We analyze the consequences of overleveraging and the potential for destabilizing effects from financial- and real-sector interactions. In a theoretical model, we demonstrate that, in the presence of regime-dependent macro feedback relations, a highly leveraged banking system can result in instabilities and downward spirals. To investigate this question empirically, we analyze time series from eight advanced economies on industrial production and the components of the country-specific financial stress indices constructed by the IMF. Employing nonlinear, multiregime vector autoregressions, we examine how industrial production is affected by the individual risk drivers making up the indices. Our results strongly suggest that financial-sector stress has a substantial, nonlinear influence on economic activity and that individual risk drivers affect output rather differently across stress regimes and across groups of countries.
