The Inefficiency Of Diversification In Economies With Endogenous Liquidation Costs

The authors consider a two-asset economy in which consumers are subject to liquidity shocks. Consumers (or banks in the case of delegation) may liquidate these assets in order to finance shortfalls of liquidity. The costs of liquidation for a consumer depend on the liquidity positions of other consumers since those are potential purchasers of assets. They show that diversification of consumers' portfolios is inefficient in this economy. In the absence of situations of insolvency it is even efficient to have their portfolios completely undiversified.