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Intermediary Leverage Cycles and Financial Stability

Author

Listed:
  • Tobias Adrian

    (International Monetary Fund)

  • Nina Boyarchenko

    (Federal Reserve Bank of New York)

Abstract

We develop a theory of financial intermediary leverage cycles in the context of a dynamic model of the macroeconomy. The interaction between a production sector, a financial intermediation sector, and a household sector gives rise to amplification of fundamental shocks that affect real economic activity. The model features two state variables that represent the dynamics of the economy: the net worth and the leverage of financial intermediaries. The leverage of the intermediaries is procyclical owing to risk-sensitive funding constraints. Relative to an economy with constant leverage, financial intermediaries generate higher output and consumption growth and lower consumption volatility in normal times, but at the cost of systemic solvency and liquidity risks. We show that tightening intermediaries’ risk constraints affects the systemic risk-return trade-off, by lowering the likelihood of systemic crises at the cost of higher pricing of risk. Our model thus represents a conceptual framework for cyclical macroprudential policies within a dynamic stochastic general equilibrium model.

Suggested Citation

  • Tobias Adrian & Nina Boyarchenko, 2012. "Intermediary Leverage Cycles and Financial Stability," Working Papers 2012-010, Becker Friedman Institute for Research In Economics.
  • Handle: RePEc:bfi:wpaper:2012-010
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    References listed on IDEAS

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    More about this item

    Keywords

    systemic risk; macroprudential policy; DSGE; amplification; capital regulation; financial intermediation;

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy

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