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Market Procyclicality and Systemic Risk

Listed author(s):
  • Paolo Tasca

    ()

  • Stefano Battiston

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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Paper provided by ETH Zurich, Chair of Systems Design in its series Working Papers with number ETH-RC-12-012.

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Handle: RePEc:stz:wpaper:eth-rc-12-012
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