Working Paper: CEPR ID: DP15269
Authors: Viral V. Acharya; Aaditya M. Iyer; Rangarajan K. Sundaram
Abstract: We address the paradox that financial innovations aimed at risk-sharing appear to havemade the world riskier. Financial innovations facilitate hedging idiosyncratic risks amongagents; however, aggregate risks can be hedged only with liquid assets. When risk-sharing isprimitive, agents self-hedge and hold more liquid assets; this buffers aggregate risks, resultingin few correlated failures compared to when there is greater risk sharing. We apply this insightto build a model of a clearinghouse to show that as risk-sharing improves, aggregate liquidityfalls but correlated failures rise. Public liquidity injections, for example, in the form of alender-of-last-resort can reduce this systemic risk ex post, but induce lower ex-ante levels ofprivate liquidity, which can in turn aggravate welfare costs from such injections.
Keywords: risk-sharing; systemic risk; financial innovations
JEL Codes: G21; G22; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Risk-sharing arrangements (G32) | Reduction in holding of liquid assets (G33) |
| Reduction in holding of liquid assets (G33) | Increased likelihood of counterparty defaults during aggregate shocks (F65) |
| Improved risk-sharing (G32) | Reduction in holding of liquid assets (G33) |
| Improved risk-sharing (G32) | Increased vulnerability to aggregate shocks (F65) |
| Public liquidity injections (E44) | Lower ex-ante private liquidity (G19) |
| Improved risk-sharing (G32) | Increased systemic fragility (F12) |
| Correlation of risks among agents (C10) | Effective risk-sharing (G52) |
| High correlations among agents (C10) | Systemic failure (P11) |