Working Paper: CEPR ID: DP10890
Authors: Nikolaos I. Papanikolaou; Christian Wolff
Abstract: In this paper we study the relationship between leverage and risk in commercial banking market. We employ a panel data set that consists of the biggest US commercial banks and which extends from 2002 to 2010 thus covering both the years before the outbreak of the current financial crisis as well as those followed. We make clear distinctions among different leverage types like on- and off-balance sheet leverage as well as short- and long-term leverage, which have never been made in the relevant literature. Our findings provide evidence that excessive leverage, both explicit and hidden off-the-balance sheet, rendered large banks vulnerable to financial shocks thus contributing to the fragility of the whole banking industry. In a similar vein, a direct link between short- and long-term leverage with risk is reported before the crisis, showing that leverage has been one of the key factors responsible for the serious liquidity shortages that were revealed after 2007 when the crisis erupted. We also demonstrate that banks which concentrate on traditional banking activities typically carry less risk exposure than those that are involved with modern financial instruments. Overall, our results provide a better understanding of the role of leverage in destabilizing the whole system whereas at the same time contribute to the current discussion on the resilience of the banking sector through the strengthening of the existing regulatory framework.
Keywords: commercial banking; financial crisis; leverage; risk
JEL Codes: C23; D02; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| excessive leverage (G32) | vulnerability of large banks to financial shocks (F65) |
| short-term leverage (G32) | soundness of the banking system (G21) |
| short-term leverage (G32) | liquidity risks (G33) |
| leverage types (G32) | total bank risk (G21) |
| short-term leverage (G32) | total bank risk (G21) |
| long-term leverage (G32) | total bank risk (G21) |
| credit risk (G21) | leverage and risk analysis (G32) |
| liquidity risk (G33) | leverage and risk analysis (G32) |
| embedded leverage (Y60) | total bank risk (G21) |
| off-balance sheet leverage (G32) | total bank risk (G21) |