Risk-Sharing and the Creation of Systemic Risk

Viral Acharya, Aaditya M. Iyer and Rangarajan K. Sundaram
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Aaditya M. Iyer: Man Group, Man Investments Inc., 452 Fifth Avenue, 27th floor, New York, NY 10018, USA
Rangarajan K. Sundaram: Stern School of Business, New York University, 44 West Fourth Street, New York, NY 10012, USA

JRFM, 2020, vol. 13, issue 8, 1-38

Abstract: We address the paradox that financial innovations aimed at risk-sharing appear to have made the world riskier. Financial innovations facilitate hedging idiosyncratic risks among agents; however, aggregate risks can be hedged only with liquid assets. When risk-sharing is primitive, agents self-hedge and hold more liquid assets; this buffers aggregate risks, resulting in few correlated failures compared to when there is greater risk sharing. We apply this insight to build a model of a clearinghouse to show that as risk-sharing improves, aggregate liquidity falls but correlated failures rise. Public liquidity injections, for example, in the form of a lender-of-last-resort can reduce this systemic risk ex post, but induce lower ex-ante levels of private liquidity, which can in turn aggravate welfare costs from such injections.

Keywords: banking; clearinghouses; systemic risk (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2020
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