Financial shocks and leverage of financial institutions: When do they matter?

We provide empirical evidence that the amplification of financial shocks through leverage of financial institutions is both time-varying and heterogeneous across types of financial institutions. Using institution-level micro data on market-based leverage, we find that the strength of this amplification varies over time and that deleveraging by global systemically important banks and broker-dealers has significantly more adverse effects on macroeconomic outcomes than deleveraging by depository institutions, particularly within a financial constraint regime. In our framework, this regime is not imposed but emerges endogenously from the state of financial and monetary conditions. To uncover these dynamics, we develop and apply an endogenous regime-switching structural vector autoregressive model with time-varying transition probabilities and introduce structural identification techniques to this class of models. • Leverage of financial institutions amplifies financial shocks in a time-varying manner. • Amplification differs markedly across financial institution types. • In a financial-constraint regime, deleveraging by global systemically important banks (GSIBs) and broker-dealers worsens macro-outcomes the most. • A financial-constraint regime emerges endogenously from financial conditions. • We develop an endogenous regime-switching structural vector autoregressive model (RS-SVAR) with time-varying transition probabilities and introduce structural identification techniques for this model class.