Risk-Sharing Externalities

Financial crises typically occur because firms and financial institutions are highly exposed to aggregate shocks. We propose a theory to explain these exposures. We study a model where entrepreneurs can issue state-contingent claims to consumers. Even though entrepreneurs can use these instruments t...

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Bibliographic Details
Published inThe Journal of political economy Vol. 131; no. 3; pp. 595 - 632
Main Authors Bocola, Luigi, Lorenzoni, Guido
Format Journal Article
LanguageEnglish
Published Chicago The University of Chicago Press 01.03.2023
University of Chicago, acting through its Press
Subjects
Consumers
Economic crisis
Entrepreneurs
Financial institutions
High risk
Insurance
Political economy
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Summary:Financial crises typically occur because firms and financial institutions are highly exposed to aggregate shocks. We propose a theory to explain these exposures. We study a model where entrepreneurs can issue state-contingent claims to consumers. Even though entrepreneurs can use these instruments to hedge negative shocks, they do not necessarily do so because insuring against these shocks is expensive, as consumers are also harmed by them. This effect is self-reinforcing because riskier balance sheets for entrepreneurs imply higher income volatility for the consumers, making insurance more costly in equilibrium. We show that this feedback is quantitatively important and leads to inefficiently high risk exposure for entrepreneurs.
ISSN:0022-3808
1537-534X
DOI:10.1086/722088