Discussion paper

DP15269 Risk-Sharing and the Creation of Systemic Risk

We address the paradox that financial innovations aimed at risk-sharing appear to have
made the world riskier. Financial innovations facilitate hedging idiosyncratic risks among
agents; however, aggregate risks can be hedged only with liquid assets. When risk-sharing is
primitive, agents self-hedge and hold more liquid assets; this buffers aggregate risks, resulting
in few correlated failures compared to when there is greater risk sharing. We apply this insight
to build a model of a clearinghouse to show that as risk-sharing improves, aggregate liquidity
falls but correlated failures rise. Public liquidity injections, for example, in the form of a
lender-of-last-resort can reduce this systemic risk ex post, but induce lower ex-ante levels of
private liquidity, which can in turn aggravate welfare costs from such injections.


Acharya, V, A Iyer and R Sundaram (2020), ‘DP15269 Risk-Sharing and the Creation of Systemic Risk‘, CEPR Discussion Paper No. 15269. CEPR Press, Paris & London. https://cepr.org/publications/dp15269