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

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 buildup 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 the financial constraint regime. We also find evidence for a role of heterogeneity of financial institutions including depository financial institutions, globally systemically important banks, and selected nonbank financial institutions. Our results suggest that the leverage ratio is a useful indicator from a policy perspective