Quantifying the Impact of Leveraging and Diversification on Systemic Risk
Excessive 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.
|Date of creation:||22 Mar 2013|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: (510) 642-1922
Fax: (510) 642-5018
Web page: http://www.escholarship.org/repec/iber_finance/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Paolo Tasca & Stefano Battiston, . "Diversification and Financial Stability," Working Papers CCSS-11-001, ETH Zurich, Chair of Systems Design.
- 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.
- Joseph E. Stiglitz, 2010. "Risk and Global Economic Architecture: Why Full Financial Integration May Be Undesirable," NBER Working Papers 15718, National Bureau of Economic Research, Inc.
- Merton, Robert C., 1973.
"On the pricing of corporate debt: the risk structure of interest rates,"
684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
- Nobuhiro Kiyotaki & John Moore, 2002. "Balance-Sheet Contagion," American Economic Review, American Economic Association, vol. 92(2), pages 46-50, May.
- 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.
- 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.
When requesting a correction, please mention this item's handle: RePEc:cdl:rpfina:qt7s57834n. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Lisa Schiff)
If references are entirely missing, you can add them using this form.