The dealer leverage cycle is independent of the risk-taking

channel
Anusar Farooqui
December 13, 2016
Abstract
We examine the relationships between dealer balance sheet quantities and the term
spread. We find that the term spread predicts 1-year forward equity growth and asset
growth but not leverage growth. Our interpretation is that the dealer leverage cycle
is independent of the risk-taking channel of monetary policy. We propose to identify
the dealer leverage cycle by the component of dealer asset growth orthogonal to both
equity growth and the (lagged) term spread.

Risk-taking channel

Adrian and Shin (2010) identify a risk-taking channel of monetary policy as follows. A
decline in the policy rate increases the term spread and hence future net interest margins
thereby boosting dealers capital position and risk appetite; in turn resulting in the compression of risk premia and the expansion of credit supply, thus stimulating real activity.
The key working part here is the eect of the term spread on dealer risk appetite. In
this note, we document that the term spread predicts 1-year ahead dealer equity and asset
growth but not dealer leverage. Moreover, we show that dealer equity growth orthogonal
to that predicted by the spread is also contemporaneously correlated with asset growth.
Furthermore, we show that, as expected, dealer leverage growth is tightly correlated with
dealer asset growth orthogonal to both 1-year lagged term spread and equity growth. Our
interpretation is that the dealer leverage cycle is independent of the risk-taking channel of
monetary policy.
We obtain quarterly balance sheet data for US securities broker-dealers from the Federal
Reserves Flow of Funds. We restrict our attention to the classical period of the marketbased credit system: Q4-1985 to Q2-2008. We log transform all balance sheet quantities.
Figure 1.2 displays the contemporaneous simple linear relationships between asset, equity and leverage growth. We see that quarter-on-quarter, the relationship between leverage
growth and asset growth is tighter than the relationship between equity growth and asset
growth (R2 = 0.65 vs. 0.19). Looked at year-on-year, the inequality is reversed: It is
1

equity growth that tracks asset growth more closely than leverage growth (R2 = 0.41 vs.
0.28).
Next, we turn to the ability of the term spread to predict balance sheet quantities.
Figure 1.3 displays R2 (left column) and p-values (right column) obtained by projecting
annual asset growth, equity growth and leverage growth on lagged term spread. The
horizontal axis displays the number of quarters that the term spread is lagged. We see that
the term spread predicts equity growth and asset growth four quarters ahead (R2 = 0.11
and R2 = 0.08) while the spread is a very poor predictor of leverage growth.
We now concentrate on asset growth. We would like to know whether the spread
predicts asset growth even after controlling for equity growth. Our strategy is to decompose
equity growth into a component predicted by the spread and a component orthogonal to
the prediction. That is, we use the fitted values and residuals from the projection of annual
equity growth onto 1-year lagged term spread as predictors for asset growth.
log(assets)t,t+4 =

log(equity)spread
t,t+4 +

log(equity)?
t,t+4 + "t+4 .

(1.1)

Table 1.1 shows the estimates. We see that the term spread strongly predicts asset growth
even after controlling for equity growth. Figure 1.1 displays actual and fitted dealer asset
growth together with the estimated contributions over the whole period Q4-1985 to Q22008. We observe that the lagged term spread explains the largest component of asset
growth and equity growth orthogonal to that predicted by the spread also explains a
substantial portion of asset growth. Note that while the fit is good, there is still considerable
variation left unexplained. Since equity and leverage together determine asset growth,
we know that the residuals is due to variation in dealer leverage. Figure 1.4 displays
the tight linear correlation between residual asset growth and leverage growth. Note the
improvement over relationship between annual asset growth and annual leverage growth
(R2 = 0.854 vs. R2 = 0.278). Figure 1.5 shows residual asset growth and the fitted values.
We propose to identify the dealer leverage cycle with residual asset growth.
Table 1.1: Dealer asset growth (qtrly)
Variable
constant
equityspread
equity?
R2

Estimate
0.011
1.267
0.653
0.435

Std Error
0.031
0.309
0.092

t-statistic
0.357
4.102
7.128
adj. R2

p-value
0.722
0.000
0.000
0.422

Figure 1.1: Risk-taking channel of monetary policy.

References
Tobias Adrian and Hyun Song Shin. Financial intermediaries and monetary economics.
FRB of New York Sta Report, (398), 2010.
Claudio Borio and Haibin Zhu. Capital regulation, risk-taking and monetary policy: a
missing link in the transmission mechanism? Journal of Financial Stability, 8(4):236
251, 2012.

Figure 1.2: Contemporaneous correlations between dealer balance sheet quantities.

Figure 1.3: The term spread predicts equity and assets but not leverage.

Figure 1.4: Residual growth in dealer assets is explained by leverage.

Figure 1.5: Residual dealer asset growth captures the dealer leverage cycle.