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Portfolio diversification and systemic risk in interbank networks

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  • Tasca, Paolo
  • Battiston, Stefano
  • Deghi, Andrea

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.

Suggested Citation

  • Tasca, Paolo & Battiston, Stefano & Deghi, Andrea, 2017. "Portfolio diversification and systemic risk in interbank networks," Journal of Economic Dynamics and Control, Elsevier, vol. 82(C), pages 96-124.
  • Handle: RePEc:eee:dyncon:v:82:y:2017:i:c:p:96-124
    DOI: 10.1016/j.jedc.2017.01.013
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    References listed on IDEAS

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    1. repec:eee:finlet:v:27:y:2018:i:c:p:185-192 is not listed on IDEAS

    More about this item

    Keywords

    Naive diversification; Leverage; Default probability; Financial networks; Contagion; Systemic risk;

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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