Tasca, Paolo;
Battiston, Stefano;
(2014)
Diversification and Financial Stability.
(SRC Discussion Paper
10).
Systemic Risk Centre, London School of Economics and Political Science: London, UK.
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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.
| Type: | Working / discussion paper |
|---|---|
| Title: | Diversification and Financial Stability |
| Open access status: | An open access version is available from UCL Discovery |
| Publisher version: | https://www.systemicrisk.ac.uk/publications/discus... |
| Language: | English |
| Additional information: | This version is the version of record. For information on re-use, please refer to the publisher’s terms and conditions. |
| Keywords: | Naive Diversification, Leverage, Default Probability |
| UCL classification: | UCL UCL > Provost and Vice Provost Offices > UCL BEAMS UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science > Dept of Computer Science |
| URI: | https://discovery.ucl.ac.uk/id/eprint/10186749 |
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