Banks Interconnectivity and Leverage

Abstract

In the period that preceded the 2008 crisis, US financial intermediaries have become more leveraged (measured as the ratio of assets over equity) and interconnected (measured as the share of liabilities held by other financial intermediaries). This upward trend in leverage and interconnectivity sharply reversed after the crisis. To understand this dynamic pattern we develop a model where banks make risky investments in the non-financial sector and sell part of their investments to other financial institutions (diversification). The model predicts a positive correlation between leverage and interconnectivity. By allowing for Bayesian learning about the likelihood of a bank crisis (aggregate risk), we show that the model can also generate the dynamics of leverage and interconnectivity observed in the data. Finally, we provide broad empirical support for the key properties of the model using balance sheet data for over 14,000 financial intermediaries in 32 OECD countries. (joint with Alessandro Barattieri and Laura Moretti)