How dark is the dark side of diversification?

TL;DR

This paper challenges the common view on diversification in banking, showing that while diversification increases joint default risk, it can reduce systemic risk when measured with VaR, leading to different regulatory incentives.

Contribution

It demonstrates that using VaR as a risk measure alters the perceived impact of diversification on systemic stability, contrasting prior findings.

Findings

Diversification reduces systemic risk when measured with VaR.

Diversification increases joint default probability.

Different risk measures lead to different policy implications.

Abstract

Against the widely held belief that diversification at banking institutions contributes to the stability of the financial system, Wagner (2010) found that diversification actually makes systemic crisis more likely. While it is true, as Wagner asserts, that the probability of joint default of the diversified portfolios is larger; we contend that, as common practice, the effect of diversification is examined with respect to a risk measure like VaR. We find that when banks use VaR, diversification does reduce individual and systemic risk. This, in turn, generates a different set of incentives for banks and regulators.