Procyclical Leverage Research Articles

Dynamic leverage policy in Islamic and conventional banks during crises in the OIC countries: a procyclicality and prospect-theory analysis

Purpose The purpose of this study is to investigate and compare the dynamic leverage policies of Islamic and conventional banks within selected Organization of Islamic Cooperation (OIC) countries. The study specifically focuses on the concepts of leverage procyclicality and prospect theory. Design/methodology/approach To achieve the research objectives, the study uses data from three distinct periods: Crisis I (2007–2009), Crisis II (2011–2012) and Crisis III (2020). The analysis uses dynamic panel-data regression, using the generalized method of moments (GMM) technique. Findings The research findings indicate that both Islamic and conventional banks demonstrate leverage procyclicality. Interestingly, Islamic banks exhibit weaker leverage procyclicality during normal conditions but display stronger procyclicality during crises compared to their conventional counterparts. The application of prospect theory reveals that both bank types exhibit risk-taking or risk-averse behavior through leverage under certain financial and market performance measures as the first-level domain of the gain-vs-loss condition. Furthermore, during crises (as the second-level domain of the normal-vs-crisis condition), both Islamic and conventional banks experience heightened leverage. Notably, Islamic banks, owing to their lower risk exposure and greater shock resilience, demonstrate lesser risk-taking behavior through leverage than conventional banks, both during periods of underperformance and worsening conditions amid crises. These findings validate the extension of prospect theory's applicability in a two-level domain perspective. The dynamic nature of leverage policy, being procyclical and adhering to prospect theory, also varies following different crises specifically. Research limitations/implications The study's limitations include the unequal crisis periods (Crises I, II and III), leading to an imbalanced examination of their effects, certain financial and market performance metrics that fail to corroborate the expected hypotheses and the limited generalizability of findings beyond the selected OIC countries. Practical implications Understanding the intricate dynamics and behavioral aspects of leverage policy for both Islamic and conventional banks, particularly during crisis scenarios, proves crucial for reviewing banking regulations, making informed financial decisions and managing risks effectively. Originality/value This study enriches the current knowledge by presenting two key points. First, it highlights the dynamic nature of leverage procyclicality in Islamic banks, showing a change from weaker procyclicality in normal conditions to stronger procyclicality during crises compared to conventional banks. Second, it expands the application of prospect theory by introducing a dual-level domain context. Examining the comparative leverage policies of Islamic and conventional banks during different crises within OIC countries provides novel insights into leverage procyclicality and behavioral responses.

Animal spirits, bankruptcies, and monetary policy effectiveness in a hybrid macroeconomic agent-based financial accelerator model

This paper develops a hybrid model with an agent-based financial accelerator framework embedded in a standard new Keynesian economy. It explores the interactions between the financial accelerator and the credit market, focusing on the effects of bankruptcy. The paper replicates credit-market relationships, modeling various credit crunch scenarios. It uncovers endogenous fluctuations and “animal spirits” in entrepreneurs’ expectations, driving investment and production decisions. Notably, higher pro-cyclical leverage can have destabilizing effects in the presence of small shocks, increasing entrepreneurs’ bankruptcies. The results suggest that monetary policy’s effectiveness in stabilizing fluctuations depends on factors such as heterogeneity, bounded rationality, and heuristic updating mechanisms. Moderate monetary policies perform better in terms of economic growth with moderate-to-low volatility, while aggressive policies on inflation assist bounded rational agents in reducing errors in investment decisions and default rates, fostering a more stable macroeconomic environment. Increasing forecasting options introduces diversification among entrepreneurs, reducing volatility and stabilizing investments. More options mitigate investment fluctuations, acting as a counterbalance to prevailing market sentiments. Over time, individuals weakly adhering to trends or adopting contrarian approaches come to dominate the population of entrepreneurs, enhancing the overall stability of investment decisions.

Heterogeneous effects of macroprudential policies on firm leverage and value

We empirically investigate the effect of financial institution-targeted macroprudential policies on firms using a comprehensive macroprudential policy dataset and corporate panel data across 35 countries. We find that tightening of macroprudential measures persistently curbs the leverage of firms, while loosening is related to the increase in leverage. We also find that this effect on leverage is heterogeneous across firms, as net macroprudential policy actions reduce the procyclicality of leverage more significantly for small firms and firms with high leverage. Also, we estimate the effect of macroprudential policies on firm value to evaluate potential policy trade-offs as the policies restrict the firms' access to credit during economic booms while protecting them from future financial crises. The effect of macroprudential policies on firm value is generally positive despite the policies' restrictive nature. Further, the effect on firm value is heterogeneous depending on firm characteristics: the positive effect becomes stronger as firms are less leveraged, but this positive effect is weaker for firms that grow faster, suggesting potential costs of macroprudential policies for these firms.

