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All for one and none for all! Diversification, regulation and the tragedy of the commons.

Some proverbs come in contradictory pairs, for instance “Too many cooks spoil the broth” and “Many hands make light work”. I’d like to present an example that I feel illustrates two of these simultaneously. Everyone knows “Don’t put all your eggs in one basket”, including banks, which diversify by holding many different investments of different types. But while it may be in banks’ best interests to lower their levels of risk through diversification, it may plausibly raise the risk of a system-wide failure: if all banks follow that same advice, the rest of us may be “In for a penny, in for a pound”.

This is the argument given by Beale et al. in their paper Individual versus systemic risk and the Regulator’s Dilemma. Here’s a simple example that illustrates the main idea, adapted from a related comment in the earlier paper Systemic risk: the dynamics of model banking system.

Some people are playing a dice game. Each of them rolls a single fair die once and receives £1 for rolling a 1, £2 for a 2, and so on, up to £6 for a 6. However, afterwards they each have to pay £1.50 for the privilege of playing this rewarding game. Each of them starts out with no money, and so if they roll a 1, they go bankrupt.

If you play this game, there’s a \frac{1}{6} chance that you’d go bankrupt on your roll. Let’s say ten people play the game: the chance of all of them going bankrupt on their single throw is (1/6)^{10}, which is about one in sixty million.

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