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A Pareto Criterion on Systemic Risk

Wang, Weijia and Huang, Shaoan (2019): A Pareto Criterion on Systemic Risk.

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Abstract

Perfect risk sharing is not an optimal design for the financial system because it can increase systemic risk by facilitating risk contagion among financial institutions. However, risk sharing dominates betting according to most Pareto efficiency criteria. One reason for this might be that those Pareto criteria consider individual risk rather than systemic risk and neglect that betting may reduce systemic risk by segmenting the financial system and preventing financial contagion. Refining Pareto criterion to cover systemic risk, I propose the systemic Pareto criterion which has two features: 1) satisfying facts that betting dominates risk sharing when systemic risk is considered. 2) being applicable to scenarios with the constant aggregate endowment to which current criteria cannot provide compelling suggestions. One implication from this paper is that betting can act as the stabilizer of the economy and prohibiting betting is not always helpful for financial stability.

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