Procyclical Leverage and Value-at-Risk

Abstract

The availability of credit varies over the business cycle through shifts in the leverage of financial intermediaries. Empirically, we find that intermediary leverage is negatively aligned with the banks' value-at-risk (VaR). Motivated by the evidence, we explore a contracting model that captures the observed features. Under general conditions on the outcome distribution given by Extreme Value Theory (EVT), intermediaries maintain a constant probability of default to shifts in the outcome distribution, implying substantial deleveraging during downturns. For some parameter values, we can solve the model explicitly, thereby endogenizing the VaR threshold probability from the contracting problem.JEL classification: G21, G32

The contribution of bank regulation and fair value accounting to procyclical leverage

“…The macroeconomic variables include percentage change in the S&P 500 VIX, percentage change in the S&P 500 equity index, percentage change in Moody's Baa-rated corporate bond spreads, 36 Finding that accounting leverage is procyclical for banks that do not face binding regulatory leverage constraints raises the question of what sources other than bank regulation can contribute to procyclical leverage. One possible source is that banks could maintain capital to meet an internally imposed value-atrisk criterion (Adrian and Shin 2014). Another possible source relates to the fact that banks fund new asset purchases in repo markets by pledging assets as collateral.…”

Concentrated Capital Losses and the Pricing of Corporate Credit Risk

“…A related way in which portfolio performance relates to risk bearing capacity is through value at risk constraints, as in Adrian and Shin (2013). Theoretical treatments of VaR constraints use the wealth of the trader as a state variable.…”

ESBies: Safety in the Tranches

“…First, the increase in bank leverage raises the probability that the home sovereign will bail-out the bank's bondholders, insofar as the bank is deemed too important (or politically connected) to fail (Acharya, Drechsler & Schnabl, 2014). Second, in response to their increase in leverage, banks shed assets in an attempt to return to their target leverage ratio (Adrian & Shin, 2014). This includes cuts in loans to firms and households; the attendant credit crunch reduces economic activity (Altavilla et al, 2016).…”