Risky adjustments or adjustments to risks: Decomposing bank leverage

By use of cointegration analysis, this paper splits bank leverage into a short- and long-run dimension. Regarding the long run, if banks’ leverage ratios or related liability shares are stable over time, they form a cointegrating relationship. Thus, cointegration tests indicate whether banks’ liability ratios were stable or subject to structural breaks during the financial crisis in 2007 and 2008. By endogenous identification of structural breaks, my analysis tracks the precise channels of banks’ leverage adjustments. Findings on the long run suggest that banks cut their leverage twice. In June 2007 banks significantly reduced their foreign debt, while in April 2008 they withdrew from interbank borrowing. Regarding the short run, I study how banks adjust to the dynamics of risk proxies from distinct financial markets. Findings on the short run point out that banks’ reactions to risks differ considerably across different types of financial markets.