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Paper: ETH-RC-12-012

Title: Market Procyclicality and Systemic Risk

Authors: Paolo Tasca*, Stefano Battiston


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

Manuscript status:

JEL codes: G20, G28
PACS numbers:

Local copy of the paper: ETH-RC-12-012.pdf

Submission date: 6-8-2012

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