply, these effects were concentrated in loans originated by banks with below-median capital buffers. Highly levered SMEs that relied on low-capital large banks for funding before ...
Speech
Financial Stability and Regulatory Policy in a Low Interest Rate Environment
I would suggest that the potential costs of the excessive leverage that arise in a low interest rate environment deserve more research and, I suspect, more focused and proactive policy actions.
Discussion Paper
Houses as ATMs No Longer
Housing equity is the primary form of collateral that households use for borrowing. This makes it a potentially important source of consumption funding, especially for younger households. In a previous post we showed that owner’s equity in residential real estate has finally, thanks to increasing home prices, rebounded to and essentially re-attained its 2005 peak level. Yet in spite of a gain of more than $7 trillion in housing equity since 2012, so far homeowners haven’t been tapping this equity at anything like the pace we witnessed during the housing boom that ended in 2006. In this ...
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 ...
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 ...