Diversification and systemic risk in the banking system

The recent financial crisis has motivated efforts to understand how systemic risk endogenously arises and what structure can make the financial system more stable. This paper provides a comprehensive model with a heterogeneous interbank network and overlapping portfolios in order to study the systemic risk contagion. The effects of interbank counterparty diversification and investment portfolio diversification on systemic risk are compared and validated. The results show that investment portfolio diversification is more effective in certain cases in which the illiquid assets are sensitive to fire sales. In addition, a high leverage ratio for an individual bank promotes the stability of the banking system and the reserve-deposit ratio. The banking system is more stable when the interbank network has high heterogeneity and a low clustering coefficient. All results are discussed in relation to the potential regulations that are aimed at reducing systemic risk. (C) 2019 Elsevier Ltd. All rights reserved.