Balance Sheet Capacity Of Financial Sector And Endogenous Risk

Since the1990s, the effect of financial sectors on real economy is increasinglyprominent. On the one hand, financial activities are able to boost the economicdevelopment and accelerate the economic growth. On the other hand, once a small shockon financial market takes place, it has sustainable and cyclical impact o n the realeconomy, which may cause rapid economic turmoil or even great recession. The reasonwhy a small financial shock gives rise to the tremendous economic fluctuation is worthyof study.Based on the former researches, market participants have a significant influence onthe volatility of financial market. When market players believe that trouble is ahead, theytake actions that bring about realized volatility, which is endogenous risk (also known as“big fluctuation”). As for financial intermediates, they mayalso work onthe process that“a small shock” triggers “a big fluctuation”. This paper aims to spell out the precise conduction mechanism by borrowing tools from corporate finance into the study of assetpricing and financial market fluctuation. The method from the paper of Denielsson，Shinand Zigrand (2011) is utilized to explain and deduce the model elaborately building onthe work on Lagrange multiplier associated with Value-at-Risk constraints. Therefore, therelationship among the risk premiums, volatility and balance sheet of financialintermediates is obtained. Moreover, how the three above are affected by the exogenousshock (also known as “small shock”). At last, the economic significance is analyzed through numerical examples and the conclusion can be applied to the financialregulations of real economy.This paper solves for the equilibrium in closed form and come to the conclusion thatunder the pro-cyclical balance sheet management mode of financial intermediates,exogenous shock will be amplified and strengthened through financial intermediates. Balance sheet capacity, volatility and risk premiums are interactive and jointlydetermined, which are core of the amplification effect above. The conclusions of modeland empirical evidence indicate that the balance sheet of financial intermediates plays animportant role as the driver of the financial cycle.