Banks Interconnectivity and Leverage

We show that higher interconnectivity among financial intermediaries induces banks to choose more leverage. Although this leads to higher investment growth, the banking sector becomes more vulnerable to aggregate shocks (crises). We also show that learning about the likelihood of a crisis could have played an important role in generating the high interconnectivity and leverage before the 2008 crisis and the drastic reversal after the crisis. Using balance sheet data for over 14,000 financial intermediaries in 30 OECD countries we find that there is a strong positive correlation between our proxy for interconnectivity and leverage, consistent with the model.