Individual and Systemic Risk Trade-offs Induced by Information Barriers in the Financial System

Investment diversification has been strongly debated in the aftermath of the global financial crisis of 2007-2009, due to its potential adverse effects on systemic risk. In this thesis, we investigate the effects that investors' limited information, and their diversification choices due to that information, may have on the systemic risk of the financial system as a whole. In our work, information availability represents agents' level of awareness of the available options they can employ in order to diversify their portfolio in a given market, and we examine it in terms of two relevant information barriers:

a) assets accessibility, representing private and public information available to investors about the existing assets they may use to diversify their portfolio;

b) agents diversifiability, representing investors' 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 assets and investors according to their accessibility and diversifiability respectively.

Our contributions are summarized as follows:

         ∙  We demonstrate the existence of a trade-off between individual diversification activity and systemic risk caused by the two information barriers.

         ∙  We provide analytical characterization of barriers thresholds, that allow us to determine conditions under which diversification activity under limited information may amplify systemic risk.

         ∙  We illustrate the discrepancy between aggregate and systemic risk, which reflects agents’ ignorance about the extra risk the may add to the system, given that the only risk they perceive, when making their   diversification decisions, is their individual risk.

         ∙  We employ a simulation model in order to investigate the sensitivity of risk performance to our theoretical assumptions and solidify our theoretical results.