Scandinavian Working Papers in Economics

Discussion Papers on Economics,
University of Southern Denmark, Department of Economics

No 3/2021: A Leverage-Based Measure of Financial Stability

Tobias Adrian (), Karol Jan Borowiecki () and Alexander Tepper ()
Additional contact information
Tobias Adrian: Monetary and Capital Markets Department, Postal: International Monetary Fund
Karol Jan Borowiecki: Department of Business and Economics, Postal: University of Southern Denmark, Campusvej 55, DK-5230 Odense M, Denmark
Alexander Tepper: Columbia University, Postal: U.S.A.

Abstract: The size and the leverage of financial market investors and the elasticity of demand of unlevered investors define MinMaSS, the smallest market size that can support a given degree of leverage. The financial system's potential for financial crises can be measured by the stability ratio, the fraction of total market size to MinMaSS. We use that financial stability metric to gauge the buildup of vulnerability in the run-up to the 1998 Long-Term Capital Management crisis and argue that policymakers could have detected the potential for the crisis.

Keywords: Leverage; financial crisis; financial stability; minimum market size for stability; MinMaSS; stability ratio; Long-Term Capital Management; LTCM

JEL-codes: G01; G10; G20; G21

37 pages, February 17, 2021

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