Leverage, Securitization and Shadow Banking: Theory and Policy

Leverage and securitization are at the core of the shadow banking system. We provide a non-technical review of the theory of leverage developed in collateral general equilibrium models with incomplete markets. We explain how leverage can be endogenously determined in equilibrium, and its relation with tail risk, volatility and asset prices. We provide a description of the Leverage Cycle and how it differs from a Credit Cycle. We also describe some crosssectional implications of multiple leverage cycles, including contagion, flight to collateral, and swings in the issuance volume of the highest quality debt. Finally, we review some ideas on how to measure and manage leverage. ∗George Washington University, Washington, DC †Yale University, New Haven, CT, Santa Fe Institute, Ellington Capital Management. ‡Prepared for the Sixteenth Annual International Banking Conference. IMF and Federal Reserve Bank of Chicago. 2013.