NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Risk Sharing Externalities

Luigi Bocola, Guido Lorenzoni

NBER Working Paper No. 26985
Issued in April 2020
NBER Program(s):Asset Pricing, Corporate Finance, Economic Fluctuations and Growth, Monetary Economics

Financial crises typically arise because firms and financial institutions choose balance sheets that expose them to aggregate risk. We propose a theory to explain these risk exposures. We study a financial accelerator model where entrepreneurs can issue state-contingent claims to consumers. Even though entrepreneurs could use these contingent claims to hedge negative shocks, we show that they tend not to do so. This is because it is costly to buy insurance against these shocks as consumers are also harmed by them. This effect is self-reinforcing, as the fact that entrepreneurs are unhedged amplifies the negative effects of shocks on consumers’ incomes. We show that this feedback can be quantitatively important and lead to inefficiently high risk exposure for entrepreneurs.

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Document Object Identifier (DOI): 10.3386/w26985

 
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