A Leverage-Based Measure of Financial Instability

Abstract

The size and the leverage of financial market investors and the elasticity of demand of unlevered investors define MinMaSS, the smallest market size that can support a given degree of leverage. The financial system’s potential for financial crises can be measured by the stability ratio, the fraction of total market size to MinMaSS. We use that financial stability metric to gauge the buildup of vulnerability in the run-up to the 1998 Long-Term Capital Management crisis and argue that policymakers could have detected the potential for the crisis.

Keywords: leverage, financial crisis, financial stability, minimum market size for stability, MinMaSS, instability ratio, Long-Term Capital Management, LTCM

JEL Classification: E58, G01, G10, G20