%0 Generic
%A Tasca, Paolo
%A Battiston, Stefano
%C London, UK
%D 2014
%F discovery:10186749
%I Systemic Risk Centre, London School of Economics and Political Science
%K Naive Diversification, Leverage, Default Probability
%N 10
%T Diversification and Financial Stability
%U https://discovery.ucl.ac.uk/id/eprint/10186749/
%X 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.
%Z This version is the version of record. For information on re-use, please refer to the publisher’s terms and conditions.