Monetary policy and leverage shocks

• Date: 01 April 2017
• DOI: http://doi.org/10.1002/ijfe.1571
• Author: Khandokar Istiak,Apostolos Serletis
• Published date: 01 April 2017

Received: 15 September 2015 Revised: 1 February 2016 Accepted: 23 November 2016

DOI 10.1002/ijfe.1571

RESEARCH ARTICLE

Monetary policy and leverage shocks

Khandokar Istiak1Apostolos Serletis2

1Department of Economics and Finance, University

of South Alabama, Mobile, 36688, AL, USA

2Department of Economics, University of Calgary,

Calgary, T2N 1N4, Alberta, Canada

Correspondence

Apostolos Serletis, Department of Economics,

University of Calgary,Calgary, Alberta T2N 1N4,

Canada.

Email: serletis@ucalgary.ca

JEL Classification: E43; E52; E61; G12

Abstract

The current mainstream approach to monetary policy in the United States is based

on the new Keynesian model and is expressed in terms of the federal funds rate. It

ignores the role of financial intermediary leverage (or collateral rates). But as the

federal funds rate has reached the zero lower bound, the issue is whether there is a

useful role of leverage in monetary policy and business cycle analysis. Motivated

by these considerations and by recent financial intermediary asset pricing theories

in this paper, we investigate the macroeconomic effects of broker–dealer leverage

and the interdependence between monetary policy and broker–dealer leverage in the

context of a structural vector autoregression model, using quarterly U.S. data over

the period from 1967:1 to 2014:3. We address the simultaneity problem of identify-

ing monetary policy and leverage shocks by using a combination of short-run and

long-run restrictions. We also use the sign restriction approach to the identification

of shocks to distinguish between leverage supply and leverage demand shocks, as

one would expect the macroeconomic effectsof these two types of leverage shocks to

be quite different. Our results show that monetary policy and broker–dealer leverage

demand shocks produce results that capture reasonable macroeconomic dynamics.

KEYWORDS

asset pricing, leverage, monetary policy, security broker–dealers

1INTRODUCTION

The mainstream approach to monetary policy is mainly based

on the new Keynesian model and is expressed in terms of

the interest rate on overnight loans between banks, such as

the federal funds rate in the United States. However, in the

aftermath of the global financial crisis and Great Reces-

sion, short-term nominal interest rates have hardly moved at

all, while central bank policies have been the most volatile

and extreme in their entire histories. This has discredited

the short-term interest rate as an indicator of policy and

led central banks to look elsewhere. For example, the Fed-

eral Reserve and many central banks around the world have

departed from the traditional interest-rate targeting approach

to monetary policy and are now focusing on their balance

sheet instead, using quantitative measures of monetary policy,

such as credit easing and quantitative easing.

One issue with the current approach to monetary pol-

icy is that it hardly takes into account the role of the

financial intermediary sector. In this approach, financial

intermediaries play a passive role that the central bank uses

as a channel to implement monetary policy. However, banks

and other financial intermediaries have been at the center

of the recent global financial crisis. Moreover, a number of

market-based financial intermediaries, such as finance com-

panies, security broker-dealers, and asset-backed securities

issuers, havebecome a very impor tant component of the inter-

mediary sector and evolved into the shadow banking system.

Unlike traditional banks, shadow banks are not constrained

by relationship-based lending and their balance sheets are

almost fully marked to market. They have been at the cen-

ter of the global financial crisis and there is almost universal

agreement that the financial crisis originated in this unregu-

lated shadow banking system. See, for example, Fostel and

Geanakoplos (2008), Geanakoplos (2010, 2012), and Adrian

and Shin (2010, 2011, 2012).

A number of recent theories give financial intermedi-

aries a central role in economics and finance. It has been

argued, for example, that the mainstream approach to mone-

tary policy ignores the role of financial intermediary leverage

Int J Fin Econ. 2017;22:115–128. wileyonlinelibrary.com/journal/ijfe Copyright © 2017 John Wiley & Sons, Ltd. 115