Leverage in a Crisis

The He and Krishnamurthy models imply that the financial intermediary sector – measured broadly, and not just focused for example on hedge funds – has leverage that rises during crisis. The prediction is due to a mix of general equilibrium and corporate finance arguments. First, in the model, in general equilibrium the intermediary sector must retains the bulk of risk exposure from intermediated assets. For example, in the recent crisis this means that while MBS gets shuffled around across different parts of intermediary sector, in the end it is the intermediary sector that retains most of the MBS. Households don’t suddenly bypass intermediaries and purchase subprime MBS in their direct invesment portfolios. Second, negative shocks to the intermediary sector deplete their equity faster than their debt, and moreover make it harder to raise new equity relative to debt. This last logic comes from thinking about corporate finance: equity is junior to debt and so in an environment where there may be financing frictions, equity frictions are tighter than debt frictions. The two points combine to imply that when there are negative shocks the intermediary sector holds intermediated assets using less equity and more debt. That is, leverage of the intermediary sector rises.