Procyclical Leverage and Value-at-Risk

29 Pages Posted: 31 Jul 2008 Last revised: 31 Mar 2011

See all articles by Tobias Adrian

Tobias Adrian

International Monetary Fund

Hyun Song Shin

Bank for International Settlements (BIS)

Date Written: March 2011

Abstract

We explore the microfoundations of the procyclicality of the financial system. Contrary to the classical corporate finance literature where assets are pre-determined, we construct a model consistent with the evidence where equity, not assets, is the pre-determined variable. Under this framework, the optimal contract between banks and their creditors constrains leverage according to a Value-at-Risk rule where the probability of a bank's failure is held constant, irrespective of the risk environment. Thus, as risk fluctuates over time, banks manage risk by aggressively expanding and contracting their balance sheet size through leverage adjustments. We provide empirical support for these predictions from the five Wall Street investment banks.

Keywords: security brokers and dealers, contracting in financial institutions

JEL Classification: D02, G20, G32

Suggested Citation

Adrian, Tobias and Shin, Hyun Song, Procyclical Leverage and Value-at-Risk (March 2011). FRB of New York Staff Report No. 338. Available at SSRN: https://ssrn.com/abstract=1189342 or http://dx.doi.org/10.2139/ssrn.1189342

Tobias Adrian (Contact Author)

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://www.tobiasadrian.com

Hyun Song Shin

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

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