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Diversification and Financial Stability

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  • Paolo Tasca
  • Stefano Battiston

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.

Suggested Citation

  • Paolo Tasca & Stefano Battiston, "undated". "Diversification and Financial Stability," Working Papers CCSS-11-001, ETH Zurich, Chair of Systems Design.
    • Handle: RePEc:stz:wpaper:ccss-11-001
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    More about this item

    Keywords

    Systemic Risk; Financial Crisis; Diversification; Default Probability;
    All these keywords.

    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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