Asset diversification and systemic risk in the financial system

Yichen Zhou and Honggang Li ()
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Yichen Zhou: Beijing Normal University
Honggang Li: Beijing Normal University

Journal of Economic Interaction and Coordination, 2019, vol. 14, issue 2, No 2, 247-272

Abstract: Abstract In this study, we have developed a complex network system from the obligation links among banks and links created by portfolio overlaps to simulate the behavior of the financial system. In the network system, we adopt a dynamic allocation mechanism of liquidity to cope with external shocks of liquidity to the bank system. This dynamic mechanism introduces a reinforcing feedback that represents the cycle of assets and liabilities, emphasizing the effect of asset diversification (interbank and external asset diversification). Our results show that the financial system is “robust-yet-fragile” with asset diversification: for small external liquidity shocks, both interbank and external asset diversification can contribute to reducing individual risk and stabilizing the system, whereas for large liquidity shocks, high diversification amplifies the initial impact and destabilizes the entire system. In other words, high diversification can promote liquidity allocation and risk sharing in normal times but amplify the initial shock and engender endogenous systemic crisis in times of distress. This result indicates that diversification is a trade-off between individual risk and systemic risk and is a double-sided sword to risk management of the financial system.

Keywords: Complexity in financial system; Systemic risk; Complex network; Liquidity allocation; Diversification (search for similar items in EconPapers)
Date: 2019
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DOI: 10.1007/s11403-017-0205-4

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