Systemic Portfolio Diversification

37 Pages Posted: 23 Mar 2019 Last revised: 25 Jun 2020

See all articles by Agostino Capponi

Agostino Capponi

Columbia University

Marko Weber

National University of Singapore (NUS) - Department of Mathematics

Date Written: June 24, 2020

Abstract

We study the portfolio selection problem of banks when they account for fire-sale spillovers. Our analysis highlights the fundamental trade-off between diversification at the individual and systemic level. While sacrificing individual diversification benefits to reduce portfolio commonality may increase each bank's liquidation probability, we show that it also lowers the endogenous probability of a costly widespread sell-off. We argue that a higher heterogeneity in leverage is socially beneficial because it gives banks stronger incentives to achieve systemic diversification. The socially optimal systemic diversification can be attained by taxing banks for creating interlinked portfolios with high concentration on illiquid assets.

Keywords: systemic diversification, leverage, fire-sale externalities, illiquidity concentration, aggregate vulnerability

JEL Classification: G01, G21, G38

Suggested Citation

Capponi, Agostino and Weber, Marko, Systemic Portfolio Diversification (June 24, 2020). Available at SSRN: https://ssrn.com/abstract=3345399 or http://dx.doi.org/10.2139/ssrn.3345399

Agostino Capponi (Contact Author)

Columbia University ( email )

S. W. Mudd Building
New York, NY 10027
United States

Marko Weber

National University of Singapore (NUS) - Department of Mathematics ( email )

Department of Mathematics
Singapore, 117543
Singapore

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