Market Efficient Portfolios in a Systemic Economy

We study the ex ante minimization of market inefficiency, defined in terms of minimum deviation of market prices from fundamental values, from a centralized planner’s perspective. Prices are pressured from exogenous trading actions of leverage-targeting banks, which rebalance their portfolios in response to asset shocks. We characterize market inefficiency in terms of two key drivers, the banks’ systemic significance and the statistical moments of asset shocks, and develop an explicit expression for the matrix of asset holdings that minimizes such inefficiency. Our analysis shows that to reduce inefficiencies, portfolio holdings should deviate more from a full diversification strategy if there is little heterogeneity in banks’ systemic significance.