Diversification and Financial Stability
London School of Economics & Political Science
April 30, 2011
CCSS Working Paper No. 11-001
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, G33working papers series
Date posted: July 5, 2011
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