Systemic Portfolio Diversification

We study the portfolio choice problem of banks, taking into account losses due to fire-sale spillovers. We show that the optimal asset allocation can be recovered as the unique Nash equilibrium of a potential game. Our analysis highlights the key tradeoff between individual diversification and systemic risk. In a stylized model economy featuring two banks and two assets, we show that sacrificing individual diversification to reduce portfolio commonality increases the likelihood of a sale event, while simultaneously decreasing the probability of a costly systemic sell-off. Banks have stronger incentives to achieve systemic diversification if there is more heterogeneity in leverage among them, leading to a decrease in the overall vulnerability of the system. We provide numerical evidence that our conclusions are robust with respect to the number of banks and assets in the system.