Individual and systemic risk trade-offs induced by information barriers in the financial system

Abstract

Investment diversification is a risk management technique that allows to create balanced portfolios that achieve a certain rate of return on one's investment, within a certain risk allowance. Despite the advantages it offers to investors, diversification has been strongly debated in the aftermath of the global financial crisis of 2007-2009, because it is believed to have potential adverse effects on systemic risk. In this thesis, we specifically investigate the adverse effects that limited information availability of investors, and the diversification choices they make due to that information, may have on the systemic risk of the financial system as a whole. Information availability here is seen as the level of awareness for each agent of the available options he can employ in order to diversify his portfolio in the given market, examined in terms of two so-called "information barriers": a) assets accessibility, representing private and public information offered to each investor about the available assets in the market, b) agents diversifiability, representing the agent's experience in processing this information in order to make better diversification decisions. Building on an existing stylized financial system model, we enrich it by partitioning the assets and the investors according to their accessibility and diversifiability respectively. Our contribution is threefold; we demonstrate a tradeoff between individual diversification activity and systemic risk induced by the two information barriers, we provide analytical characterization and numerical representation of the conditions under which diversification activity under limited information may amplify systemic risk and finally we observe and highlight a discrepancy that is created between actual and perceived risk for increasing level of information availability in the system.