We propose a general equilibrium framework with financial intermediaries subject to endogenous leverage constraints, and assess its ability to explain the observed fluctuations in intermediary leverage and real economic activity. In the model, intermediaries ("banks") borrow in the form of short-term risky debt. The presence of risk-shifting moral hazard gives rise to a leverage constraint, and creates a link between the volatility in bank asset returns and leverage. Unlike TFP or capital quality shocks, volatility shocks produce empirically plausible fluctuations in bank leverage. The model replicates well the fall in leverage, assets, and GDP during the 2007-2009 financial crisis.
"Bank Leverage Cycles."
American Economic Journal: Macroeconomics,
Asymmetric and Private Information; Mechanism Design
Financial Markets and the Macroeconomy
Banks; Depository Institutions; Micro Finance Institutions; Mortgages
Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill