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Banks Interconnectivity and Leverage

Time:2016-06-14 14:23:00  Hits:[]

In the period that preceded the 2008 crisis, US financial intermediaries have become
more leveraged (measured as the ratio of assets over equity) and interconnected (measured as the share of liabilities held by other nancial intermediaries). This upward trend in leverage and interconnectivity sharply reversed after the crisis. To understand the factors that could have caused this dynamic, we develop a model where banks make risky investments in the non- nancial sector and sell part of their investments to other banks (diversi cation). The model predicts a positive correlation between leverage and interconnectivity which we explore empirically using balance sheet data for over 14,000 financial intermediaries in 32 OECD countries. We enrich the theoretical model by allowing for Bayesian learning about the likelihood of a bank crisis (aggregate risk) and show that the model can generate the dynamics of leverage and interconnectivity observed in the data.
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