Quantifying the Impact of Leveraging and Diversification on Systemic Risk
AbstractExcessive leverage, i.e. the abuse of debt financing, is considered one of the Â 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 Â correlations arise from overlaps in banks' portfolios. Portfolio Â diversification is used as a strategy to mitigate losses from investments in risky projects. We calculate an optimal level of Â diversification that has to be reached for a given level of excessive leverage to still mitigate an increase in systemic risk. In our Â 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 InfoPaper 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.
Date of creation: 22 Mar 2013
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Business; Systemic Risk; Leverage; Diversification;
Other versions of this item:
- Paolo Tasca & Pavlin Mavrodiev & Frank Schweitzer, . "Quantifying the Impact of Leveraging and Diversification on Systemic Risk," Working Papers ETH-RC-13-003, ETH Zurich, Chair of Systems Design.
- Paolo Tasca & Pavlin Mavrodiev & Frank Schweitzer, 2013. "Quantifying the Impact of Leveraging and Diversification on Systemic Risk," Papers 1303.5552, arXiv.org.
- NEP-ALL-2013-07-28 (All new papers)
- NEP-BAN-2013-07-28 (Banking)
- NEP-PPM-2013-07-28 (Project, Program & Portfolio Management)
- NEP-RMG-2013-07-28 (Risk Management)
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