The currency channel of the global bank leverage cycle

The amplitude of leverage procyclicality is heterogeneous across banks and across countries. This paper introduces international diversification of bank balance sheets as a factor in this observed heterogeneity, with a special emphasis on currency diversification. Based on a new theoretical framework, it shows that the impact of international diversification on leverage procyclicality depends on the relative performance of economies, the global business cycle and the exchange rate regime. By altering the distribution of global bank portfolios, international diversification adds a currency channel to the risk channel of the global leverage cycle. Using granular data on banks located in Prance, the paper shows that the pre-crisis international diversification of banks increased leverage procyclicality during the 2008–2009 crisis. Focusing on the currency channel, namely the valuation effect of currency diversification, my results show that it had a negative effect on leverage procyclicality during this period. The currency channel thus helped to offset part of the increased risk caused by the crisis. These findings draw attention to the specific role of balance sheet currency diversification in financial stability risk.

Leverage and systemic risk pro-cyclicality in the Chinese financial system

In this paper, we investigate the relationship between balance sheet size and leverage (i.e., leverage pro-cyclicality) and the pro-cyclicality of systemic risk using three systemic risk measures such as ΔCoVaR (Adrian and Brunnermeier (2016)), MES (Acharya et al. (2017)), SRISK (Brownlees and Engle (2016)). We conduct an extensive panel data analysis using a sample of 264 Chinese listed financial institutions (43 commercial banks, 74 finance services and 147 real estate finance services) over 2005:4–2019:4. We also study the impact of different phases of the financial turmoil by considering three subperiods, the “Global Financial Crisis” (2007:1–2009:4), the “Monetary Policy Restriction” (2010:1–2014:4), and the “2015 Chinese Stock Crash” (2015:1–2019:4). We find that leverage pro-cyclicality mainly affects CBs, in particular during the global financial crisis and the monetary policy restriction. We also find that larger financial institutions increase systemic risk, in particular commercial banks, which from 2016 started increasing shadow banking activities, and the real estate financial services with their activity closer to commercial banking.

Leverage and balance-sheet size: a comparative study between Islamic and conventional banks

ABSTRACT We carry out a comparative analysis of procyclical leverage between Islamic banks and conventional banks in the GCC countries and Malaysia. We collect an unbalanced panel data set including 57 conventional banks and 73 Islamic banks covering the period 2000–2019. First, we document strong evidence of procyclical leverage for our sample banks. Second, our results highlight that conventional banks have statistically stronger leverage procyclicality than Islamic banks, even after controlling for accounting profitability, economic conditions, bank regulations, and wholesale funding. Moreover, we document that the differential in the leverage procyclicality across Islamic banks and conventional banks has been stronger after the global financial crisis, and seems to be more pronounced in small banks compared with large banks. Our findings suggest that the differential in the leverage procyclicality across the two types of banks is related to their different business models. An implication of our results is that the low leverage procyclicality of Islamic banks is a key factor contributing to the stability of a dual banking system.

Leverage dynamics over the business cycle: Evidence from Taiwan listed and unlisted firms

As the role of credit expansion in fueling economic booms and sowing the seeds of severe economic downturns has been the focus of many recent studies, e.g., Koo (2009) and Jordà et al. (2013, 2015), in the current study we employ data on Taiwan’s 1477 publicly listed firms and 1358 unlisted firms over the period of 1986–2014 to study their leverage dynamics over the business cycle. Through our panel regressions, we find (1) debt financing and equity financing are procyclical for most firms examined; (2) for the less mature firms, the leverage ratio tends to move countercyclically for unlisted firms while procyclically for the larger-sized publicly listed firms; (3) for the more mature firms, the leverage ratio tends to be mildly countercyclical for most unlisted firms while procyclical for most publicly listed firms; (4) the procyclicality of leverage is strongest for the largest publicly listed firms while the countercyclicality of leverage is strongest for the less mature smallest unlisted firms. Our overall findings accord well with the prediction of Berger and Udell (1998)’s “financial growth cycle hypothesis” and have the important implication that Taiwan’s small and medium enterprises, a major part of the private sector, are unlikely to be the source of over-leveraging and financial instability.

