Endogenous collateral constraints and the leverage cycle

Abstract

We review the theory of leverage developed in collateral equilibrium models with incomplete markets. We explain how leverage tends to boost asset prices and create bubbles. We show how leverage can be endogenously determined in equilibrium and how it depends on volatility. We describe the dynamic feedback properties of leverage, volatility, and asset prices, in what we call the leverage cycle, and show how it differs from a credit cycle. We also describe some cross-sectional implications of multiple leverage cycles, including contagion, flight to collateral, and swings in the issuance volume of the highest-quality debt. © 2014 by Annual Reviews. All rights reserved.