Financial intermediary leverage and monetary policy transmission

Abstract

Monetary policy is more effective when financial intermediaries have a higher equity share in their total assets. When the leverage ratio is one standard deviation below average, the marginal effect of a monetary policy shock on realized S&P 500 returns is 89% larger in an event window study. In a VAR exercise, the impulse responses of real variables to a given monetary policy shock also have larger magnitudes when financial intermediaries have a lower leverage. The financial intermediary leverage is counter-cyclical, explaining why monetary policy is less effective during recessions as found in the literature.