Ambiguity attitudes and the leverage cycle

Financial crises originate in debt markets, where beliefs formation about asset values affects the value of collateral, hence the leverage cycles. We introduce novel state-contingent ambiguity attitudes, which endogenously induce pessimism in recessions and optimism in booms, in a model with occasionally binding collateral constraints and exogenous debt supply. Ambiguity is measured in the data through GMM estimation of the Euler equations, and delivers over-extrapolative behaviors through forecasters' beliefs' wedges and forecast errors. Analytically and numerically (global methods), it is shown that the model explains asset price and debt cycle facts. Optimism heightens the build-up of debt and asset prices prior to a crisis event and enhances leverage pro-cyclicality; pessimism heightens the de-leveraging following it.

Divergent risk-attitudes and endogenous collateral constraints

Financial crises are anticipated by leverage build-up and asset price booms and followed by sharp de-leveraging and asset price burst. Leverage pro-cyclicality, debt margins counter-cyclicality and heightened asset price volatility are often hard to reconcile with credit frictions models, with and without occasionally binding constraints. We show that a model in which the anticipatory effects of occasionally binding collateral constraints interact with borrowers' time-varying risk-attitudes (modeled through gain-loss reference dependent utilities) and with borrowers/lenders risk-attitudes heterogeneity can explain those facts. Simulations through global methods show that the model can also match numerous statistics characterizing the asset price and leverage cycles.

Heterogeneous Effects of Macroprudential Policies on Firm Leverage and Value

We empirically investigate the effect of financial institution-targeted macroprudential policies on firms, using a comprehensive macroprudential policy dataset and corporate panel data across 29 countries. We find that the tightening of macroprudential measures persistently curbs the leverage growth of firms, while there is no indication that the loosening of the measures is related to the increase in leverage growth. We also find that this effect on leverage is heterogeneous across firms, as net macroprudential policy actions reduce the procyclicality of leverage more significantly for small firms and firms with high leverage. Also, we estimate the effect of macroprudential policies on firm value to evaluate potential policy trade-offs as the policies restrict the firms' access to credit during economic booms while protecting them from future financial crises. The effect of macroprudential policies on firm value is generally positive despite the policies' restrictive nature. Further, the effect on firm value is heterogeneous depending on firm characteristics: the positive effect becomes stronger as firms are less leveraged; but this positive effect is weaker for firms that grow faster, suggesting potential costs of macroprudential policies for these firms.

Procyclical leverage in Europe and its role in asset pricing

Since the global financial crisis a growing literature stresses that financial intermediaries balance sheet management may reinforce financial market shocks with severe consequences for the real sector of the economy. In this paper we provide empirical evidence for this view from European and German asset markets. GMM estimations as well as dynamic asset pricing models reveal that broker–dealer leverage is procyclical with a positive price of risk and also forecasts future asset returns. Overall, our results provide evidence in favor of the importance of broker-dealers as marginal investors in asset markets.

Procyclical leverage: Evidence from banks’ lending and financing decisions

Abstract Middle-aged people have a higher demand for bank loans compared to other age groups and banks that are active in regions with more middle-aged residents are exposed to higher loan demand. This generates a geographically varying demand for loans. Using this variation, we show that banks increase their loan supply and expand their balance sheet with an increase in their loan demand. They finance this expansion mainly with debt. This leads to a decrease in their Tier 1 ratios and an increase in their leverage, i.e., leverage is procyclical. By differentiating between worse-and better-capitalized banks, we highlight the importance of bank capital in banks’ lending and financing decisions.

Housing Boom, Mortgage Default and Agency Friction

The housing prices and the mortgage debt witnessed faster growth than GDP in the run-up of the Great Recession. I document a mortgage market puzzle during the boom period: (1) the mortgage risk measured by the ex post delinquency increased, but (2) the mortgage spread decreased. The default premium alone cannot explain the decreasing mortgage spread in the boom episode. I develop a dynamic general equilibrium model of the housing and the mortgage markets with borrowers, depositors, and intermediaries to explain the empirical fact. The model features the tightness of the lending condition and the mortgage risk as the aggregate shocks, which generate the time-varying liquidity and default premiums in the mortgage spread. I quantify the contribution of the aggregate risks to the boom-bust dynamics before and after the Great Recession. A plausible size of the income shock alone is insufficient to generate the observed movement in the mortgage spread. The model shows that the lending relaxation that eases the leverage constraint of an intermediary leads to the increasing mortgage credit and the decreasing mortgage spread in the boom period. The lending condition shock generates pro-cyclical leverage of intermediaries that amplifies the aggregate shocks in the boom-bust dynamics.

