Diversification, leverage and systemic risk

By March 2012Research

Author/s: P Tasca
Source/Publisher: Università Ca’Foscari Venezia
Publication date: 2012/3/23
Download: PDF] from unive.it

The Thesis investigates from a theoretical perspective the relationship between leverage, diversification and systemic risk. Moving from the folk wisdom that asset diversification enhances financial stability by dispersing credit risks, we contribute to the debate shedding light on a critical facet of this strategy. First a representative leveraged investor is considered. Under the standard framework of asset pricing theory in a frictionless, arbitrage-free and complete market, we show that maximum diversification may increase the default risk. Then, we consider a financial system of interconnected banks whose assets include also securities outside the financial network. We show that diversification in external assets displays a knife-edge effect: beyond a certain range, it may induce financial instability. Finally, we found that in presence of procyclical capital requirements that create a positive feedback loop between leverage and asset prices, the knife-edge property is amplified.

image011

Picture: Variation of the expected time to default w.r.t. the number of external assets in balance sheet.