In this study, we have developed a complex network system from the obligation links among banks and links created by portfolio overlaps to simulate the
behavior of the financial system. In the network system, we adopt a dynamic allocation mechanism of liquidity to cope with external shocks of liquidity to the bank
system. This dynamic mechanism introduces a reinforcing feedback that represents
the cycle of assets and liabilities, emphasizing the effect of asset diversification (interbank and external asset diversification). Our results show that the financial system
is “robust-yet-fragile” with asset diversification: for small external liquidity shocks,
both interbank and external asset diversification can contribute to reducing individual
risk and stabilizing the system, whereas for large liquidity shocks, high diversification
amplifies the initial impact and destabilizes the entire system. In other words, high
diversification can promote liquidity allocation and risk sharing in normal times but
amplify the initial shock and engender endogenous systemic crisis in times of distress. This result indicates that diversification is a trade-off between individual risk
and systemic risk and is a double-sided sword to risk management of the financial
system.