Leverage Shocks Research Articles

Intermediary Leverage Shocks and Funding Conditions

ABSTRACTThe aggregate leverage of broker‐dealers responds to demand and supply disturbances that have opposite effects on financial markets. Specifically, leverage supply shocks that relax broker‐dealers' funding constraints increase leverage, liquidity, and returns and carry a positive price of risk, while leverage demand shocks also increase leverage but reduce liquidity and returns and carry a negative price of risk. Disentangling demand‐ and supply‐like shocks resolves existing puzzles around the price of leverage risk and yields consistent evidence across many markets of a central role for intermediation frictions and dealers' aggregate leverage in asset pricing.

Resilient forces: The role of intangible capital in mitigating financial contagion dynamics

This essay explores the mechanics of financial shocks within a globalized framework, employing a two-country macroeconomic model to distinguish between core and periphery economies. Our research indicates that intangible assets, serving as stable collateral, respond more robustly to economic shocks than traditional physical forms. Moreover, the study highlights the complex transmission mechanisms of productivity and leverage shocks, revealing that while the financial sector effectively assimilates the positive economic outcomes resulting from a productivity shock, leverage shocks, despite depleting capital, paradoxically stimulate overall economic output.

Financial leverage interactions: evidence from US households and government sectors

ABSTRACT Applying VAR/SVAR analysis to the national balance sheet data of the US, this paper provides evidence that the households markedly interact with those of government sectors through the channel of financial leverage, which is defined as the liabilities-to-assets ratio. In particular, the impulse-response and forecasting error decomposition analysis further show that the federal government plays an important role in absorbing the leverage shocks in households. Nevertheless, it should be emphasized that this role of the federal government as somewhat of a macroeconomic stabilizer also costs it heavily in view of its escalating leverage over time. Among other concerns, this highly leveraged financial position renders the federal balance sheet more vulnerable to macro-financial risks, thus reducing the room for manoeuvre for countercyclical policies. Finally, with a relatively low and stable leverage ratio, the state/local governments seem to be less involved in such interactions. However, their prudent balance sheet position also implies that they play a minor role in fiscal measures supporting households during economic downturns.

Disentangling the Effects of Uncertainty, Monetary Policy and Leverage Shocks on the Economy*

AbstractIn this paper, we assess the information content and predictive ability of various risk and uncertainty measures in predicting various measures of real economic activity as well as undertake a comparative analysis of the relative importance of uncertainty, monetary policy and leverage shocks in the macroeconomic business cycle. We find that the macroeconomic uncertainty index and the Chicago Fed national financial conditions risk index have the strongest predictive relationship with economic activities. Also, in the context of a Bayesian monetary structural vector autoregressive, we use the penalty function approach to a sequential identification of uncertainty, monetary policy and leverage shocks, and find that uncertainty shocks are a relatively more important source of variations in the economy than traditional monetary policy shocks. However, monetary policy shocks still outperform uncertainty shocks in explaining inflation dynamics.

Intermediary Leverage Shocks and Funding Conditions

The leverage of financial broker-dealers responds to demand- and supply-like shocks. Supply shocks relax their funding constraint and raise leverage, while demand shocks also raise leverage but tighten the constraint. The shocks play opposite roles in financial markets. Leverage supply shocks improve liquidity and carry a positive price of risk, while leverage demand shocks worsen liquidity and carry a negative price of risk. Because of this difference in signs, disentangling the two types of shocks strengthens the evidence for intermediation frictions in asset pricing, resolves some of the existing puzzles, and can help understand the different mechanisms driving broker-dealer leverage.

The nature of shadow bank leverage shocks on the macroeconomy

Recently a group of non-bank financial institutions, known as the shadow banks, has developed beside the traditional commercial banking sector in the US. Based on the argument of Serletis and Xu (2019) that the traditional banking was overtaken by shadow banks at around the year of 2000, I run two structural VAR models to examine the impact of shadow bank leverage shocks on some key economic indicators in pre-2000 and post-2000 periods. This is a new approach in the literature to examine how the macroeconomy is influenced by the shadow banking sector over time. I find that the traditional contractionary interest rate policy is not helpful to control the leverage of shadow banks. The impulse responses from the VAR models show that shadow bank leverage has become an important economic indicator during the post-2000 period because of its capacity to influence key macroeconomic variables. I suggest the policymakers controlling the leverage of the shadow banks besides the traditional contractionary monetary policy to prevent asset bubbles and maintain financial stability.

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.

