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SUMMARY:When Micro Prudence increases Macro Risk: The Destabilizing Effect
 s of Financial Innovation\, Leverage\, and Diversification  - Lillo\, F (S
 cuola Normale Superiore\, Pisa)
DTSTART:20140922T130000Z
DTEND:20140922T134500Z
UID:TALK54412@talks.cam.ac.uk
CONTACT:Mustapha Amrani
DESCRIPTION:We propose a simple analytically tractable model showing how b
 asic common practices of accounting and risk management are able to destab
 ilize the financial market\, when feedback effects and illiquidity are tak
 en into account. Specifically our model considers financial institutions h
 aving capital requirements in the form of VaR constraint and following sta
 ndard mark-to-market and risk management rules. They also face a diversifi
 cation cost that prevent them to fully diversify their portfolio. We provi
 de a full analytical quantification of the multivariate feedback effects b
 etween investment prices and bank behavior induced by portfolio rebalancin
 g in presence of asset illiquidity and show how changes in the constraints
  of the bank portfolio optimization endogenously drive the dynamics of the
  balance sheet aggregate of financial institutions and creates systemic ri
 sk. The model shows that when financial innovation reduces the cost of div
 ersification below a given threshold\, the strength (due to higher leverag
 e) and coordination (due to similarity of bank portfolios) of feedback eff
 ects increase. Under fairly general assumptions on the institution's expec
 tations on future asset volatility and correlation\, we observe that when 
 the diversification cost is decreased or the VaR constraint is loosened\, 
 the dynamics of the system develops cycles and eventually display a chaoti
 c behavior. Further decrease triggers a transition to a non stationary dyn
 amics characterized by steep growths (bubbles) and plunges (bursts) of mar
 ket prices. (in collaboration with F. Corsi\, S. Marmi\, P. Mazzarisi)
LOCATION:Seminar Room 1\, Newton Institute
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