Market Procyclicality and Systemic Risk

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.