Working Paper

The Transmission of Financial Shocks and Leverage of Financial Institutions: An Endogenous Regime-Switching Framework

Abstract: We conduct a novel empirical analysis of the role of leverage of financial institutions for the transmission of financial shocks to the macroeconomy. For that purpose, we develop an endogenous regime-switching structural vector autoregressive model with time-varying transition probabilities that depend on the state of the economy. We propose new identification techniques for regime switching models. Recently developed theoretical models emphasize the role of bank balance sheets for the build-up of financial instabilities and the amplification of financial shocks. We build a market-based measure of leverage of financial institutions employing institution-level data and find empirical evidence that real effects of financial shocks are amplified by the leverage of financial institutions in a financial-constraint regime. We also find evidence of heterogeneity in how depository financial institutions, global systemically important banks, and selected nonbank financial institutions affect the transmission of shocks to the macroeconomy. Our results confirm the leverage ratio as a useful indicator from a policy perspective.

Keywords: regime switching; time-varying transition probabilities; financial shocks; leverage; bank and nonbank financial institutions; heterogeneity;

JEL Classification: C11; C32; C53; C55; E44; G21;

https://doi.org/10.29338/wp2022-05

Status: Published in 2022

Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta Working Paper

Publication Date: 2022-06-02

Number: 2022-5

Note: The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility. The authors thank Francesco Ferrante, Robert Tetlow and Tao Zha for valuable discussions and Jose Berrospide, Richard Clarida, Jurgen Doornik, Nathan Foley-Fisher, Jesper Linde, Helmut Luetkepohl, Sophokles Mavroides, Teodora Paligorova, Lubomir Petrasek, Chris Sims, Gustavo Suarez, Skander van den Heuvel, Min Wei and seminar participants at Oxford University, the Federal Reserve Board, the Federal Reserve Bank of Atlanta, the Federal Reserve System and the IMF, the European Economic Association, the International Association of Applied Econometrics and NBER-NSF conferences and the conference "Innovations in Time Series Econometrics" in Berlin for useful comments. Valuable research assistance by Kevin Starnes, Rebecca John, Jack McCoy and Hongyi Wu is gratefully acknowledged. This paper was previously circulated titled: "The transmission of financial shocks and leverage of banks: An endogenous regime switching framework."