The financial turmoil of 2007-08 has dramatically underscored the ­significance of financial intermediaries’ balance sheets for financial market and macroeconomic performance. In “Liquidity, Monetary Policy, and Financial Cycles” (Current Issues in Economics and Finance, vol. 14, no. 1), Tobias Adrian and Hyun Song Shin examine how banks and other financial intermediaries manage their balance sheets in response to market price fluctuations. In particular, the authors track how these institutions adjust their leverage when the value of their balance sheet assets rises or falls.

The authors find that, contrary to common assumptions, financial institutions increase their leverage during asset price booms and reduce it during downturns—in other words, financial institution leverage is pro-cyclical. Such behavior, the authors argue, tends to exacerbate the fluctuations of the financial cycle.

How does this occur? As Adrian and Shin explain, the balance sheet adjustments of individual institutions have the potential to set adverse feedback effects in motion. During a boom, institutions react to the increase in the value of their assets by using borrowed funds to buy more of the assets. The increased demand for these assets pushes up the price, strengthening the institutions’ balance sheets, and prompts the institutions to boost their leverage and further expand their asset holdings.

During downturns, this dynamic is reversed: Institutions react to a decline in asset value and the weakening of their balance sheets by reducing leverage. To pay down debt, they may sell assets; such sales depress the price of the assets and weaken balance sheets further, setting off another round of selling and price declines.

These institutional behaviors can affect the economy as a whole: Balance sheet adjustments that result in pro-cyclical leverage will amplify shocks to asset prices.

According to Adrian and Shin, the tool that financial institutions use to adjust their leverage is collateralized borrowing or, more specifically, the repurchase agreement (repo). The authors suggest that the growth rate of the stock of repos may consequently be a very useful measure of liquidity in a market-based system.

Taking their analysis a step further, Adrian and Shin show a close correlation between the growth rate of repos and the degree of ease in monetary policy: “When monetary policy is loose, the stock of repos grows rapidly and market liquidity is high; when monetary policy is tight, repo growth is slow and market liquidity declines markedly.” This correlation leads the authors to observe that the federal funds rate—the short-term rate targeted by policymakers—could be an important determinant of the growth of balance sheets and the liquidity of the financial system.