Banks and Markets from an Insurance Perspective

This article aims to clarify the analogy between contingent claims in a complete market and banking contracts in a capitalized financial intermediary that combines both deposit and equity. It brings together insurance theory and financial intermediation theory in a synthetic model by focusing on the risk allocation function rather than on a particular kind of institutional arrangement. The model includes both idiosyncratic liquidity risk and aggregate uncertainty on asset return, and it focuses on risk allocation in a perfect information setting from an insurance perspective. This article then highlights that equity contracts are equivalent to state-contingent claims in the aggregate-risk shifting, that deposit contracts are equivalent to type-contingent claims in the idiosyncratic-risk mutualization, and that banks and markets both implement the optimal allocation by simply using different mechanisms.