Systemic Portfolio Diversification
37 Pages Posted: 23 Mar 2019 Last revised: 25 Jun 2020
Date Written: June 24, 2020
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: Suggested Citation