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Quantifying the Impact of Leveraging and Diversification on Systemic Risk

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  • Tasca, Paolo
  • Mavrodiev, Pavlin
  • Schweitzer, Frank

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.

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Bibliographic Info

Paper provided by Research Program in Finance, Institute for Business and Economic Research, UC Berkeley in its series Research Program in Finance, Working Paper Series with number qt7s57834n.

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Date of creation: 22 Mar 2013
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Handle: RePEc:cdl:rpfina:qt7s57834n

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Keywords: Business; Systemic Risk; Leverage; Diversification;

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  1. John L. Evans & Stephen H. Archer, 1968. "Diversification And The Reduction Of Dispersion: An Empirical Analysis," Journal of Finance, American Finance Association, vol. 23(5), pages 761-767, December.
  2. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  3. Paolo Tasca & Stefano Battiston, . "Diversification and Financial Stability," Working Papers CCSS-11-001, ETH Zurich, Chair of Systems Design.
  4. Joseph E. Stiglitz, 2010. "Risk and Global Economic Architecture: Why Full Financial Integration May Be Undesirable," American Economic Review, American Economic Association, vol. 100(2), pages 388-92, May.
  5. Nobuhiro Kiyotaki & John Moore, 2002. "Balance-Sheet Contagion," American Economic Review, American Economic Association, vol. 92(2), pages 46-50, May.
  6. Elton, Edwin J & Gruber, Martin J, 1977. "Risk Reduction and Portfolio Size: An Analytical Solution," The Journal of Business, University of Chicago Press, vol. 50(4), pages 415-37, October.
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