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Risk-Sharing and the Creation of Systemic Risk

Author

Listed:
  • Viral V. Acharya

    (Stern School of Business, New York University, 44 West Fourth Street, New York, NY 10012, USA)

  • 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)

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.

Suggested Citation

  • Viral V. Acharya & Aaditya M. Iyer & Rangarajan K. Sundaram, 2020. "Risk-Sharing and the Creation of Systemic Risk," JRFM, MDPI, vol. 13(8), pages 1-38, August.
    • Handle: RePEc:gam:jjrfmx:v:13:y:2020:i:8:p:183-:d:399900
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    References listed on IDEAS

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    More about this item

    Keywords

    banking; clearinghouses; systemic risk;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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