Monetary policy and leverage shocks

The current mainstream approach to monetary policy in the United States is based on the new Keynesian model and is expressed in terms of the federal funds rate. It ignores the role of financial intermediary leverage (or collateral rates). But as the federal funds rate has reached the zero lower bound, the issue is whether there is a useful role of leverage in monetary policy and business cycle analysis. Motivated by these considerations and by recent financial intermediary asset pricing theories in this paper, we investigate the macroeconomic effects of broker–dealer leverage and the interdependence between monetary policy and broker–dealer leverage in the context of a structural vector autoregression model, using quarterly U.S. data over the period from 1967:1 to 2014:3. We address the simultaneity problem of identifying monetary policy and leverage shocks by using a combination of short-run and long-run restrictions. We also use the sign restriction approach to the identification of shocks to distinguish between leverage supply and leverage demand shocks, as one would expect the macroeconomic effects of these two types of leverage shocks to be quite different. Our results show that monetary policy and broker–dealer leverage demand shocks produce results that capture reasonable macroeconomic dynamics.

Monetary Policy and Leverage Shocks

The current mainstream approach to monetary policy in the United States is based on the new Keynesian model and is expressed in terms of the federal funds rate. It ignores the role of financial intermediary leverage (or collateral rates). But as the federal funds rate has reached the zero lower bound, the issue is whether there is a useful role of leverage in monetary policy and business cycle analysis. Motivated by these considerations and by recent financial intermediary asset pricing theories, in this paper we investigate the macroeconomic effects of broker-dealer leverage and the interdependence between monetary policy and broker-dealer leverage in the context of a structural vector autoregression model, using quarterly U.S. data over the period from 1967:1 to 2014:3. We address the simultaneity problem of identifying monetary policy and leverage shocks by using a combination of short-run and long-run restrictions. We also use the sign restrictions approach to the identification of shocks to distinguish between leverage supply and leverage demand shocks, as one would expect the macroeconomic effects of these two types of leverage shocks to be quite different. Our results show that monetary policy and broker-dealer leverage demand shocks produce results that capture reasonable macroeconomic dynamics.

Capital structure pre-balancing: Evidence from convertible bonds

A large body of the corporate finance literature is devoted to capital structure. This literature examines whether firms have a target capital structure, and whether they actively rebalance their capital structure toward a target. Since conversion of a convertible bond causes a drop in leverage, target capital structure theory suggests that the structure should be rebalanced in the future. I consistently find that following a realized conversion firms rebalance their positions in less than a year. When the stock price passes the conversion price threshold for a convertible bond, the firm expects this drop in leverage to occur in the near future. Using a regression discontinuity design around the conversion price threshold for those conversions that are decided by investors, not by the firm, my paper documents a 20% increase in leverage before an actual drop in leverage. That is to say, firms do not wait for the realization of leverage shocks but rather respond to anticipated shocks. A quantile treatment effect analysis reveals the effect to be a hump-shaped function of leverage, with a peak for firms with a conditional leverage ratio around the 70th percentile.

International Evidence on the Heterogeneity of Capital Structure Adjustment Speeds

This study analyzes the heterogeneity in the speed of adjustment of leverage ratios subsequent to shocks. Using a sample of firms from the G-7 countries, we estimate capital structure adjustment speeds using a wide range of different dynamic panel methodologies. The mean estimated speed of adjustment is 20% per year, which corresponds to a shock’s half-life of about three years. We compare adjustment speeds in both market- and bank-based economies and show that firms from market-based countries rebalance faster after leverage shocks. Investigating the firm-level determinants of adjustment speed, our findings indicate that highly over-leveraged firms, firms with a higher financing deficit, and constrained firms exert adjustment with a faster speed. Finally, the macroeconomic environment has an impact on the speed of adjustment. Firms adjust more slowly during bad macroeconomic states, and the adjustment dynamics exhibit managerial market-timing behavior.

Learning Leverage 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 their economic environment. When agents update their beliefs about the unobserved process driving financial shocks to the leverage ratio, the responses of output 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 the actual leverage innovations, the learning model predicts the correct magnitude for the Great Recession, while its rational expectations counterpart predicts a counter-factual expansion. In addition, we show that procyclical leverage reinforces the impact of learning and, accordingly, that macro-prudential policies enforcing countercyclical leverage dampen the effects of leverage shocks. Finally, we illustrate how learning with a misspecified model that ignores real/financial linkages also contributes to magnify financial shocks.

