Individual and systemic risk trade-offs induced by diversification barriers

Abstract

Investment diversification is believed to have potential adverse effects on systemic risk. This paper examines the performance of systemic risk with respect to two factors: the available diversification choices and the investor's ability to utilize them. Building on an existing stylized financial system model, we enrich it by partitioning the assets and the investors according to their accessibility level and their ability to expand into the available diversification choices respectively. We show the existence of a trade-off between individual diversification and systemic risk caused by the two factors and we provide analytical characterization of phase transition thresholds for these factors. These thresholds determine under what conditions diversification activity may amplify systemic risk.