Liquidity and Leverage
Federal Reserve Bank of New York
Hyun Song Shin
Bank for International Settlements; Princeton University - Department of Economics
January 1, 2009
FRB of New York Staff Report No. 328
In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, eliciting responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in dealer repos—the primary margin of adjustment for the aggregate balance sheets of intermediaries—forecast changes in financial market risk as measured by the innovations in the Chicago Board Options Exchange Volatility Index (VIX). Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.
Number of Pages in PDF File: 39
Keywords: financial market liquidity, financial cycles, financial intermediary leverage
JEL Classification: E32, E44, G10, G20
Date posted: June 4, 2008 ; Last revised: November 11, 2010
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