Banks Interconnectivity and Leverage

In the period that preceded the 2008 crisis, US financial intermediaries have become more leveraged (measured as the ratio of assets over equity) and interconnected (measured as the share of liabilities held by other financial intermediaries). This upward trend in leverage and interconnectivity sharply reversed after the crisis. To understand the factors that could have caused this dynamic, we develop a model where banks make risky investments in the non-financial sector and sell part of their investments to other banks (diversification). The model predicts a positive correlation between leverage and interconnectivity which we explore empirically using balance sheet data for over 14,000 financial intermediaries in 32 OECD countries. We enrich the theoretical model by allowing for Bayesian learning about the likelihood of a bank crisis (aggregate risk) and show that the model can capture the dynamics of leverage and interconnectivity observed in the data.