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Risk Pooling, Leverage, and the Business Cycle

Author

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  • Pietro Dindo

    (Department of Economics, University Of Venice CÃ Foscari)

  • Andrea Modena

    (Department of Economics, University Of Venice CÃ Foscari)

  • Loriana Pelizzon

    (Department of Economics, University Of Venice CÃ Foscari; SAFE-Goethe University Frankfurt)

Abstract

This paper investigates the interdependence between the risk-pooling activity of the financial sector and: output, consumption, risk-free rate, and Sharpe ratio in a dynamic general equilibrium model of a productive economy. Due to their exposure to idiosyncratic shocks and market segmentation, heterogeneous households/entrepreneurs (h/entrepreneurs) are willing to mitigate their risk through a financial sector. The financial sector pools risky claims issued by different firms within its assets, faces an associated intermediation cost and, via leverage, provides a risk-free asset to h/entrepreneurs. Exogenous systematic shocks change the relative size of the financial sector, and thus the equilibrium amount of pooled risk, making financial leverage state-dependent and counter-cyclical. We study how this mechanism endogenously channels amplification of consumption and mitigation of output fluctuations. In equilibrium, financial sector leverage also determines counter-cyclical Sharpe ratios and pro-cyclical risk-free interest rates. Last, we investigate the relationship between the size of the financial sector, leverage, and welfare. We show that limiting financial sector leverage determines a sub-optimal pooling of idiosyncratic risk but fosters the growth rate of the h/entrepreneurs' consumption. On the other side, when the financial sector is too large, it destroys too many resources after intermediation costs. Therefore, the h/entrepreneurs benefit the most when the financial sector is neither too small nor too big.

Suggested Citation

  • Pietro Dindo & Andrea Modena & Loriana Pelizzon, 2019. "Risk Pooling, Leverage, and the Business Cycle," Working Papers 2019: 21, Department of Economics, University of Venice "Ca' Foscari".
  • Handle: RePEc:ven:wpaper:2019:21
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    Cited by:

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    More about this item

    Keywords

    Amplification; Business Cycle; Financial Frictions; Leverage; Risk Pooling;
    All these keywords.

    JEL classification:

    • E13 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Neoclassical
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E69 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Other
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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