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Intermediary Leverage Cycles and Financial Stability

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Systemic Risk: Mathematical Modelling and Interdisciplinary Approaches

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 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. When the regulator’s tool-kit is expanded to include a liquidity ratio, liquidity requirements are preferable to capital requirements, as tightening liquidity requirements lowers the likelihood of systemic distress without impairing consumption growth. Finally, we show that in a model with two types of intermediaries – a “bank” facing risk-based constraints and a “fund” facing skin-in-the-game constraints – bank sector growth leads total financial sector asset growth, while growth of the fund sector does not, which is a feature we confirm in the data.

This talk is part of the Isaac Newton Institute Seminar Series series.

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