Shadow banking and the dynamics of aggregate leverage: An application of the Kalman filter to cyclical leverage measures

During the last decades, banks off-balance sheet (OBS) activities (e.g. securitization, trading and fee-based activities) have greatly contributed to the increase in bank risk. However, the standard financial indicators such as the Value-at-Risk and the accounting leverage, exclude these non-traditional activities, and neglect the increased risk market-oriented banking generates. In this paper, we study various measures of leverage in the context of shadow banking, relying on a dynamic setting, which features Kalman filter procedures and different detrending methods. Applying this framework to Canadian data, we can detect the increase in risk associated to banks new business lines years before what the conventional risk measures predict. We also find that the elasticity measures of leverage, compared to the simple balance sheet ratios like the ratio of assets to equity or the mandatory leverage measure, are generally more forward-looking indicators of bank risk, and better capture the cyclical pattern of bank leverage. The main contribution of this paper is to show that OBS activities exert a stronger influence on these leverage measures during expansion periods.