When Micro Prudence Increases Macro Risk: The Destabilizing Effects of Financial Innovation, Leverage, and Diversification

36 Pages Posted: 13 Jun 2013  

Fulvio Corsi

University of Pisa - Department of Economics; City University London

Stefano Marmi

Scuola Normale Superiore

Fabrizio Lillo

Università di Bologna

Date Written: June 12, 2013

Abstract

By exploiting basic common practice accounting and risk management rules, we propose a simple analytical dynamical model to investigate the effects of micro-prudential changes on macro-prudential outcomes. Specifically, we study the consequence of the introduction of a financial innovation that allow reducing the cost of portfolio diversification in a financial system populated by financial institutions having capital requirements in the form of VaR constraint, and following standard mark-to-market and risk management rules. We provide a full analytical quantification of the multivariate feedback effects between investment prices and bank behavior induced by portfolio re-balancing in presence of asset lliquidity, and show how changes in the constraints of the bank portfolio optimization endogenously drive the dynamics of the balance sheet aggregate of financial institutions and, thereby, the availability of bank liquidity to the economic system and systemic risk. The model shows that when financial innovation reduces the cost of diversification below a given threshold, the strength (due to higher leverage) and coordination (due to similarity of bank portfolios) of feedback effects increase, triggering a transition from a stationary dynamics of price returns to a non stationary one characterized by steep growths (bubbles) and plunges (bursts) of market prices.

Keywords: financial innovation, leverage, diversification, endogenous risk, financial crises

JEL Classification: E51, G11, G18, G21

Suggested Citation

Corsi, Fulvio and Marmi, Stefano and Lillo, Fabrizio, When Micro Prudence Increases Macro Risk: The Destabilizing Effects of Financial Innovation, Leverage, and Diversification (June 12, 2013). Available at SSRN: https://ssrn.com/abstract=2278298 or http://dx.doi.org/10.2139/ssrn.2278298

Fulvio Corsi (Contact Author)

University of Pisa - Department of Economics ( email )

via Ridolfi 10
I-56100 Pisa, PI 56100
Italy

City University London ( email )

Northampton Square
London, EC1V OHB
United Kingdom

Stefano Marmi

Scuola Normale Superiore ( email )

Piazza dei Cavalieri, 7
Pisa, 56126
Italy
+39050509064 (Phone)
+39050563513 (Fax)

HOME PAGE: http://homepage.sns.it/marmi/

Fabrizio Lillo

Università di Bologna ( email )

Via Zamboni, 33
Bologna, 40126
Italy

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