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

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 spi...

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Bibliographic Details
Published in:Macroeconomic dynamics 2018-10, Vol.22 (7), p.1750-1768
Main Authors: Gross, Marco, Henry, Jerome, Semmler, Willi
Format: Article
Language:English
Subjects:
Economic models
Economic theory
Macroeconomics
Regression analysis
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Summary: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.
ISSN:1365-1005
1469-8056
DOI:10.1017/S1365100516001024