Quantifying the Impact of Leveraging and Diversification on Systemic Risk

ETH Risk Center – Working Paper Series No. ETH-RC-13-003

14 Pages Posted: 10 Jan 2014

See all articles by Paolo Tasca

Paolo Tasca

UCL Centre for Blockchain Technologies

Pavlin Mavrodiev

ETH Zurich

Frank Schweitzer

ETH Zürich

Multiple version iconThere are 2 versions of this paper

Date Written: March 22, 2013

Abstract

Excessive leverage, i.e. the abuse of debt financing, is considered one of the primary factors in the default of financial institutions. Systemic risk results from correlations between individual default probabilities that cannot be considered independent. Based on the structural framework by Merton (1974), we discuss a model in which these correlations arise from overlaps in banks’ portfolios. Portfolio diversification is used as a strategy to mitigate losses from investments in risky projects. We calculate an optimal level of diversification that has to be reached for a given level of excessive leverage to still mitigate an increase in systemic risk. In our model, this optimal diversification further depends on the market size and the market conditions (e.g. volatility). It allows to distinguish between a safe regime, in which excessive leverage does not result in an increase of systemic risk, and a risky regime, in which excessive leverage cannot be mitigated leading to an increased systemic risk. Our results are of relevance for financial regulators.

Keywords: Systemic risk, Leverage, Diversification

JEL Classification: G20, G28

Suggested Citation

Tasca, Paolo and Mavrodiev, Pavlin and Schweitzer, Frank, Quantifying the Impact of Leveraging and Diversification on Systemic Risk (March 22, 2013). ETH Risk Center – Working Paper Series No. ETH-RC-13-003. Available at SSRN: https://ssrn.com/abstract=2376366 or http://dx.doi.org/10.2139/ssrn.2376366

Paolo Tasca (Contact Author)

UCL Centre for Blockchain Technologies ( email )

Gower Street
London, WC1E 6BT
United Kingdom

HOME PAGE: http://paolotasca.com

Pavlin Mavrodiev

ETH Zurich ( email )

WEV G 206 Weinbergstrasse 56/58
Zurich, 8092
Switzerland

Frank Schweitzer

ETH Zürich ( email )

Weinbergstrasse 56/58
WEV Room G 211
Zurich, CH-8032
Switzerland
+41 44 632 83 50 (Phone)

HOME PAGE: http://www.sg.ethz.ch

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