Risk Pooling, Leverage, and the Business Cycle
Pietro Dindo (),
Andrea Modena and
Loriana Pelizzon ()
No 7772, CESifo Working Paper Series from CESifo Group Munich
This paper investigates the interdependence between the risk-pooling activity of the financial sector and: output, consumption, risk-free rate, and Sharpe ratio in a dynamic general equilibrium model of a productive economy. Due to their exposure to idiosyncratic shocks and market segmentation, heterogeneous households/entrepreneurs (h/entrepreneurs) are willing to mitigate their risk through a financial sector. The financial sector pools risky claims issued by different firms within its assets, faces an associated intermediation cost and, via leverage, provides a risk-free asset to h/entrepreneurs. Exogenous systematic shocks change the relative size of the financial sector, and thus the equilibrium amount of pooled risk, making financial leverage state-dependent and counter-cyclical. We study how this mechanism endogenously channels amplification of consumption and mitigation of output fluctuations. In equilibrium, financial sector leverage also determines counter-cyclical Sharpe ratios and pro-cyclical risk-free interest rates. Last, we investigate the relationship between the size of the financial sector, leverage, and welfare. We show that limiting financial sector leverage determines a sub-optimal pooling of idiosyncratic risk but fosters the growth rate of the h/entrepreneurs’ consumption. On the other side, when the financial sector is too large, it destroys too many resources after intermediation costs. Therefore, the h/entrepreneurs benefit the most when the financial sector is neither too small nor too big.
Keywords: amplification; business cycle; financial frictions; leverage; risk pooling (search for similar items in EconPapers)
JEL-codes: E13 E32 E69 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-bec, nep-dge and nep-mac
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Working Paper: Risk Pooling, Leverage, and the Business Cycle (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:ces:ceswps:_7772
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