Theoretical Analysis of Financial Innovation's effect on Financial Leverage Fluctuations and Financial Crisis

According to researchers, fluctuation of financial leverage is one of the most important causes of instability of financial systems and its vulnerability to exogenous shocks and financial crises. Hence, developing theoretical models to explain origins of financial leverage fluctuation and its role in occurrence of financial crises becomes very important. In this study, by using a new definition of aggregated financial leverage, the role of financial innovations (qualitative development of financial system) in fluctuations of financial leverage and occurrence of financial crisis is modeled theoretically. The theoretical model is based on the neoclassical growth theory of Frank P. Ramsey (1928) which will be solved and discussed explicitly. The model is calibrated by using Iran economic data and the cyclical variation of aggregated financial leverage is estimated. The results of the study show that outbreak of financial innovations would cause expansion of credit supply and through its effect on physical capital; the aggregated financial leverage will change proportionately. In return, revision of supervisory regulations would induce financial leverage to move in opposite side. Accordingly, frequent occurrence of financial innovations and regulation revision would cause financial cycles. On the other hand, if some financial innovations occur prior to regulations revision, the extent of variations may become enough to generate financial crisis.