offerings (see Ritter (1984)). This cyclicality seems in part related to the state of investor supply. Helwege and Liang (2004) show that hot markets are largely driven by greater investor optimism rather than by changes in adverse selection costs, managerial optimism or technology. More generally, the supply of external financing, with related effects on asset prices, seems to vary for reasons that are unrelated to the real economy. While often not explicitly investigated, some of these variations seem to have large real consequences (see Titman (2013), for an overview of how various shocks to debt and equity markets and other market segments can affect real activity, among others, through corporate investment-related externalities).

The impact of procyclical leverage on the real economy can be especially perverse in times of stress, when financial institutions and markets cut back on financing and asset prices drop sharply. Almeida et al (2012) show how the GFC led to a reduction in investment for firms for which long-term debt happened to mature in the third quarter of 2007 (of several percentage points relative other firms). Using a DSGE model, Mendoza (2005) shows that as leverage drops from 15% to 11% during a crisis, a 2% wealth-neutral shock leads to about a 4% drop in consumption and investment and a 1.3% decline in output (see also Adrian et al (2012) and Adrian and Shin (2014)).

These variations seem to relate to countries’ institutional environment. For example, countries, with market-based financial systems tend to exhibit greater cyclicality in leverage. In market-based systems, the effective use of collateralisation and the development of more sophisticated risk management and information-sharing mechanisms mean that leverage can be increased with greater ease. In bank-oriented systems, in contrast, leverage is more restricted, in part due to regulations. Consequently, leverage and asset price cycles more likely arise in market-based systems (IMF (2009)). As changes in leverage and liquidity within the financial system affect the real economy, shocks to asset prices can consequently have a greater real impact.

Because short-term collateralised borrowing is the chief tool used by financial institutions to adjust their leverage, the leverage channel relates to (and affects) monetary policy. Adrian and Shin (2008) show that repos and reverse repos transactions, in which borrowers provide securities as collateral, are used heavily to adjust leverage. Since the growth of repo transactions is closely associated with the ease or restrictiveness of monetary policy, a strong connection arises between monetary policy and liquidity. When monetary policy is “loose” (“tight”), there is more likely to be rapid (slow) growth in repos and financial market liquidity tends to be high (low). Furthermore, as Geanakoplos (2003) shows, not only does leverage display endogenous cycles but the interest rate becomes endogenous. With both leverage and interest rates adjusting, this can lead to further procyclical supply side behaviour (see Geanakoplos (2010) for a review).

Both monetary policy and macroeconomic conditions appear to affect the risk appetite of financial intermediaries and their supply of credit. Adrian et al (2010b) study the links between the growth of financial intermediaries’ balance sheets, the macroeconomic risk premium and output in the United States. The empirical behaviour of the macroeconomic risk premium tracks closely that of the term spread of interest rates and of the premium charged to more risky credits. They also develop a measure of intermediary risk appetite using changes in balance sheet quantities. In response to shocks to risk appetite, the macroeconomic risk premium and output exhibit significant and persistent changes. Higher risk appetite is associated with a decline in the risk premium and a pick up in output (Figure 30