Bank Leverage Shocks and the Macroeconomy: A New Look in a Data-Rich Environment

The recent crisis has revealed the potentially dramatic consequences of allowing the build-up of an overstretched leverage of the financial system, and prompted proposals by bank supervisors to significantly tighten bank capital requirements as part of the new Basel 3 regulations. Although these proposals have been fiercely debated ever since, the empirical question of the macroeconomic consequences of shocks to banks' leverage, be they policy induced or not, remains still largely unsettled. In this paper, we aim to overcome some longstanding identification issues hampering such assessments and propose a new approach based on a data-rich environment at both the micro (bank) level and the macro level, using a combination of bank panel regressions and macroeconomic factor models. We first identify bank leverage shocks at the micro level and aggregate them to an economy-wide measure. We then compute impulse responses of a large array of macroeconomic indicators to our aggregate bank leverage shock, using the new methodology developed by Ng and Stevanovic (2012). We find significant and robust evidence of a contractionary impact of an unexpected shock reducing the leverage of large banks.

Intermediary Leverage Cycles and Financial Stability

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. The pricing of risk varies as a function of intermediary leverage, and asset return exposure to intermediary leverage shocks earns 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.

Capital Structure Decisions of Globally-Listed Shipping Companies

Debt capital has traditionally been the most important source of external finance in the maritime industry. The access that shipping companies nowadays have to the international capital markets provides them with a broader range of financing instruments. As such, this study investigates the determinants of capital structure decisions using a sample of 115 exchange-listed shipping companies. We test whether listed shipping companies follow a target capital structure, and we analyze the dynamics of their capital structure adjustment subsequent to shocks in leverage. When compared with industrial firms from the G7 countries, listed shipping companies exhibit higher leverage ratios and higher financial risk. Standard capital structure variables exert a significant impact on the cross-sectional variation of leverage ratios in the shipping industry. Asset tangibility is positively related to corporate leverage, and its economic impact is more pronounced than in other industries. Moreover, profitability, asset risk, and operating leverage are inversely related to leverage. There is only weak evidence for market-timing behavior of shipping companies. Because demand and supply in the maritime industry are closely related to the macroeconomic environment, leverage behaves counter-cyclically. Applying a set of different dynamic panel estimators, we document that the speed of adjustment after leverage shocks is significantly lower during an economic recession. On average, however, the speed of adjustment in the maritime industry is higher compared with the G7 benchmark sample. These findings indicate that there are substantial costs of deviation from the target leverage ratio due to high expected costs of financial distress. Our results also have implications for corporate risk management activities.

Bank Leverage Shocks and the Macroeconomy: A New Look in a Data-Rich Environment

The recent crisis has revealed the potentially dramatic consequences of allowing the build-up of an overstretched leverage of the financial system, and prompted proposals by bank supervisors to significantly tighten bank capital requirements as part of the new Basel 3 regulations. Although these proposals have been fiercely debated ever since, the empirical question of the macroeconomic consequences of shocks to banks’ leverage, be they policy induced or not, remains still largely unsettled. In this paper, we aim to overcome some longstanding identification issues hampering such assessments and propose a new approach based on a data-rich environment at both the micro (bank) level and the macro level, using a combination of bank panel regressions and macroeconomic factor models. We first identify bank leverage shocks at the micro level and aggregate them to an economy-wide measure. We then compute impulse responses of a large array of macroeconomic indicators to our aggregate bank leverage shock, using the new methodology developed by Ng and Stevanovic (2012). We find significant and robust evidence of a contractionary impact of an unexpected shock reducing the leverage of large banks.

Capital Structure Pre-Balancing: Evidence from Convertible Bonds

A large body of the corporate finance literature is devoted to capital structure. This literature examines whether firms have a target capital structure, and whether they actively rebalance their capital structure towards a target. Conversion of a convertible bond causes a drop in leverage, which target capital structure theory suggests should be rebalanced in the future. Consistently, I find that following a realized conversion, firms rebalance their positions in less than a year. When the stock price passes the conversion price threshold for a convertible bond, the firm expects this drop in leverage to occur in the near future. Using a regression discontinuity design around the conversion price threshold, for those conversions that are decided by investors, not by the firm my paper documents a 21% increase in leverage before an actual drop in leverage. That is to say, firms do not wait for the realization of leverage shocks, but rather respond to anticipated shocks. A quantile treatment effect analysis reveals the effect to be a hump-shaped function of leverage, with a peak for firms with a leverage ratio around the 70th percentile.