Securitization and the dark side of diversification

Diversification by banks affects the systemic risk of the sector. Importantly, Wagner (2010) shows that linear diversification increases systemic risk. We consider the case of securitization, whereby loan portfolios are sliced into tranches with different seniority levels. We show that tranching offers nonlinear diversification strategies, which can reduce the failure risk of individual institutions beyond the minimum level attainable by linear diversification without increasing systemic risk.