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Endogenous Collateral Constraints and the Leverage Cycle

Author

Listed:
  • Ana Fostel

    (Department of Economics, George Washington University, Washington, DC 20052;)

  • John Geanakoplos

    (Department of Economics, Yale University, New Haven, Connecticut 06520
    Santa Fe Institute, Santa Fe, New Mexico 87501
    Ellington Capital Management, Old Greenwich, Connecticut 06870)

Abstract

We review the theory of leverage developed in collateral equilibrium models with incomplete markets. We explain how leverage tends to boost asset prices and create bubbles. We show how leverage can be endogenously determined in equilibrium and how it depends on volatility. We describe the dynamic feedback properties of leverage, volatility, and asset prices, in what we call the leverage cycle, and show how it differs from a credit cycle. We also describe some cross-sectional implications of multiple leverage cycles, including contagion, flight to collateral, and swings in the issuance volume of the highest-quality debt.

Suggested Citation

  • Ana Fostel & John Geanakoplos, 2014. "Endogenous Collateral Constraints and the Leverage Cycle," Annual Review of Economics, Annual Reviews, vol. 6(1), pages 771-799, August.
    • Handle: RePEc:anr:reveco:v:6:y:2014:p:771-799
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    File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-economics-080213-041426
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    More about this item

    Keywords

    collateral equilibrium; collateral value; liquidity wedge; volatility; flight to collateral; contagion; adverse selection; agent-based models;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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