Market Procyclicality and Systemic Risk
RC Working Paper No. 12-012
31 Pages Posted: 3 Nov 2012
Date Written: August 6, 2012
We model the systemic risk associated with the so-called balance-sheet amplification mechanism in a system of banks with interlocked balance sheets and with positions in real-economy-related assets. Our modeling framework integrates a stochastic price dynamics with an active balance-sheet management aimed to maintain the Value-at-Risk at a target level. We find that a strong compliance with capital requirements, usually alleged to be procyclical, does not increase systemic risk unless the asset market is illiquid. Conversely, when the asset market is illiquid, even a weak compliance with capital requirements increases significantly systemic risk. Our findings have implications in terms of possible macro-prudential policies to mitigate systemic risk.
Keywords: Systemic risk, Procyclicality, Leverage, Network models
JEL Classification: G20, G28
Suggested Citation: Suggested Citation