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Traditionally, booms and busts have been attributed to investors' excessive or insufficient demand, irrational exuberance and panics, or fraud. The leverage cycle begins with the observation that much of demand is facilitated by borrowing, and that crashes often occur simultaneously with the withdrawal of lending.

Lenders are worried about default, and therefore attach credit terms like collateral or minimum credit ratings to their contracts. The credit surface, depicting interest rates as a function of the credit terms, emerges in leverage cycle equilibrium. Investors and lenders (and regulators) choose where on the credit surface they trade. The leverage cycle is about booms when credit terms, especially collateral, are chosen to be loose, and busts when they suddenly become tight, in contrast to the traditional fixation on the (riskless) interest rate.

Leverage cycle crashes are triggered at the top of the cycle by scary bad news, which has three effects. The bad news reduces every agent's valuation of the asset. The increased uncertainty steepens the credit surface, causing credit terms to tighten on new loans, explaining the withdrawal of credit. The high valuation leveraged investors holding the asset lose wealth when the price falls; if their debts are due, they lose liquid wealth and face margin calls, and may be forced to sell their collateral. Each effect feeds back and exacerbates the others, and increases uncertainty.

The credit surface is steeper for long loans than short loans because uncertainty is higher. Investors respond by borrowing short, voluntarily exposing themselves to margin calls.

When uncertainty rises, the credit surface steepens more for low credit rating agents than for highly rated agents, leading to more inequality. The leverage cycle also applies to banks, leading to a theory of insolvency runs rather than panic runs. The leverage cycle policy implication for banks is that there should be transparency, which will induce depositors or regulators to hold down bank leverage before insolvency is reached. This is contrary to the view that opaqueness is a virtue of banks because it lessens panic.

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