Leverage Constraints and the International Transmission of Shocks

Abstract

Recent macroeconomic experience has drawn attention to the importance of interdependence among countries through financial markets and institutions, independently of traditional trade linkages. This paper develops a model of the international transmission of shocks due to interdependent portfolio holdings among leverage-constrained investors. In our model, without leverage constraints on investment, financial integration itself has no implication for international macro co-movements. When leverage constraints bind however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel which results in a positive comovement of production, independently of the size of international trade linkages. In addition, the paper shows that, with binding leverage constraints, the type of financial integration is critical for international co-movement. If international financial markets allow for trade only in non-contingent bonds, but not equities, then the international comovement of shocks is negative. Thus, with leverage constraints, moving from bond trade to equity trade reverses the sign of the international transmission of shocks.

Financial Regulation, Financial Globalization, and the Synchronization of Economic Activity

“…8 Dynamic stochastic general equilibrium models may also yield a positive (rather than a negative) relation between banking integration and business cycle synchronization (stemming from the feedback from interest rates to capital values). The early literature models this by introducing financial frictions into the standard international real business cycle model (with productivity/technology shocks), which stop or reverse the direction of capital flows (Calvo and Mendoza (2000)), or by introducing leveraged and constrained firms that liquidate and run asset prices down when they are hit by a negative shock to their capital (Devereux and Yetman (2010)). 9 The recent literature introduces banking shocks in addition to productivity shocks (e.g., Perri and Quadrini (2011), Mendoza and Quadrini (2010), Enders, Kollmann, and Müller (2010), Kalemli-Ozcan, Papaioannou, and Perri (2013)).…”

Cross-Country Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure

“…For the 2008 crisis, using data for 45 large banks in Europe and the United States, Eichengreen et al (2009) find that sensitivity to common shocks increased fall of 2008 volatility peaks for bank credit default swap spreads. Devereux and Yetman (2009) link cross-border lending and leverage to recessions.…”

Global Collateral and Capital Flows

“…In contrast, in our model price crashes are larger with financial integration, not in autarky. Theoretical work by Devereux and Yetman (2010) and Ueda (2012) present models, with financial intermediaries or with leverage constraints, in which financial integration affects spillovers, propagation through interdependent portfolios, and business-cycle synchronization.…”