Optimal portfolio allocations in a heterogenous banking system

We study the portfolio selection implications of leverage requirements, when banks need to deleverage in response to price shocks to satisfy these regulatory requirements. Banks choose their asset holdings in order to minimize... [ view full abstract ]

We study the portfolio selection implications of leverage requirements, when banks need to deleverage in response to price shocks to satisfy these regulatory requirements. Banks choose their asset holdings in order to minimize their expected execution costs. Consistent with the classic theory of portfolio allocation, diversification is optimal only if each bank neglects the impact caused by other agents' liquidation actions. If banks are heterogeneous in their leverage ratios, in equilibrium they reduce portfolio overlapping and seek diversity, at the expense of sacrificing diversification benefits at the individual level. The bank's equilibrium allocation is not socially efficient. A benevolent social planner aiming for minimal deadweight losses from liquidation should incentive banks to increase their diversity.