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Risk sharing and financial stability: a welfare analysis

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  • Weijia Wang

    (Zhejiang Gongshang University)

  • Shaoan Huang

    (Shangdong University)

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.

Suggested Citation

  • Weijia Wang & Shaoan Huang, 2021. "Risk sharing and financial stability: a welfare analysis," Journal of Economic Interaction and Coordination, Springer;Society for Economic Science with Heterogeneous Interacting Agents, vol. 16(1), pages 211-228, January.
    • Handle: RePEc:spr:jeicoo:v:16:y:2021:i:1:d:10.1007_s11403-020-00291-5
    DOI: 10.1007/s11403-020-00291-5
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