Diversification and Financial Stability

Paolo Tasca and Stefano Battiston

No CCSS-11-001, Working Papers from ETH Zurich, Chair of Systems Design

Abstract: The recent credit crisis of 2007/08 has raised a debate about the so-called knife-edge properties of financial markets. The paper contributes to the debate shedding light on the controversial relation between risk-diversification and financial stability. We model a financial network where assets held by borrowers to meet their obligations, include claims against other borrowers and securities exogenous to the network. The balance-sheet approach is conjugated with a stochastic setting and by a mean-field approximation the law of motion of the system's fragility is derived. We show that diversification has an ambiguous effect and beyond a certain levels elicits financial instability. Moreover, we find that risk-sharing restrictions create a socially preferable outcome. Our findings have significant implications for future policy recommendation.

Keywords: Systemic Risk; Financial Crisis; Diversification; Default Probability (search for similar items in EconPapers)
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Working Paper: Diversification and financial stability (2014)
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