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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.
Viral V. Acharya; Aaditya M. Iyer; Rangarajan K. Sundaram. Risk-Sharing and the Creation of Systemic Risk. Journal of Risk and Financial Management 2020, 13, 183 .
AMA StyleViral V. Acharya, Aaditya M. Iyer, Rangarajan K. Sundaram. Risk-Sharing and the Creation of Systemic Risk. Journal of Risk and Financial Management. 2020; 13 (8):183.
Chicago/Turabian StyleViral V. Acharya; Aaditya M. Iyer; Rangarajan K. Sundaram. 2020. "Risk-Sharing and the Creation of Systemic Risk." Journal of Risk and Financial Management 13, no. 8: 183.