Inefficient Diversification

29 Pages Posted: 9 Jan 2013

Date Written: December 1, 2012


This paper argues that in the presence of liquidation costs, portfolio diversification by financial institutions may be socially inefficient. We propose a stylized model in which individual banks have an incentive to hold diversified portfolios. Yet, at the same time, diversification may increase the aggregate risk faced by the banks’ depositors, creating a negative externality. The increase in systemic risk is due to the fact that even though diversification decreases the probability of each bank’s failure, it may increase the probability of joint failures, which may be socially inefficient when the depositors are risk-averse. The presence of such externalities suggests that financial innovations that enable banks to engineer more diversified portfolios have non-trivial welfare implications.

Keywords: Diversification, financial intermediation, systemic risk, bank runs

JEL Classification: G01, G11, G21

Suggested Citation

Bimpikis, Kostas and Tahbaz-Salehi, Alireza, Inefficient Diversification (December 1, 2012). Columbia Business School Research Paper No. 13-1, Available at SSRN: or

Kostas Bimpikis

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Alireza Tahbaz-Salehi (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

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