Banks Interconnectivity and Leverage

In the period that preceded the 2008 crisis, US ï¬ nancial intermediaries have become more leveraged (measured as the ratio of assets over equity) and interconnected (measured as the share of liabilities held by other ï¬ nancial 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-ï¬ nancial sector and sell part of their investments to other banks (diversiï¬ cation). The model predicts a positive correlation between leverage and interconnectivity which we explore empirically using balance sheet data for over 14,000 ï¬ nancial 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.