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Financial Intermediary Leverage and Value-at-Risk

Fluctuations in leverage have come to the fore in the debate on the propagation of financial distress. In particular, the phenomenon of “de-leveraging” in which financial intermediaries as a group attempt to contract their balance sheets simultaeneously has received attention as a key part in the propagation mechanism.

When the financial system as a whole holds long-term, illiquid assets financed by short-term liabilities, a synchronized contraction of balance sheets will cause stresses that show up somewhere in the system. Even if some institutions can adjust down their balance sheets flexibly in response to the greater stress, not everyone can.

This is because the system as a whole has a maturity mismatch. Something has to give. There will be pinch points in the system that will be exposed by the de-leveraging, and these are the institutions that suffer a liquidity crisis. Arguably, Bear Stearns was precisely such a pinch point in the de-leveraging episode in March 2008.

Fluctuations in leverage are therefore central to the proper understanding of financial market distress. Our task in this paper is a foundational one in which we model the determination of leverage and balance sheet size of financial intermediaries in their dealings with their creditors. Financial intermediaries borrow in order to lend. Hence, they are both debtors as well as creditors. As such, the bilateral contracting model can then be embedded in a system context to examine liquidity crises.

Financial Intermediary Leverage and Value-at-Risk