The Myth of Diversification: The Destabilizing Impact of Diversification on Financial Institutions

Abstract

This article analyses the impact of asset and activity diversification on the stability of major financial institutions. Diversification is typically viewed as a positive element in risk management. However, examining recent examples concerning diversified multinational financial institutions and a theoretical model of failure risk facing them, this article demonstrates that under certain conditions, diversification can actually increase systemic risk. Financial conglomerates can be ‘too big to manage’, they can become too similar to each other and susceptible to coordinated failure, and, most importantly, catastrophic losses in one part of the firm can overwhelm the whole firm. Based on this finding, this article proposes a number of mitigation measures to limit intra-firm spillover and to make the resolution of troubled financial institutions smoother.