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Securitized banking, procyclical bank leverage, and financial instability

Hyun Woong Park

Structural Change and Economic Dynamics, 2019, vol. 49, issue C, 283-300

Abstract: This paper provides a theoretical explanation of procyclical leverage of the broker-dealer sector and examines its macroeconomic consequences within the context of the securitized banking system characterized by loan securitization and collateralized short-term borrowing. First, from a model of repo transaction, it is shown that a broker–dealer (repo borrower)'s optimal leverage is positively related to asset prices. The main mechanism underlying this relation is a movement of repo rate, which reflects counter-party risks and collateral value risks repo lenders are facing. Second, based on this result, I develop a macroeconomic model with a securitized banking system characterized by procyclical bank leverage and identify conditions under which the model exhibits a limit cycle behavior. A vulnerability of the repo market to asset price fluctuations leads to procyclical bank leverage, which aggravates asset price cycles driven by the supply-led credit expansion and collapse. It is also found that as the procyclicality of bank leverage becomes stronger the financial cycles also get more intense and severe.

Keywords: Securitized banking; Procyclical bank leverage; Credit supply; Financial instability; Limit cycle (search for similar items in EconPapers)
JEL-codes: E32 E44 E51 G21 G24 (search for similar items in EconPapers)
Date: 2019
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Handle: RePEc:eee:streco:v:49:y:2019:i:c:p:283-300