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: Suggested Citation