Margins, debt capacity, and systemic risk

Summary

Focus

We lay out a stylised accounting framework for system-wide debt capacity, when debt serves both as an obligation of the borrower, and also as the collateral pledged by the lender to secure additional funding. Our focus is on fluctuations in margins and leverage. Changes in margin (and the corresponding fluctuations in leverage) are reflected in the fluctuations in the balance sheet size of market participants and in the financial system's broader risk-taking capacity. A sharp increase in margins, especially after a protracted period of thin margins, will tighten financial conditions for the whole system. We use our framework to provide a perspective on the liquidity imbalances that rocked financial markets in March 2020, amid the uncertainty of the Covid-19 pandemic.

Contribution

Our framework is particularly useful in studying the propagation of systemic risk with non-bank financial intermediaries that rely on collateralised borrowing or synthetic leverage in derivatives markets. Traditionally, systemic risk narratives have relied on the "domino" model of cascading defaults. However, while insolvency often figures in systemic crises, it needs not do so. We stress that spillovers that work through prices can become potent channels through which stress can spread. Fluctuations in leverage working through shifts in risk-taking capacity can also propagate stress powerfully, especially in settings with market-based intermediation.

Findings

Two features emerge from our framework which shed light on systemic risk propagation. The first is the recursive nature of debt capacity, in which the debt capacity of one investor increases in proportion to the debt capacity of other investors. In this sense, leverage enables greater leverage. Conversely, deleveraging by one investor begets deleveraging by other investors, resulting in the deleverage of the whole system. The second is that deleveraging and the "dash for cash" are two sides of the same coin. In particular, when there is a generalised increase in margins across all assets in the financial system, there is a broad-based shift in the portfolio composition of investors from riskier assets with high margins toward cash-like assets with low margins.

Abstract

Debt capacity depends on margins. When set in a financial system context with collateralized borrowing, two additional features emerge. The first is the recursive property of leverage whereby higher leverage by one player begets higher leverage overall, reflecting the nature of debt as collateral for others. The second feature is that the "dash for cash" is the mirror image of deleveraging. In any setting where market participants engage in margin budgeting, a generalized increase in margins entails a shift of the overall portfolio away from riskier to safer assets. These findings have important implications for the design of non-bank financial intermediary (NBFI) regulations and of central bank backstops.

JEL classification:  G22, G23, G28

Keywords: financial intermediation, non-banks, market-based finance, market liquidity, systemic risk