Measuring synthetic leverage in interest rate swaps

Synthetic leverage is a key source of vulnerability for the non-bank financial intermediation (NBFI) sector. Yet there is lack of consensus on how to measure it. In this article, we propose a novel methodological framework to measure synthetic leverage and apply it to interest rate swaps using data gathered under the European Market Infrastructure Regulation (EMIR). Our contribution is threefold. First, compared with notional-based measures of synthetic leverage, our formula is sensitive to changes in the underlying risk factor and thus reflects different degrees of resilience to interest rate shocks. Second, thanks to its duration-based approach, our methodology is particularly suitable as a policy tool for scenario analysis. Finally, by providing an estimate of the leverage risk that an institution faces through its derivatives positions, our framework makes it possible to investigate the potential implications for an NBFI entity’s overall exposure to liquidity and solvency risk. JEL Classification: G10, G23, G28.