Intermediary Leverage Cycles and Financial Stability

The financial crisis of 2007-09 highlighted the central role that financial intermediaries play in the propagation and amplification of shocks. Intermediaries increase leverage during the boom, which then makes them more vulnerable to adverse economic developments. In this post, we review evidence on the balance-sheet behavior of financial intermediaries and describe a channel that allows intermediaries to increase leverage during booms when asset market volatility tends to be low, which in turn forces them to dramatically reduce leverage once volatility increases. As shown during the financial crisis of 2007-08, the contraction of intermediary leverage is accompanied by increases in borrowing rates for households and a contraction of credit. The formal modeling of this amplification mechanism allows a welfare analysis of the tightness of regulatory capital requirements. We find that while loose capital constraints generate excessive risk-taking by intermediaries, tight funding constraints inhibit intermediaries? risk-sharing and investment functions, which then lowers welfare.