Systemic Portfolio Diversification

We study the portfolio selection problem of banks which 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 increases the probability that a sale occurs, it also lowers the probability of a costly widespread sell-off. We argue that high heterogeneity in leverage is socially beneficial because it gives banks strong incentives to achieve systemic diversification. The socially optimal level of systemic diversification can be attained by taxing banks for creating interlinked portfolios with high concentration on illiquid assets