The Leverage Bearing Capacity: A New Tool for Intermediary Asset Pricing

Abstract

We introduce a new proxy for the health of financial intermediaries—the Leverage Bearing Capacity (LBC). LBC is the leverage of a fictitious intermediary that targets a fixed level of risk and rebalances its capital structure on an ongoing basis. Our proposed measure is based on market values, available at any frequency, forward-looking, and relies solely on no-arbitrage. Building on an intermediary asset pricing model, we validate LBC theoretically and show that it proxies the marginal wealth of intermediaries. We conduct two event studies to highlight that LBC incorporates uncertainty about the assets of financial intermediaries. Lastly, we show that these features translate into superior asset pricing performance.

Keywords: Intermediary asset pricing, financial intermediation, option-implied information, leverage, financial constraints, risk-bearing capacity, balance sheet valuation

JEL Classification: G12, G13, G20, G32