Diversification and financial stability

Paolo Tasca and Stefano Battiston

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: 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 sub-optimal. 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-passage-time 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 over-diversified with respect to the level of socially desirable diversification.

Keywords: naive diversification; leverage; default probability (search for similar items in EconPapers)
JEL-codes: G20 G28 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2014-02-17
New Economics Papers: this item is included in nep-ban and nep-rmg
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Citations: View citations in EconPapers (4)

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http://eprints.lse.ac.uk/59297/ Open access version. (application/pdf)

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Working Paper: Diversification and Financial Stability
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:59297

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