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Intermediary leverage cycles and financial stability

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Abstract

We present a theory of financial intermediary leverage cycles within a dynamic model of the macroeconomy. Intermediaries face risk-based funding constraints that give rise to procyclical leverage and a procyclical share of intermediated credit. The pricing of risk varies as a function of intermediary leverage, and asset return exposures to intermediary leverage shocks earn a positive risk premium. Relative to an economy with constant leverage, financial intermediaries generate higher consumption growth and lower consumption volatility in normal times, at the cost of endogenous systemic financial risk. The severity of systemic crisis depends on two state variables: intermediaries’ leverage and net worth. Regulations that tighten funding constraints affect the systemic risk-return tradeoff by lowering the likelihood of systemic crises at the cost of higher pricing of risk.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 567.

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Length: 57 pages
Date of creation: 2012
Date of revision: 01 Feb 2015
Handle: RePEc:fip:fednsr:567
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Keywords: financial stability; macro-finance; macroprudential; capital regulation; dynamic equilibrium models; asset pricing;

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Find related papers by JEL classification:
  • E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy
  • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
  • G00 - Financial Economics - - General - - - General
  • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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  14. Tobias Adrian & Erkko Etula & Tyler Muir, 2014. "Financial Intermediaries and the Cross-Section of Asset Returns," Journal of Finance, American Finance Association, vol. 69(6), pages 2557-2596, December.
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  17. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
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