Financial Intermediation, Leverage, and Macroeconomic Instability

Gregory Phelan

No 2015-02, Department of Economics Working Papers from Department of Economics, Williams College

Abstract: This paper investigates how financial-sector leverage affects macroeconomic instability and welfare. In the model, banks borrow (use leverage) to allocate resources to productive projects and provide liquidity. When banks do not actively issue new equity, aggregate outcomes depend on the level of equity in the financial sector. Equilibrium is inefficient because agents do not internalize how their decisions affect volatility, aggregate leverage, and the returns on assets. Leverage creates systemic risk, which increases the frequency and duration of crises. Limiting leverage decreases asset-price volatility and increases expected returns, which decrease the likelihood that the financial sector is undercapitalized.

Keywords: Leverage; Macroeconomic Instability; Borrowing Constraints; Banks; Macroprudential Regulation; Financial Crises (search for similar items in EconPapers)
JEL-codes: E44 G01 G20 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2015-04, Revised 2016-01
New Economics Papers: this item is included in nep-ban, nep-dge and nep-mac
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Citations: View citations in EconPapers (1)

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Journal Article: Financial Intermediation, Leverage, and Macroeconomic Instability (2016)
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