Systemic Portfolio Diversification
44 Pages Posted: 23 Mar 2019 Last revised: 8 Mar 2021
Date Written: March 8, 2021
We study the portfolio allocation problem of banks in the presence of fire-sale spillovers. We show that the joint portfolio selection problem may be framed as a potential game, and prove the existence of an equilibrium outcome. Our analysis suggests that while sacrificing individual diversification benefits to reduce portfolio commonality increases the probability that a sale occurs, it also lowers the probability of a costly widespread sell-off. We prove that if heterogeneity in leverage is higher, banks have stronger incentives to achieve systemic diversification. This in turn reduces the expected aggregate vulnerability of the system.
Keywords: systemic diversification, leverage, fire-sale externalities, aggregate vulnerability
JEL Classification: G01, G21, G38
Suggested Citation: Suggested Citation