Procyclical Leverage in Europe and its Role in Asset Pricing

Broker-dealer leverage has recently proven to be strongly procyclical, exhibiting impressive explanatory power for a large cross-section of asset returns in the US. In this paper we add empirical evidence to this finding, showing that European and German broker-dealers actively manage their balance sheets. Moreover, by applying standard Fama-MacBeth regressions as well as dynamic asset pricing models (Adrian, Crump, and Moench, 2015), we confirm the importance of brokerdealer balance-sheet indicators for asset pricing. In particular, leverage shows a procyclical behavior with a positive price of risk. Moreover, high leverage coincides with high asset prices, thereby forecasting lower future returns.

Banks’ leverage behaviour in a two-agent new Keynesian model

We study the distributive effects of a negative shock to banks assets in a saver-capitalist model. We analyze how this kind of heterogeneity affects macroeconomic variables and the distribution between savers and capitalists through banks leverage procyclicality. The distributive effects are non-favourable to savers and long lasting. Lower risk aversion of capitalists strengthens and lengthens the procyclicality of leverage, leading to a lower decrease of savers’ income and consumption. Whilst stricter regulatory requirements are favourable to savers, a tougher inflation targeting is unfavourable to savers. The model is robust to the combined introduction of labour market frictions and hysteresis, which together generate an amplification and lengthening of the recessionary and distributive effects unfavourable to savers.

Securitized banking, procyclical bank leverage, and financial instability

This paper provides a theoretical explanation of procyclical leverage of the broker-dealer sector and examines its macroeconomic consequences within the context of the securitized banking system characterized by loan securitization and collateralized short-term borrowing. First, from a model of repo transaction, it is shown that a broker–dealer (repo borrower)'s optimal leverage is positively related to asset prices. The main mechanism underlying this relation is a movement of repo rate, which reflects counter-party risks and collateral value risks repo lenders are facing. Second, based on this result, I develop a macroeconomic model with a securitized banking system characterized by procyclical bank leverage and identify conditions under which the model exhibits a limit cycle behavior. A vulnerability of the repo market to asset price fluctuations leads to procyclical bank leverage, which aggravates asset price cycles driven by the supply-led credit expansion and collapse. It is also found that as the procyclicality of bank leverage becomes stronger the financial cycles also get more intense and severe.

Investment dealer collateral and leverage procyclicality

This paper introduces a novel data set to examine the relationship between leverage and asset growth in the Canadian investment broker-dealer sector over the period of 1992–2010. Investment dealers have highly procyclical leverage, in that leverage growth is highly correlated with asset growth. This is largely due to collateralized borrowing, whereby increases in asset values lead to increases in collateral (margin deposits), allowing investment dealers to borrow against these deposits and purchase more assets. Of course, decreases in collateral value have the opposite effect and margins can be destabilizing if investment broker-dealers are forced to de-leverage.

Learning financial shocks and the Great Recession

This paper develops a simple business-cycle model in which financial shocks have large macroeconomic effects when private agents are gradually learning the uncertain environment. Agents update their beliefs about the reduced-form structure of the economy. Because the persistence of leverage is overestimated by adaptive learners, the responses of output, investment, and other aggregates under adaptive learning are significantly larger than under rational expectations. In our benchmark case calibrated using US data on leverage, debt-to-GDP and land value-to-GDP ratios for 1996Q1–2008Q4, learning amplifies leverage shocks by a factor of about three, relative to rational expectations. When fed with actual leverage innovations observed over that period, the learning model predicts that the persistence of leverage shocks is increasingly overestimated after 2002 and that a sizeable recession occurs in 2008–2010, while its rational expectations counterpart predicts a counter-factual expansion. In addition, we show that procyclical leverage reinforces the amplification due to learning and, accordingly, that macro-prudential policies that enforce countercyclical leverage dampen the effects of leverage shocks.

Erratum to: The contribution of bank regulation and fair value accounting to procyclical leverage

Erratum to: The contribution of bank regulation and fair value accounting to procyclical leverage

The contribution of bank regulation and fair value accounting to procyclical leverage

Our analysis of how banks’ responses to asset price changes can result in procyclical leverage reveals that, for banks with a binding regulatory leverage constraint, absent differences in regulatory risk weights across assets, procyclical leverage does not occur. For banks without a binding constraint, fair value and bank regulation both can contribute to procyclical leverage. Empirical findings based on a large sample of U.S. commercial banks reveal that bank regulation explains procyclical leverage for banks relatively close to the regulatory leverage constraint and contributes to procyclical leverage for those that are not. We also show that fair value accounting does not contribute to procyclical leverage.