Financial Intermediation, Leverage, and Macroeconomic Instability

Abstract

This paper investigates how financial sector leverage affects macroeconomic instability and welfare. In the model, banks borrow (use leverage) to allocate resources to productive projects and pro vide liquidity. When banks do not actively issue new equity, aggregate outcomes depend on the level of equity in the financial sector. Equilibrium is inefficient because agents do not internalize how their decisions affect volatility, aggregate leverage, and the returns on assets. Leverage creates systemic risk, which increases the frequency and duration of crises. Limiting leverage decreases asset price volatility and increases expected returns, which decrease the likelihood that the financial sector is undercapitalized. (JEL E32, E44, G01, G21)