Diversification and financial stability

Author/s: P Tasca, S Battiston
Published in: CCSS Working Paper
Publication date: 2011/4/30
Download: [PDF] from lse.ac.uk

This paper contributes to a growing literature on the pitfalls of diversification by shedding light on a new mechanism under which, full risk diversification can be suboptimal.
In particular, banks must choose the optimal level of diversification in a market where returns display a bimodal distribution. This feature results from the combination of two opposite economic trends that are weighted by the probability of being either in a bad or in a good state of the world. Banks have also interlocked balance sheets, with interbank claims marked-to-market according to the individual default probability of the obligor. Default is determined by extending the Black and Cox (1976) first-passagetime approach to a network context. We find that, even in the absence of transaction costs, the optimal level of risk diversification is interior. Moreover, in the presence of market externalities, individual incentives favor a banking system that is overdiversified with respect to the level of socially desirable diversification.

Parabolic expression of the market leverage

Picture: Parabolic expression of the market leverage