Risk-Sharing Externalities

Financial crises typically occur because firms and financial institutions are highly exposed to aggregate shocks. We propose a theory explain these exposures. study model where entrepreneurs can issue state-contingent claims consumers. Even though use instruments hedge negative shocks, they do not necessarily so insuring against shocks is expensive, as consumers also harmed by them. This effect self-reinforcing riskier balance sheets for imply higher income volatility the consumers, making insurance more costly in equilibrium. show that this feedback quantitatively important leads inefficiently high risk exposure entrepreneurs.