History has shown that how an economy bounces back after a crisis is not determined simply by the size of the crisis itself. The US stock market lost a huge proportion of its value during the 2001 dot-com crash, but there were few lasting effects on the economy. In contrast, after the 2008 crash, recovery took years, with significant, persistent effects on output and employment.
There is evidence that one reason the recession following the 2008 crash was so deep was that the financial system itself was damaged. Contrary to many conventional theories about market behavior, it is not households, but financial intermediaries—broker-dealers trading across all asset classes—that are responsible for a large share of transactions, note Chicago Booth’s Zhiguo He and Bryan T. Kelly and Asaf Manela of Washington University. Shocks to the financial health of these intermediaries thus have a big impact on markets and asset prices, which can ripple through the economy.
The researchers reexamined asset pricing and risk premiums from the perspective of financial intermediaries. Their findings illustrate how the financial sector affects the economy.
Building on an earlier model by He and Stanford’s Arvind Krishnamurthy, which demonstrated that intermediaries with a low capital ratio become more cautious about investing in risky assets, He, Kelly, and Manela focused on the primary dealer counterparties of the New York Federal Reserve. Primary dealers are institutions that deal directly with the Fed, including purchasing federal debt at auction and selling it to clients; they include systemically important banks such as Goldman Sachs, Deutsche Bank, and J. P. Morgan.
The researchers constructed a measure of banks’ capital ratios and find that some assets are more sensitive to this capital risk than others. The authors call this sensitivity a “capital beta.” He and Krishnamurthy’s earlier model suggests that the expected return on assets is not just a function of market betas. Banks will hold assets with a high capital beta only when compensated for the capital risk.
He, Kelly, and Manela test the relationship between the capital beta and expected returns in seven asset classes: stocks, US government and corporate bonds, other sovereign bonds, options, credit default swaps, commodities, and foreign exchange. They find that the premiums rewarding capital risk for five of the seven asset classes range from 7 percent to 11 percent, with foreign exchange and options being somewhat higher. The data are consistent with a capital-risk premium of 9 percent for all asset classes.
The research suggests that the dealers do, in fact, act as the pivotal players, setting asset prices on the margin. A large shock to the banking system, or one that hits several markets at once so that it deals a serious blow to intermediaries’ capital, may be transferred to other markets, affecting the system as a whole. If financial stress is an important source of risk and cannot be diversified away, assets that are more sensitive to risk should, on average, earn a risk premium.