Optimal portfolio for a robust financial system

Abstract

This study presents an ANWSER model (asset network systemic risk model) to quantify the risk of financial contagion which manifests itself in a financial crisis. The transmission of financial distress is governed by a heterogeneous interbank credit network and an investment portfolio of banks. Bankruptcy reproductive ratio of a financial system is computed as a function of the diversity and risk exposure of an investment portfolio of banks, and the denseness and concentration of a heterogeneous interbank credit network. An analytic solution of the bankruptcy reproductive ratio for a small financial system is derived and a numerical solution for a large financial system is obtained. For a large financial system, large diversity among banks in the investment portfolio makes financial contagion more damaging on the average. But large diversity is essentially effective in eliminating the risk of financial contagion in the worst case of financial crisis scenarios. A bank-unique specialization portfolio is more suitable than a uniform diversification portfolio and a system-wide specialization portfolio in strengthening the robustness of a financial system.