The Federal Reserve Bank of New York today released Liquidity, Monetary Policy, and Financial Cycles, the latest article in its series Current Issues in Economics and Finance.
Authors Tobias Adrian and Hyun Song Shin examine how banks and other financial intermediaries adjust their leverage in response to a rise or fall in the value of their balance sheet assets. They find that these institutions increase their leverage during asset price booms and reduce it during downturns—a pattern of behavior that amplifies the fluctuations of the financial cycle.
The tool that the institutions use to adjust their leverage is collateralized borrowing or, more specifically, the repurchase agreement (repo). Adrian and Shin suggest that the growth rate of the stock of repos may be a very useful measure of liquidity in a market-based financial system.
Finally, the authors show a close correlation between the growth rate of repos and the degree of ease in monetary policy: “when monetary policy is loose, the stock of repos grows rapidly and market liquidity is high; when monetary policy is tight, repo growth is slow and market liquidity declines markedly.”
Tobias Adrian is a senior economist in the Capital Markets Function of the Research and Statistics Group. Hyun Song Shin is a professor of economics at Princeton University.