Wednesday, 2 January 2008

Procyclical leverage

In an important and useful paper, Liquidity, Monetary Policy and Financial Cycles, Tobias Adrian and Hyun Song Shin discuss the phenomenon of procyclical leverage. The argument goes roughly like this:

Consider an increase in the price of financial assets. That strengthens the balance sheets of banks and hedge funds holding those assets, i.e. the total net worth of hedge funds and banks increases as a proportion of their total assets. When balance sheets become stronger, leverage falls. Therefore to maintain or increase leverage they must respond to rising asset prices by borrowing more.

(I've summarised but the broad thrust of the author's argument is there.) Note too that rising asset prices tend to occur with low or falling volatility so VAR-based capital models will show low risk and hence encourage further leveraging up.

The next bit is obvious:

If we further hypothesize that greater demand for the asset tends to put upward pressure on its price, then there is the potential for a feedback effect in which stronger balance sheets feed greater demand for the asset, which in turn raises the asset's price and lead to stronger balance sheets, causing further buying, leverage, and price rises.

Of course

The mechanism works exactly in reverse in downturns.

The possibility of this phenomenon has been noted before in theory (see for instance my discussion here or here), but Adrian and Shin present compelling evidence that procyclical (balance sheet) leverage is a historical reality. This is shown for instance in the chart above which illustrates the close relationship between asset growth and liability growth for U.S. broker/dealers.

2008 will be a year of deleverage, balance sheet repair, capital raising, and price rediscovery. That's if things go well and institutions can find enough liquidity to finance themselves during this process. Meanwhile the quick, bold and cash rich will find good opportunities among oversold assets. Just don't go in the water too early: it will be cold out there for a while.


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