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.
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