Diversification and Systemic Bank Runs

Diversification through pooling and tranching securities was supposed to mitigate creditor runs in financial institutions by reducing their credit risk, yet many financial institutions holding diversified portfolios experienced creditor runs in the recent financial crisis of 2007-2009. We present a theoretical model to explain this puzzle. In our model, because financial institutions all hold similar (diversified) portfolios, their behavior in the asset market is clustered: they either sell their assets at the same time or collectively do not sell. Such clustering behavior reduces market liquidity after an adverse shock and increases the probability of a panic run by creditors. We show that diversification, while making the financial system more robust against small shocks, increases the possibility of a systemic crisis in the case of a larger shock; diversification, inducing stronger strategic complementarities across institutions, makes a self-fulfilling systemic crisis (multiple equilibria) more likely. Because individual institutions either over-diversify or under-diversity in the competitive equilibrium compared with the social optimum, there is room for regulation.