Inefficient Diversification ∗

This paper argues that in environments that exhibit non-convexities, risk diversification by financial institutions may be socially inefficient. To this end, we study a stylized, micro-founded model in which individual banks have an incentive to hold diversified portfolios in order to minimize the likelihood of bank runs. Yet, at the same time, diversification may increase the aggregate risk faced by the banks’ depositors, creating a negative externality. The increase in systemic risk in such an environment is due to the fact that even though diversification decreases the probability of each bank’s failure, it may increase the probability of joint failures, which may be socially inefficient when the depositors are risk-averse. The presence of such externalities suggests that financial innovations that enable banks to engineer more diversified portfolios may have nontrivial welfare implications.