“Systemic risk refers to the risk that a financial system as a whole is susceptible to failures initiated by the characteristics of the system itself.”۱ If strong links between financial institutions are present, a shock to only a small number of entities might propagate through the system and trigger substantial financial losses. Significant dependence can thus increase the risk of a system-wide breakdown. Financial institutions influence each other via direct or indirect channels such as credit contracts, similar asset portfolios that are jointly exposed to price impact in market crises, and cross-shareholdings. Frictions like, e.g., bankruptcy costs may amplify the impact of the effect of the firms’ interaction. The aim of the current paper consists in constructing and analyzing a comprehensive model that integrates all effects mentioned above. This multi-factor setting allows to assess regulatory policies in a robust manner. To the best of our knowledge, such a contribution is still missing in the literature.

(i) We prove the existence of a clearing equilibrium that is not necessarily unique and provide an algorithm for the computation of the greatest and the least equilibrium. The equilibrium is characterized by the vector of clearing payments and the price of the commonly held illiquid asset that is exposed to price effects.

(ii) We study the impact of bankruptcy costs, fire sales, and cross-holdings on systemic risk in numerical experiments. We demonstrate that fire sales and bankruptcy costs can trigger and amplify financial crises. Policies that mitigate their impact might significantly enhance the resilience of the financial system. Cross-holdings do, in contrast, have a stabilizing effect, if they can be exchanged for liquid assets. Central banks that engage in such a market can reduce the number of defaults in the system.

(iii) We study policy implications and regulatory instruments, including central bank guarantees, quantitative easing, the significance of last wills of financial institutions, and the efficiency of capital requirements. We find that capital adequacy ratios based on risk-weighted assets reduce systemic risk, if they are sufficiently high. However, they do not rely on any statistics that capture systemic risk in a proper way. Comparative statics show that capital adequacy ratios can be equal for varying parameters of our model that are associated with completely different levels of systemic risk. This demonstrates that classical capital adequacy ratios are a very rough instrument. A much better alternative are systemic risk measures that we analyze in the last section.