Leverage Of Financial Intermediaries Research Articles

Inequality and Asset Fire Sales

It is widely acknowledged that fire sales were a critical factor in inducing and exacerbating the financial crises of 2007--2008. The leverage of financial intermediaries, which is defined as the ratio of total assets to capital, is a key factor in causing fire sales. Why do financial intermediaries expand their balance sheets despite subsequently having to sell their assets at discounted prices? To examine this question, we incorporate financial intermediaries into a three-period incomplete market economy model, in which households face countercyclical and uninsured idiosyncratic income shocks. We demonstrate that countercyclical income inequality and market incompleteness result in leveraged investment and subsequent asset fire sales by financial intermediaries in equilibrium. The first contribution of this paper is that we demonstrate that the mechanism between asset prices and leverages could successfully solve the famed asset-pricing puzzles. The second contribution is that we analyze the impact of financial regulation on the welfare of ex ante homogeneous households.

The Financial Intermediation Premium in the Cross Section of Stock Returns

Using syndicated loan data, I document a premium for the exposure of nonfinancial firms to risks of financial intermediation. Firms that borrow from high-leverage financial intermediaries have on average 4% higher returns than firms with low-leverage lenders. This premium cannot be attributed to differences in firm characteristics. Instead, it stems from the underdiversified lender syndicate structure and elevated firm's refinancing intensity, materializing through inability to favorably renegotiate lending terms and obtain additional financing. Exploiting the dispersion in leverage of financial intermediaries extending credit, I propose a macroeconomic indicator that captures changes in lending standards and forecasts industrial production and unemployment.

The Effects of Robo-Signing on the Economy and Unconventional Monetary Policy

As Akerlof and Shiller (2009) argue, corruption and bad faith played an important role in determining the severity of the recent recessions in the US. This paper studies the impact of robo-signing, which is a typical example of economic bad faith, on the economy and unconventional monetary policy during the last financial crisis. We modify the DSGE model by Gertler and Karadi (2011) by including the features of robo-signing. The paper concludes that banks’ bad faith magnifies the financial crisis through the transmission channel related to changes in the leverage of financial intermediaries and induces the central bank to conduct a more aggressive unconventional monetary policy. We suggest a theoretical framework for studying cases of economic bad faith during the last financial crisis, and provide a model that well fits the data.

Procyclical Leverage and Value-at-Risk

The availability of credit varies over the business cycle through shifts in the leverage of financial intermediaries. Empirically, we find that intermediary leverage is negatively aligned with the banks’ value-at-risk (VaR). Motivated by the evidence, we explore a contracting model that captures the observed features. Under general conditions on the outcome distribution given by Extreme Value Theory (EVT), intermediaries maintain a constant probability of default to shifts in the outcome distribution, implying substantial deleveraging during downturns. For some parameter values, we can solve the model explicitly, thereby endogenizing the VaR threshold probability from the contracting problem.

Procyclical Leverage and Value-at-Risk

The availability of credit varies over the business cycle through shifts in the leverage of financial intermediaries. Empirically, we find that intermediary leverage is negatively aligned with the banks' Value-at-Risk (VaR). Motivated by the evidence, we explore a contracting model that captures the observed features. Under general conditions on the outcome distribution given by Extreme Value Theory (EVT), intermediaries maintain a constant probability of default to shifts in the outcome distribution, implying substantial deleveraging during downturns. For some parameter values, we can solve the model explicitly, thereby endogenizing the VaR threshold probability from the contracting problem.

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.