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DESTABILIZING EFFECTS OF BANK OVERLEVERAGING ON REAL ACTIVITY—AN ANALYSIS BASED ON A THRESHOLD MCS-GVAR

Published online by Cambridge University Press:  11 July 2017

Marco Gross ,
Jerome Henry  and
Willi Semmler
Marco Gross
Affiliation:
European Central Bank
Jerome Henry
Affiliation:
New School for Social Research and University of Bielefeld
Willi Semmler*
Affiliation:
New School for Social Research and University of Bielefeld
*
Address correspondence to: Willi Semmler, Henry Arnhold Professor of Economics, Department of Economics, New School for Social Research, New York, NY, USA; e-mail: semmlerw@newschool.edu.
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Abstract

We investigate the consequences of overleveraging and the potential for destabilizing effects arising from financial- and real-sector interactions. In a theoretical framework, we model overleveraging and demonstrate how a highly leveraged banking system can lead to unstable dynamics and downward spirals. Inspired by models developed by Brunnermeier, Sannikov and Stein, we empirically measure the deviation-from-optimal-leverage for a sample of large EU banks. This measure of overleveraging is used to condition the joint dynamics of credit flows and macroeconomic activity in a large-scale regime change model: a Threshold Mixed-Cross-Section Global Vector Autoregressive (T-MCS-GVAR). The regime-switching component of the model is meant to make the relationship between credit and real activity dependent on the extent to which the banking system is overleveraged. We find significant nonlinearities as a function of overleverage. The farther the observed leverage in the banking system from optimal leverage, the more detrimental is the effect of a deleveraging shock on credit supply and economic activity.

Keywords

Macro-Financial LinkagesLeverageCredit Supply
Type
Articles
Information
Macroeconomic Dynamics , Volume 22 , Special Issue 7: Recent Insights into Financial, Housing, and Monetary Markets , October 2018 , pp. 1750 - 1768
Copyright
Copyright © Cambridge University Press 2017 

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