When panic makes you blind: a chaotic route to systemic risk

DOI10.1016/J.JEDC.2018.12.009zbMATH Open1411.91521arXiv1805.00785OpenAlexW2963661791MaRDI QIDQ1734544FDOQ1734544

Authors: Piero Mazzarisi, Fabrizio Lillo, Stefano Marmi 

Publication date: 27 March 2019

Published in: Journal of Economic Dynamics and Control (Search for Journal in Brave)

Abstract: We present an analytical model to study the role of expectation feedbacks and overlapping portfolios on systemic stability of financial systems. Building on [Corsi et al., 2016], we model a set of financial institutions having Value at Risk capital requirements and investing in a portfolio of risky assets, whose prices evolve stochastically in time and are endogenously driven by the trading decisions of financial institutions. Assuming that they use adaptive expectations of risk, we show that the evolution of the system is described by a slow-fast random dynamical system, which can be studied analytically in some regimes. The model shows how the risk expectations play a central role in determining the systemic stability of the financial system and how wrong risk expectations may create panic-induced reduction or over-optimistic expansion of balance sheets. Specifically, when investors are myopic in estimating the risk, the fixed point equilibrium of the system breaks into leverage cycles and financial variables display a bifurcation cascade eventually leading to chaos. We discuss the role of financial policy and the effects of some market frictions, as the cost of diversification and financial transaction taxes, in determining the stability of the system in the presence of adaptive expectations of risk.

Full work available at URL: https://arxiv.org/abs/1805.00785

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zbMATH Keywords

random dynamical systemssystemic riskfinancial innovationsleverage cyclesautoregressive dynamicsbackward-looking expectations

Mathematics Subject Classification ID

Portfolio theory (91G10)

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Cited In (4)

• When micro prudence increases macro risk: the destabilizing effects of financial innovation, leverage, and diversification
• Analysis of Bank Leverage via Dynamical Systems and Deep Neural Networks
• Unimodal maps perturbed by heteroscedastic noise: an application to financial systems
• Heterogeneous fragility, systematic panic and optimal transparency

Uses Software

• FinTS

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