AbstractThe recent financial crisis has revealed significant externalities and systemic risks that arise from the interconnectedness of financial intermediaries' risk portfolios. We develop a model in which the negative externality arises because intermediaries' actions to diversify that are optimal for individual intermediaries may prove to be suboptimal for society. We show that the externality depends critically on the distributional properties of the risks. The optimal social outcome involves less risk-sharing, but also a lower probability for massive collapses of intermediaries. We derive the exact conditions under which risk-sharing restrictions create a socially preferable outcome. Our analysis has implications for regulation of financial institutions and risk management.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Financial Economics.
Volume (Year): 99 (2011)
Issue (Month): 2 (February)
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Web page: http://www.elsevier.com/locate/inca/505576
Financial crisis Financial institutions Systemic risk Limits of diversification;
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