1932
0
  1. Home
  2. A-Z Publications
  3. Annual Review of Economics
  4. Volume 6, 2014
  5. Article

Annual Review of Economics

Volume 6, 2014

Endogenous Collateral Constraints and the Leverage Cycle

Abstract

We review the theory of leverage developed in collateral equilibrium models with incomplete markets. We explain how leverage tends to boost asset prices and create bubbles. We show how leverage can be endogenously determined in equilibrium and how it depends on volatility. We describe the dynamic feedback properties of leverage, volatility, and asset prices, in what we call the leverage cycle, and show how it differs from a credit cycle. We also describe some cross-sectional implications of multiple leverage cycles, including contagion, flight to collateral, and swings in the issuance volume of the highest-quality debt.

Keyword(s): adverse selection, agent-based models, collateral equilibrium, collateral value, contagion, flight to collateral, liquidity wedge, volatility
Loading

Article metrics loading...

/content/journals/10.1146/annurev-economics-080213-041426
2014-08-02
2024-05-20
Loading full text...

Full text loading...

/deliver/fulltext/economics/6/1/annurev-economics-080213-041426.html?itemId=/content/journals/10.1146/annurev-economics-080213-041426&mimeType=html&fmt=ahah

Literature Cited

  1. Acharya V, Gale D, Yorulmazer T. 2011. Rollover risk and market freezes. J. Finance 66:1177–209 [Google Scholar]
  2. Acharya V, Viswanathan S. 2011. Leverage, moral hazard, and liquidity. J. Finance 66:99–138 [Google Scholar]
  3. Adrian T, Boyarchenko N. 2012. Intermediary leverage cycles and financial stability. Staff Rep. 567, Fed. Reserve Bank New York
  4. Adrian T, Shin H. 2010. Liquidity and leverage. J. Financ. Intermed. 19:418–37 [Google Scholar]
  5. Araujo A, Kubler F, Schommer S. 2012. Regulating collateral-requirements when markets are incomplete. J. Econ. Theory 147:450–76 [Google Scholar]
  6. Bernanke B, Gertler M. 1989. Agency costs, net worth, and business fluctuations. Am. Econ. Rev. 79:14–31 [Google Scholar]
  7. Bisin A, Gottardi P. 2006. Efficient competitive equilibria with adverse selection. J. Polit. Econ. 114:485–516 [Google Scholar]
  8. Brunnermeier M. 2009. Deciphering the liquidity and credit crunch 2007–2008. J. Econ. Perspect. 23:177–100 [Google Scholar]
  9. Brunnermeier M, Pedersen L. 2009. Market liquidity and funding liquidity. Rev. Financ. Stud. 22:2201–38 [Google Scholar]
  10. Brunnermeier M, Sannikov Y. 2014. A macroeconomic model with a financial sector. Am. Econ. Rev. 104:379–421 [Google Scholar]
  11. Calvo G, Mendoza E. 2000. Contagion, globalization, and the volatility of capital flows. Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies Edwards S. 15–41 Chicago: Univ. Chicago Press [Google Scholar]
  12. Corsetti G, Pesenti P, Roubini N. 1999. Paper tigers? A model of the Asian crisis. Eur. Econ. Rev. 43:1211–36 [Google Scholar]
  13. Dubey P, Geanakoplos J. 2002. Competitive pooling: Rothschild-Stiglitz reconsidered. Q. J. Econ. 117:1529–70 [Google Scholar]
  14. Fostel A, Geanakoplos J. 2008. Leverage cycles and the anxious economy. Am. Econ. Rev. 98:1211–44 [Google Scholar]
  15. Fostel A, Geanakoplos J. 2012a. Tranching, CDS and asset prices: how financial innovation can cause bubbles and crashes. Am. Econ. J. Macroecon 4:1190–225 [Google Scholar]
  16. Fostel A, Geanakoplos J. 2012b. Why does bad news increase volatility and decrease leverage?. J. Econ. Theory 147:501–25 [Google Scholar]
  17. Fostel A, Geanakoplos J. 2013. Leverage and default in binomial economies: a complete characterization. Work. Pap. 1877R, Cowles Found., Yale Univ., New Haven, CT
  18. Gale D. 1992. A Walrasian theory of markets with adverse selection. Rev. Econ. Stud 59:229–55 [Google Scholar]
  19. Garleanu N, Pedersen L. 2011. Margin-based asset pricing and the law of one price. Rev. Financ. Stud 24:1980–2022 [Google Scholar]
  20. Geanakoplos J. 1997. Promises, promises. The Economy as an Evolving Complex System II Arthur WB, Durlauf S, Lane D. 285–320 Reading, MA: Addison-Wesley [Google Scholar]
