The 2007-09 financial crisis witnessed a severe disruption of financial intermediation in many industrialised economies. Recent literature has focussed on the role played by the ‘shadow banking’ sector in the origin and propagation of financial turmoil. Shadow banking comprises all those financial intermediaries – investment banks, hedge funds, finance companies, off-balance-sheet investment vehicles – that have no access to central-bank liquidity or public-sector credit guarantees, and that are not subject to regulatory capital requirements.
Many of these financial intermediaries have primarily funded their asset purchases by means of collateralised debt with very short maturity, such as sale and repurchase (‘repo’) agreements or asset backed commercial paper. As argued by Brunnermeier (2009), Gorton and Metrick (2010, 2011), Krishnamurthy et al. (2012) and others, the initial losses suffered by some of the assets that served as collateral in repo or asset-backed commercial paper transactions, together with the uncertainty surrounding individual exposures to such assets, led the holders of that short-term debt – mostly institutional investors, such as money-market funds – to largely stop rolling over their lending. This funding freeze forced the shadow financial intermediaries to deleverage, with resulting contractions in financing flows to the real economy.
Bank leverage cycles in the US economy
The observed deleveraging of shadow intermediaries during the 2007-09 financial crisis is not an isolated episode. Since the 1960s the leverage ratio of banks has exhibited a markedly procyclical pattern, in the sense that expansions (or contractions) in balance-sheet size have gone hand in hand with increases (or decreases) in leverage1. In a recent paper (2013), we perform a systematic analysis of the cyclical fluctuations in the leverage ratio – that is, the ratio between total assets and equity capital – of US financial intermediaries. Our analysis includes depository intermediaries such as US-chartered commercial banks and savings institutions, as well as non-depository intermediaries such as security brokers and dealers and finance companies. We find that:
- First, leverage fluctuations contribute at least as much as equity fluctuations to the cyclical movements in banks’ balance-sheet size;
- Second, leverage, equity capital and total assets have roughly the same volatility, and are themselves several times more volatile than GDP.
- Third, leverage is positively correlated with total assets and (to a lesser extent) GDP, and negatively correlated with equity capital.
All these findings are robust across financial subsectors.
Why is leverage volatile and procyclical?
The volatility and procyclicality of leverage can be understood as the result of the interplay between collateralised bank debt, moral hazard, and changes in uncertainty. A significant share of banks’ liabilities are risky collateralised debt contracts funded by institutional investors. Due to limited liability, banks enjoy the upside risk in their assets over and above the face value of their debt, leaving the institutional investors to bear the downside risk2. This provides banks with an incentive to engage in inefficiently risky lending practices, that is, engage in moral hazard (see Adrian and Shin 2011a)3. Such an incentive increases with the assumed debt commitment relative to the size of the bank’s balance sheet. In order to induce each bank to invest efficiently, institutional investors restrict their lending to a certain ratio of the bank's net worth – that is, they impose a leverage constraint.
Consider now an increase in uncertainty regarding banks’ asset returns. The higher uncertainty, in combination with limited liability, makes it more attractive for banks to finance riskier projects. In order to prevent them from doing so, institutional investors must impose a tighter constraint on banks’ leverage. For any given net worth, this deleveraging forces banks to contract their balance sheets, producing a fall in intermediated credit. This leads to a fall in capital investment by firms and a consequent fall in aggregate output. This creates a positive co-movement between leverage, assets and GDP. As we show (Nuño and Thomas 2013), this mechanism can produce empirically plausible fluctuations in bank leverage in the context of a general equilibrium model with financial intermediaries.
The presence of limited liability and moral hazard in the banking sector breaks the perfect-information/complete-markets paradigm of the real business-cycle models. On the positive side, this may help to explain the observed procyclicality of bank leverage and its links with business cycles. On the normative side, the allocation of resources in this economy is not efficient, thus leaving the door open for the study of different policy interventions which may improve this allocation.
One possibility, for example, is that the government extends its public guarantee to certain types of non-deposit liabilities4. In this case, institutional investors have no incentive to apply any discipline on the debt contracts, and therefore the bank could leverage as much as it wished without paying any premium. In order to avoid it, the government should also introduce some form of macroprudential regulation, such as minimum capital requirements, to limit the growth of leverage. The dynamic design of this regulation should be aimed at improving the efficiency of the economy.
Adrian, T and H S Shin (2010), “Liquidity and Leverage”, Journal of Financial Intermediation, 19, 418-437.
Adrian, T and H S Shin (2011a), “Procyclical Leverage and Value-at-Risk”, Federal Reserve Bank of New York Staff Report 388.
Adrian, T and H S Shin (2011b), “Financial Intermediary Balance Sheet Management”, Federal Reserve Bank of New York Staff Report 532.
Brunnermeier, M K (2009), “Deciphering the Liquidity and Credit Crunch 2007-2008”, Journal of Economic Perspectives, 23, 77-100.
Gorton, Gary (2010), Slapped in the face by the invisible hand, Oxford University Press.
Gorton, G and A Metrick (2010), “Haircuts", Federal Reserve Bank of St. Louis Review, 92, 507-519.
Gorton, G and A Metrick (2011), “Securitized Banking and the Run on Repo”, Journal of Financial Economics, forthcoming.
Holmström, B and J Tirole (1997), "Financial Intermediation, Loanable Funds, and the Real Sector", Quarterly Journal of Economics, 112(3), 663-692.
Krishnamurthy, A, S Nagel and D Orlov (2012), “Sizing Up Repo”, NBER Working Paper 17768.
Merton, R C (1974), "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, 29(2), 449-470.
Minsky, H (1992), "The Financial Instability Hypothesis", Economics Working Paper Archive 74, Levy Economics Institute.
Nuño, G and C Thomas (2013), "Bank Leverage Cycles", ECB Working Paper 1524, March.
1 The positive correlation between leverage and assets was first documented for security brokers and dealers by Adrian and Shin (2010). Adrian and Shin (2011b) show that a similar comovement exists for the commercial bank subsidiaries of larger bank holding companies (BHC).
2 Indeed, limited liability implies that the payoff structure of the bank’s debt resembles that of a (short) put option on its assets , as underlined by Merton’s (1974) pioneering work.
3 See also Holmström and Tirole (1997).
4 The possibility of extending government insurance (and supervision) to bank liabilities other than deposits, such as senior tranches of selected securitisations, has been put forward by Gorton (2009) among others.