Liquidity and Leverage

TLDR

In a continuously marked‑to‑market system, asset price changes instantly alter net worth, prompting intermediaries to adjust their balance sheets, so aggregate liquidity is measured by the rate of change of these aggregate balance sheets. Marked‑to‑market leverage is strongly procyclical, producing aggregate consequences, and dealer repo changes forecast shifts in market risk as reflected in VIX innovations.

Abstract

In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, eliciting responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in dealer repos—the primary margin of adjustment for the aggregate balance sheets of intermediaries—forecast changes in financial market risk as measured by the innovations in the Chicago Board Options Exchange Volatility Index (VIX). Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.