  21. Geanakoplos J. 2003. Liquidity, default, and crashes: endogenous contracts in general equilibrium. Advances in Economics and Econometrics, Vol. 2: Theory and Applications, Eighth World Conference Dewatripont M, Hansen LP, Turnovsky SJ. 170–205 Cambridge, UK: Cambridge Univ. Press [Google Scholar]
  22. Geanakoplos J. 2010. The leverage cycle. NBER Macroeconomics Annual 2009 Acemoglu D, Rogoff K, Woodford M. 1–65 Chicago: Univ. Chicago Press [Google Scholar]
  23. Geanakoplos J, Kubler F. 2013. Why is too much leverage bad for the economy? Work. Pap., Cowles Found., Yale Univ., New Haven, CT
  24. Geanakoplos J, Polemarchakis H. 1986. Existence, regularity, and constrained suboptimality of competitive allocations when the asset market is incomplete. Essays in Honor of Kenneth Arrow Heller W, Starr R, Starrett D. 65–95 Cambridge, UK: Cambridge Univ. Press [Google Scholar]
  25. Geanakoplos J, Zame WR. 1997. Collateralized security markets. Work. Pap., Cowles Found., Yale Univ., New Haven, CT
  26. Geanakoplos J, Zame WR. 2014. Collateral equilibrium, I: a basic framework. Econ. Theory In press [Google Scholar]
  27. Gorton G. 2009. The subprime panic. Eur. Financ. Manag 15:10–46 [Google Scholar]
  28. Gromb D, Vayanos D. 2002. Equilibrium and welfare in markets with financially constrained arbitrageurs. J. Financ. Econ 66:361–407 [Google Scholar]
  29. Harrison J M, Kreps D. 1978. Speculative investor behavior in a stock market with heterogeneous expectations. Q. J. Econ 92:323–36 [Google Scholar]
  30. Hindy A. 1994. Viable prices in financial markets with solvency constraints. J. Math. Econ 24:2105–35 [Google Scholar]
  31. Holmstrom B, Tirole J. 1997. Financial intermediation, loanable funds, and the real sector. Q. J. Econ 112:663–91 [Google Scholar]
  32. King M, Wadhwani S. 1990. Transmission of volatility between stock markets. Rev. Financ. Stud 3:5–33 [Google Scholar]
  33. Kiyotaki N, Moore J. 1997. Credit cycles. J. Polit. Econ 105:211–48 [Google Scholar]
  34. Kodres L, Pritsker M. 2002. A rational expectations model of financial contagion. J. Finance 57:768–99 [Google Scholar]
  35. Kyle A, Xiong W. 2001. Contagion as a wealth effect. J. Finance 56:1401–40 [Google Scholar]
  36. Lagos R. 2010. Asset prices and liquidity in an exchange economy. J. Monet. Econ 57:913–30 [Google Scholar]
  37. Mendoza E. 2010. Sudden Stops, financial crises, and leverage. Am. Econ. Rev 100:1941–66 [Google Scholar]
  38. Minsky H. 1986. Stabilizing an Unstable Economy New Haven, CT: Yale Univ. Press
  39. Pavlova A, Rigobon R. 2008. The role of portfolio constraints in the international propagation of shocks. Rev. Econ. Stud 75:1215–56 [Google Scholar]
  40. Reinhart C, Rogoff K. 2009. This Time Is Different Princeton, NJ: Princeton Univ. Press
  41. Rustichini A, Siconolfi P. 2008. General equilibrium in economies with adverse selection. Econ. Theory 37:417–37 [Google Scholar]
  42. Simsek A. 2013. Belief disagreements and collateral constraints. Econometrica 81:1–53 [Google Scholar]
  43. Smets F, Wouters R. 2007. Shocks and frictions in US business cycles: a Bayesian DSGE approach. Am. Econ. Rev 97:586–606 [Google Scholar]
  44. Thurner S, Farmer D, Geanakoplos J. 2012. Leverage causes fat tails and clustered volatility. Quant. Finance 12:695–707 [Google Scholar]
  45. Vayanos D. 2004. Flight to quality, flight to liquidity, and the pricing of risk. NBER Work. Pap. 10327
  46. Vayanos D, Wang J. 2012. Liquidity and asset prices under asymmetric information and imperfect competition. Rev. Financ. Stud 25:1339–65 [Google Scholar]
/content/journals/10.1146/annurev-economics-080213-041426
Loading
Endogenous Collateral Constraints and the Leverage Cycle
Annual Review of Economics 6, 771 (2014); https://doi.org/10.1146/annurev-economics-080213-041426
/content/journals/10.1146/annurev-economics-080213-041426
/content/journals/10.1146/annurev-economics-080213-041426
Loading

Data & Media loading...

Supplementary Data

  • Article Type: Review Article

Most Cited Most Cited RSS feed

This is a required field
Please enter a valid email address
Approval was a Success
Invalid data
An Error Occurred
Approval was partially successful, following selected items could not be processed due to error