Price Contagion through Balance Sheet Linkages
We study price linkages between assets held by financial institutions that are required to maintain fixed capital requirements over time. We consider a market consisting of two sectors: banking and nonbanking. Firms in the banking sector actively manage their leverage ratios to conform with pre-specified target levels. The nonbanking sector consists of institutions, such as mutual funds, money market funds, insurances, and pension funds, that do not actively target a fixed leverage. We show that banks' deleveraging activities may amplify asset return shocks and lead to large fluctuations in realized returns. They can cause spill-over effects, where assets held by leverage targeting banks can experience hikes or drops caused by shocks to otherwise unrelated assets held by the same banks. Our analysis thus suggests that regulatory policies aimed at stabilizing the financial system by imposing capital constraints on banks may have unintended consequences. Fire-sale externalities are produced if leverage targeting banks become too large relative to the nonbanking sector, as measured by elasticity-weighted assets. We show that these effects can be mitigated by encouraging banks to implement asset allocation strategies with higher exposure to liquid, rather than illiquid, assets.