Risk-Sharing and the Creation of Systemic Risk

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.

Liquidity Management, Fire Sale and Liquidity Crises in Banking: The Role of Leverage

“…Hence, in our framework, capital and liquidity requirements are, at least to some extent, substitute in the sense that highly capitalised banks will automatically choose their asset mix to meet liquidity and funding requirements. 3 We are not claiming that this result implies that, in the presence of capital requirements, liquidity requirements such as LCR are redundant. 4 All we are claiming is that a restriction on banks' leverage can have a positive impact on their incentives to manage their liquidity risk.…”