Is Monitoring Leverage the Key to all Crisis Avoidance?

A new paper by economists John Geanakoplos and Lasse Pedersen posits that if it is leverage that puts the whole financial system at risk, then it is leverage that we must monitor if we ever hope to predict or avoid crisis…

Systemic  crises tend to  erupt when  highly  leveraged financial  institutions  are forced to
deleverage, sending the economy into recession; leverage is a  central element of economic
cycles and systemic risk. While traditionally the interest rate has been regarded as the single
key feature of a loan, we argue that leverage is in fact a more important measure of systemic
risk. We discuss how leverage can be monitored for assets, institutions, and individuals, and
highlight the benefits of monitoring leverage. Our main conclusions are:
 Monitoring  leverage  is  “easy”:  Leverage  at  the  asset  level  can  be  monitored  by
recording margin requirements, or, equivalently, loan‐to‐value ratios. This provides a
model‐free measure that  can be directly observed,  in  contrast to other measures of
systemic risk that require complex estimation.

 Monitoring  leverage  is  monitoring  systemic  risk:  Monitoring  leverage  provides
information about how risk builds up during booms as leverage rises, and how crises
start when leverage on new loans sharply declines.

 Liquidity crisis management: Leverage data is a crucial input for crisis management and
lending  facilities,  and  for  ascertaining  the  state  of  an  indebted  economy  in  the
aftermath of a leverage crisis.

 New vs. old leverage: The leverage on new loans is a more timely measure of credit
conditions and the beginning of a systemic  crisis than the average leverage, but the
average leverage signals the economy’s vulnerability. The economy enters a crisis when
leverage on new loans is low, and leverage on old loans is high, a de‐leveraging event
that starts a liquidity spiral.

Read it all:

Monitoring Leverage (Stern School of Business – NYU)

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