Staff Reports

Liquidity and Leverage

May 2008Number 328
Revised December 2010
JEL classification: E32, E44, G10, G20

Authors: Tobias Adrian and Hyun Song Shin

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.

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For a published version of this report, see Tobias Adrian and Hyun Song Shin, "Liquidity and Leverage," Journal of Financial Intermediation 19, no. 3 (July 2010): 418-37.