Authors: Tobias Adrian and Hyun Song Shin

We explore the microfoundations of the procyclicality of the financial system. Contrary to the classical corporate finance literature where assets are predetermined, we construct a model consistent with the evidence where equity, not assets, is the predetermined variable. Under this framework, the optimal contract between banks and their creditors constrains leverage according to a value-at-risk rule where the probability of a bank’s failure is held constant, irrespective of the risk environment. Thus, as risk fluctuates over time, banks manage risk by aggressively expanding and contracting their balance sheet size through leverage adjustments. We provide empirical support for these predictions from the five Wall Street investment banks.