Abstract
In this paper, we study the consequences of diversification on financial stability and social welfare using an agent based model that couples the real economy and a financial system. We validate the model against its ability to reproduce several stylized facts reported in real economies. We find that the risk of an isolated bank failure (i.e. idiosyncratic risk) is decreasing with diversification. In contrast, the probability of joint failures (i.e. systemic risk) is increasing with diversification which results in more downturns in the real sector. Additionally, we find that the system displays a “robust yet fragile” behaviour particularly for low diversification. Moreover, we study the impact of introducing preferential attachment into the lending relationships between banks and firms. Finally, we show that a regulatory policy that promotes bank–firm credit transactions that reduce similarity between banks can improve financial stability whilst permitting diversification.
Highlights
There is growing similarity in the asset side of banks’ balance sheets due to increased participation in the same global markets (Cai et al 2012; Liu 2015; Wagner 2010)
In this paper, we study the consequences of diversification on financial stability and social welfare using an agent based model that couples the real economy and a financial system
The true consequences of diversification as it affects the stability of the financial system and the wider economy is actively being discussed by policy makers and academics (Battiston et al 2012; Caccioli et al 2014; Tasca et al 2014; Wagner 2008, 2010)
Summary
There is growing similarity in the asset side of banks’ balance sheets due to increased participation in the same global markets (Cai et al 2012; Liu 2015; Wagner 2010). A less differentiable set of banks increases fragility and exacerbates the risk of joint failures of a large part of the financial system, which can have serious consequences on social welfare. The model implements a self-organising economy populated by rationally bounded heterogeneous agents including firms, households and banks interacting within different markets without central coordination (see Fagiolo and Roventini 2012 for an elaborate discussion on decentralised economic systems). The model implements a self-organising economy populated by rationally bounded heterogeneous agents namely firms, households and banks interacting within different markets without central coordination. A bank is required to keep a percentage ζ of its total deposits in a reserve account at the central bank
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