  Excessive leverage, i.e. the abuse of debt financing, is considered one of
the primary factors in the default of financial institutions. Systemic risk
results from correlations between individual default probabilities that cannot
be considered independent. Based on the structural framework by Merton (1974),
we discuss a model in which these correlations arise from overlaps in banks'
portfolios. Portfolio diversification is used as a strategy to mitigate losses
from investments in risky projects. We calculate an optimal level of
diversification that has to be reached for a given level of excessive leverage
to still mitigate an increase in systemic risk. In our model, this optimal
diversification further depends on the market size and the market conditions
(e.g. volatility). It allows to distinguish between a safe regime, in which
excessive leverage does not result in an increase of systemic risk, and a risky
regime, in which excessive leverage cannot be mitigated leading to an increased
systemic risk. Our results are of relevance for financial regulators.
