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Market Procyclicality and Systemic Risk

  • Tasca, Paolo
  • Battiston, Stefano

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.

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File URL: https://mpra.ub.uni-muenchen.de/45156/1/MPRA_paper_45156.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 45156.

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Date of creation: Mar 2013
Date of revision: Mar 2013
Handle: RePEc:pra:mprapa:45156
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