Market Procyclicality and Systemic Risk

RC Working Paper No. 12-012

31 Pages Posted: 3 Nov 2012

See all articles by Paolo Tasca

Paolo Tasca

UCL Centre for Blockchain Technologies

Stefano Battiston

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Date Written: August 6, 2012

Abstract

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

Tasca, Paolo and Battiston, Stefano, Market Procyclicality and Systemic Risk (August 6, 2012). RC Working Paper No. 12-012. Available at SSRN: https://ssrn.com/abstract=2170293 or http://dx.doi.org/10.2139/ssrn.2170293

Paolo Tasca (Contact Author)

UCL Centre for Blockchain Technologies ( email )

Gower Street
London, WC1E 6BT
United Kingdom

HOME PAGE: http://paolotasca.com

Stefano Battiston

University of Zurich - Department of Banking and Finance ( email )

Andreasstrasse 15
Zürich, 8050
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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