Risk sharing and financial stability: a welfare analysis

Journal of Economic Interaction and Coordination volume 16, pages211–228(2021)Cite this article

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.

This is a preview of subscription content, access via your institution.

Access options

Buy single article

Instant access to the full article PDF.

US$ 39.95

Tax calculation will be finalised during checkout.

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).

References

  1. Acemoglu D, Ozdaglar A, Tahbaz-Salehi A (2015) Systemic risk and stability in financial networks. Am Econ Rev 105(2):564–608

    Article  Google Scholar 

  2. Allen F, Gale D (2000) Financial contagion. J Polit Econ 108(1):1–33

    Article  Google Scholar 

  3. Allen F, Babus A, Carletti E (2012) Asset commonality, debt maturity and systemic risk. J Financ Econ 104(3):519–534

    Article  Google Scholar 

  4. Alon S, Gayer G (2016) Utilitarian preferences with multiple priors. Econometrica 84(3):1181–1201

    Article  Google Scholar 

  5. Back K (2010) Asset pricing and portfolio choice theory. Oxford University Press, Oxford

    Google Scholar 

  6. Battigalli P, Bonanno G (1997) The logic of belief persistence. Econ Philos 13(1):39–59

    Article  Google Scholar 

  7. Battiston S, Gatti DD, Gallegati M, Greenwald B, Stiglitz JE (2012) Liaisons dangereuses: Increasing connectivity, risk sharing, and systemic risk. J Econ Dyn Control 36(8):1121–1141

    Article  Google Scholar 

  8. Beale N, Rand DG, Battey H, Croxson K, May RM, Nowak MA (2011) Individual versus systemic risk and the regulator’s dilemma. Proc Natl Acad Sci 108(31):12647–12652

    Article  Google Scholar 

  9. Benoit S, Colliard JE, Hurlin C, Pérignon C (2017) Where the risks lie: a survey on systemic risk. Rev Finance 21(1):109–152

    Article  Google Scholar 

  10. Brunnermeier MK, Simsek A, Xiong W (2014) A welfare criterion for models with distorted beliefs. Q J Econ 129(4):1753–1797

    Article  Google Scholar 

  11. Castiglionesi F, Feriozzi F, Lorenzoni G (2017) Financial integration and liquidity crises. Manag Sci 65(3):955–975

    Article  Google Scholar 

  12. Danan E, Gajdos T, Hill B, Tallon JM (2016) Robust social decisions. Am Econ Rev 106(9):2407–25

    Article  Google Scholar 

  13. Daniel K, Hirshleifer D, Subrahmanyam A (1998) Investor psychology and security market under-and overreactions. J Finance 53(6):1839–1885

    Article  Google Scholar 

  14. Dasgupta A (2004) Financial contagion through capital connections: a model of the origin and spread of bank panics. J Eur Econ Assoc 2(6):1049–1084

    Article  Google Scholar 

  15. Foote CL, Gerardi KS, Willen PS (2012) Why did so many people make so many ex post bad decisions? The causes of the foreclosure crisis. Technical report, National Bureau of Economic Research

  16. Gilboa I (2010) Rational choice. MIT Press, Cambridge

    Google Scholar 

  17. Gilboa I, Samet D, Schmeidler D (2004) Utilitarian aggregation of beliefs and tastes. J Polit Econ 112(4):932–938

    Article  Google Scholar 

  18. Gilboa I, Samuelson L, Schmeidler D (2014) No-betting-Pareto dominance. Econometrica 82(4):1405–1442

    Article  Google Scholar 

  19. Haldane AG, May RM (2011) Systemic risk in banking ecosystems. Nature 469(7330):351

    Article  Google Scholar 

  20. Hammond PJ (1981) Ex-ante and ex-post welfare optimality under uncertainty. Economica 48(191):235–250

    Article  Google Scholar 

  21. Harsanyi JC (1955) Cardinal welfare, individualistic ethics, and interpersonal comparisons of utility. J Polit Econ 63(4):309–321

    Article  Google Scholar 

  22. Karni E, Vierø ML (2013) “Reverse Bayesianism”: a choice-based theory of growing awareness. Am Econ Rev 103(7):2790–2810

    Article  Google Scholar 

  23. Ko KJ, Huang Z (2012) Persistence of beliefs in an investment experiment. Q J Finance 2(01):1250005

    Article  Google Scholar 

  24. Mongin P (2016) Spurious unanimity and the Pareto principle. Econ Philos 32(3):511–532

    Article  Google Scholar 

  25. Nielsen CK (2003) Floating exchange rates versus a monetary union under rational beliefs: the role of endogenous uncertainty. Econ Theor 21(2–3):293–315

    Article  Google Scholar 

  26. Nielsen CK (2018) Rational overconfidence and social security: subjective beliefs, objective welfare. Econ Theor 65(2):179–229

    Article  Google Scholar 

  27. Ottaviani M, Sørensen PN (2015) Price reaction to information with heterogeneous beliefs and wealth effects: underreaction, momentum, and reversal. Am Econ Rev 105(1):1–34. https://doi.org/10.1257/aer.20120881

    Article  Google Scholar 

  28. Savage LJ (1972) The foundations of statistics. Courier Corporation, North Chelmsford

    Google Scholar 

  29. Schmeidler D (1989) Subjective probability and expected utility without additivity. Econom J Econom Soc 57:571–587

    Google Scholar 

  30. Stiglitz JE (2010a) Contagion, liberalization, and the optimal structure of globalization. J Glob Dev 1(2), Article 2

  31. Stiglitz JE (2010b) Risk and global economic architecture: why full financial integration may be undesirable. Am Econ Rev 100(2):388–92

    Article  Google Scholar 

Download references

Author information

Affiliations

  1. Tailong Finance School, Zhejiang Gongshang University, Hangzhou, China

    Weijia Wang

  2. The Center for Economic Research, Shangdong University, Jinan, China

    Shaoan Huang

Authors
  1. Weijia Wang
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Shaoan Huang
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Weijia Wang.

Additional information

Publisher's Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

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

Download citation

Keywords

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