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Diversification and Financial Stability

  • Paolo Tasca


  • Stefano Battiston

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.

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Paper provided by ETH Zurich, Chair of Systems Design in its series Working Papers with number CCSS-11-001.

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Handle: RePEc:stz:wpaper:ccss-11-001
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