Diversification and Financial Stability

CCSS Working Paper No. 11-001

27 Pages Posted: 5 Jul 2011  

Paolo Tasca

UCL Centre for Blockchain Technologies

Stefano Battiston

University of Zurich - Department of Banking and Finance

Date Written: April 30, 2011

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.

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

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

Suggested Citation

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

Paolo Tasca (Contact Author)

UCL Centre for Blockchain Technologies ( email )

Gower Street
London, WC1E 6BT
United Kingdom

HOME PAGE: http://paolotasca.com

Stefano Battiston

University of Zurich - Department of Banking and Finance ( email )

Andreasstrasse 15
Zürich, 8050
Switzerland

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