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Quantifying the Impact of Leveraging and Diversification on Systemic Risk

Author

Listed:
  • 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.

Suggested Citation

  • Tasca, Paolo & Mavrodiev, Pavlin & Schweitzer, Frank, 2013. "Quantifying the Impact of Leveraging and Diversification on Systemic Risk," Research Program in Finance, Working Paper Series qt7s57834n, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
  • Handle: RePEc:cdl:rpfina:qt7s57834n
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    References listed on IDEAS

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    Cited by:

    1. Opeoluwa Banwo & Fabio Caccioli & Paul Harrald & Francesca Medda, 2016. "The Effect Of Heterogeneity On Financial Contagion Due To Overlapping Portfolios," Advances in Complex Systems (ACS), World Scientific Publishing Co. Pte. Ltd., vol. 19(08), pages 1-20, December.
    2. Vahan Nanumyan & Antonios Garas & Frank Schweitzer, 2015. "The Network of Counterparty Risk: Analysing Correlations in OTC Derivatives," Papers 1506.04663, arXiv.org, revised Sep 2015.
    3. repec:eee:dyncon:v:82:y:2017:i:c:p:96-124 is not listed on IDEAS

    More about this item

    Keywords

    Business; Systemic Risk; Leverage; Diversification;

    JEL classification:

    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
    • G1 - Financial Economics - - General Financial Markets
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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