Risk sharing and financial stability: a welfare analysis

Abstract

Many studies on the stability of financial markets have shown that perfect risk sharing between financial institutions is not the optimal strategy because it would increase systemic risk and make the system fragile. However, risk sharing is efficient according to most Pareto efficiency criteria. One reason for this incoherency might be that those Pareto criteria consider individual risk rather than systemic risk and neglect that betting dominated by risk sharing can enhance financial stability by segmenting the financial system and preventing financial contagion. To address this issue, we propose a systemic Pareto criterion by refining the standard Pareto criterion to cover financial stability. The criterion has two features: (1) satisfying observed facts that betting dominates risk sharing under certain conditions and (2) providing compelling answers for problems to which current criteria are inapplicable. The implication for financial regulation is that betting can act as the stabilizer of the economy and that prohibiting betting is not always beneficial for the financial market.

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Notes

  1. 1.

    From the ex post perspective, no one may actually fail when they share risk but one would certainly fail when they bet. However, it would not necessarily imply that betting is more risky for the system. Suppose that the only thing the two-person society would not tolerate is that both agents fail. Given there are undiscovered states, risk sharing could result in their common failure but betting could not.

  2. 2.

    This is because people made similar bets on housing by holding assets backed by property prices. A drop in housing prices affected all those agents almost simultaneously, which is exactly the definition of common shocks. Another source of systemic risk is financial contagion which is not discussed in this paper. Interested readers are referred to pages 431–433 of the Financial Crisis Inquiry Report for more information.

  3. 3.

    For example, betting based on heterogeneous beliefs can increase the provision of socially desirable information (Brunnermeier et al. 2014).

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Correspondence to Weijia Wang.

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Wang, W., Huang, S. Risk sharing and financial stability: a welfare analysis. J Econ Interact Coord 16, 211–228 (2021). https://doi.org/10.1007/s11403-020-00291-5

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Keywords

  • Risk sharing
  • Heterogeneous beliefs
  • Pareto efficiency
  • Financial stability