Portfolio diversification and systemic risk in interbank networks

Paolo Tasca, Stefano Battiston and Andrea Deghi

Journal of Economic Dynamics and Control, 2017, vol. 82, issue C, 96-124

Abstract: This paper contributes to a growing literature on the ambiguous effects of risk diversification. In our model, banks hold claims on each other’s liabilities that are marked-to-market on the individual financial leverage of the obligor. The probability of systemic default is determined using a passage-problem approach in a network context and banks are able to internalize the network externalities of contagion through their holdings. Banks do not internalize the social costs to the real economy of a systemic default of the banking system. We investigate the optimal diversification strategy of banks in the face of opposite and persistent economic trends that are ex-ante unknown to banks. We find that the optimal level of risk diversification may be interior or extremal depending on banks exposure the external assets and that a tension arises whereby individual incentives favor a banking system that is over-diversified with respect to the level of diversification that is desirable in the social optimum.

Keywords: Naive diversification; Leverage; Default probability; Financial networks; Contagion; Systemic risk (search for similar items in EconPapers)
JEL-codes: G20 G28 (search for similar items in EconPapers)
Date: 2017
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (15)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:82:y:2017:i:c:p:96-124

DOI: 10.1016/j.jedc.2017.01.013

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