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Diversification and financial stability

Tasca, Paolo and Battiston, Stefano (2014) Diversification and financial stability. SRC Discussion Paper (No 10). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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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.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.systemicrisk.ac.uk/
Additional Information: © 2014 The Authors
Divisions: Systemic Risk Centre
Subjects: H Social Sciences > HG Finance
JEL classification: G - Financial Economics > G2 - Financial Institutions and Services > G20 - General
G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation
Sets: Research centres and groups > Systemic Risk Centre
Date Deposited: 29 Aug 2014 11:37
Last Modified: 26 Feb 2019 00:03
Projects: ES/K002309/1, CH1-01-08-2, 255987, CR12I1-127000/1
Funders: ESRC, Coping with Crises in Complex Socio-Economic Systems, European FET Open Project “FOC", SNSF project “OTC Derivatives and Systemic Risk in Financial Networks"
URI: http://eprints.lse.ac.uk/id/eprint/59297

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