Procyclical Leverage and Value-at-Risk
29 Pages Posted: 31 Jul 2008 Last revised: 31 Mar 2011
Date Written: March 2011
Abstract
We explore the microfoundations of the procyclicality of the financial system. Contrary to the classical corporate finance literature where assets are pre-determined, we construct a model consistent with the evidence where equity, not assets, is the pre-determined variable. Under this framework, the optimal contract between banks and their creditors constrains leverage according to a Value-at-Risk rule where the probability of a bank's failure is held constant, irrespective of the risk environment. Thus, as risk fluctuates over time, banks manage risk by aggressively expanding and contracting their balance sheet size through leverage adjustments. We provide empirical support for these predictions from the five Wall Street investment banks.
Keywords: security brokers and dealers, contracting in financial institutions
JEL Classification: D02, G20, G32
Suggested Citation: Suggested Citation
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