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http://ssrn.com/abstract=1878596
 
 

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Diversification and Financial Stability


Paolo Tasca


Deutsche Bundesbank; SAFE, Goethe University; London School of Economics & Political Science

Stefano Battiston


ETH Zurich

April 30, 2011

CCSS Working Paper No. 11-001

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.

Number of Pages in PDF File: 27

Keywords: Systemic Risk, Financial Crisis, Diversification, Default Probability

JEL Classification: G01, G11, G18, G2, G32, G33

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Date posted: July 5, 2011  

Suggested Citation

Tasca, Paolo and Battiston, Stefano, Diversification and Financial Stability (April 30, 2011). CCSS Working Paper No. 11-001. Available at SSRN: http://ssrn.com/abstract=1878596 or http://dx.doi.org/10.2139/ssrn.1878596

Contact Information

Paolo Tasca (Contact Author)
Deutsche Bundesbank ( email )
PO Box 10 06 02
D60006 Frankfurt
Germany
SAFE, Goethe University ( email )
Grüneburgplatz 1
Frankfurt am Main, 60323
Germany
London School of Economics & Political Science ( email )
Houghton Street
London, WC2A 2AE
United Kingdom
+44 20 7852 3551 (Phone)
Stefano Battiston
ETH Zurich ( email )
Kreuzplatz 5
Zurich, CH-8032
Switzerland
HOME PAGE: http://www.sg.ethz.ch
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