Intermediary Leverage Research Articles

The Leverage of Financial Intermediaries, Market Failure, and Regulation

This paper first presents a new approach to examine the leverage of financial intermediaries. It is driven by differing risk preferences and captures two features: Debt serves to boost the return of equity, and equity to safe net debt. Then the paper shows, for the first time, that if unregulated, financial intermediaries are leveraged over the social best level, whereas the leverage of real sectors is not subject to the market failure. The market failure is expounded for the first time. It is fixed by proper capital adequacy regulation. The regulation raises the profit of the finance sector as a whole, but individual financial intermediaries have incentive to circumvent the regulation.