Intermediary Leverage Shocks and Funding Conditions

Abstract

The aggregate leverage of broker-dealers responds to demand and supply disturbances that have opposite effects on financial markets. Leverage supply shocks that relax broker-dealers’ funding constraints raise leverage, improve liquidity, increase returns and carry a positive price of risk. Leverage demand shocks also raise leverage but worsen liquidity, reduce returns and carry a negative price of risk. Therefore, disentangling demand- and supply-like shocks resolves existing puzzles around the price of leverage risk and yields consistent evidence across many markets of a central role for intermediation frictions and dealers’ aggregate leverage in asset pricing.

Keywords: Broker-dealers, Leverage, Asset pricing

JEL Classification: E43, H42