Wednesday, November 20, 2013

New York Fed on Leverage, Assets and Financial Intermediaries

From the Federal Reserve Bank of New York's Liberty Street Economics blog:

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.

Intermediary Leverage Is Procyclical
The first chart (below) plots the growth rates of book assets, liabilities, equity, and leverage for security broker-dealers. Security broker-dealers’ balance sheets are informative, as these intermediaries operate at the heart of financial markets. The chart shows that leverage tends to grow when balance sheets expand. This is the procyclical nature of intermediary leverage: intermediaries increase leverage when their assets are expanding, reflecting the expansion of economic activity. The chart also shows that broker-dealers finance their new assets by issuing new liabilities, not by raising new equity. During the crisis of 2008-09, broker-dealers reduced their leverage drastically by selling assets and raising new equity.


Intermediary Leverage Is a Pricing Factor for Asset Returns
Broker-dealer leverage is an explanatory variable for asset valuations. Adrian, Etula, and Muir (2012) show that the covariations of stocks and bonds with intermediary leverage explain the average returns of these assets. Intuitively, a corporation whose stock return covaries positively with intermediary leverage faces systematic risk. For investors to bear this systematic risk, returns, on average, have to be high. The second chart (below) illustrates this by plotting predicted expected returns against average expected returns for a variety of stock and bond portfolios. Note that the predicted returns on the x-axis align very closely with realized average returns on the y-axis. The predicted returns are computed from the covariation of each security with broker-dealer leverage growth. Assets that covary more strongly with intermediary leverage changes earn higher returns on average. This finding illustrates that the price of leverage risk is positive, reflecting the procyclicality of leverage....MORE