Reviewing the Leverage Cycle
51 Pages Posted: 27 Sep 2013
Date Written: September 24, 2013
We review the theory of leverage developed in collateral equilibrium models with incomplete markets. We explain how leverage tends to boost asset prices, and create bubbles. We show how leverage can be endogenously determined in equilibrium, and how it depends on volatility. We describe the dynamic feedback properties of leverage, volatility, and asset prices, in what we call the Leverage Cycle. We also describe some cross-sectional implications of multiple leverage cycles, including contagion, flight to collateral, and swings in the issuance volume of the highest quality debt. We explain the differences between the leverage cycle and the credit cycle literature. Finally, we describe an agent based model of the leverage cycle in which asset prices display clustered volatility and fat tails even though all the shocks are essentially Gaussian.
Keywords: Leverage, Leverage cycle, Volatility, Collateral equilibrium, Collateral value, Liquidity wedge, Flight to collateral, Contagion, Adverse selection, Agent based models
JEL Classification: E32, E44, G01, G12, G14, G15
Suggested Citation: Suggested Citation