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Asset diversification and systemic risk in the financial system

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  • Yichen Zhou

    (Beijing Normal University)

  • Honggang Li

    (Beijing Normal University)

Abstract

In this study, we have developed a complex network system from the obligation links among banks and links created by portfolio overlaps to simulate the behavior of the financial system. In the network system, we adopt a dynamic allocation mechanism of liquidity to cope with external shocks of liquidity to the bank system. This dynamic mechanism introduces a reinforcing feedback that represents the cycle of assets and liabilities, emphasizing the effect of asset diversification (interbank and external asset diversification). Our results show that the financial system is “robust-yet-fragile” with asset diversification: for small external liquidity shocks, both interbank and external asset diversification can contribute to reducing individual risk and stabilizing the system, whereas for large liquidity shocks, high diversification amplifies the initial impact and destabilizes the entire system. In other words, high diversification can promote liquidity allocation and risk sharing in normal times but amplify the initial shock and engender endogenous systemic crisis in times of distress. This result indicates that diversification is a trade-off between individual risk and systemic risk and is a double-sided sword to risk management of the financial system.

Suggested Citation

  • Yichen Zhou & Honggang Li, 2019. "Asset diversification and systemic risk in the financial system," Journal of Economic Interaction and Coordination, Springer;Society for Economic Science with Heterogeneous Interacting Agents, vol. 14(2), pages 247-272, June.
    • Handle: RePEc:spr:jeicoo:v:14:y:2019:i:2:d:10.1007_s11403-017-0205-4
    DOI: 10.1007/s11403-017-0205-4
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    Cited by:

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    2. Jiang, Shanshan & Fan, Hong, 2021. "Systemic risk in the interbank market with overlapping portfolios and cross-ownership of the subordinated debts," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 562(C).
    3. Yajing Huang & Taoxiong Liu, 2023. "Diversification and Systemic Risk of Networks Holding Common Assets," Computational Economics, Springer;Society for Computational Economics, vol. 61(1), pages 341-388, January.

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