Intermediary Leverage Cycles and Financial Stability

Tobias Adrian
Wed, Jul 30, 2014
PIMS, University of British Columbia
PIMS Workshop on the Economics and Mathematics of Systemic Risk

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 exposure to intermediary leverage shocks earns 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 intermediaries’ leverage and net worth. Regulations that tighten funding constraints affect the systemic risk-return trade-off by lowering the likelihood of systemic crises at the cost of higher pricing of risk. (Joint work with Nina Boyarchenko - FRBNY)