Tasca, Paolo and Battiston, Stefano (2014) Diversification and financial stability. Systemic Risk Centre Discussion Papers (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 |
| Date Deposited: | 29 Aug 2014 11:37 |
| Last Modified: | 15 Sep 2023 23:32 |
| 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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