Risk pooling, leverage constraints and business cycle
Authors: Pietro Dindo (Ca' Foscari University of Venice), Andrea Modena (Ca' Foscari University of Venice), and Loriana Pelizzon (Goethe University and Ca' Foscari University of Venice)
Title: Risk pooling, leverage constraints and business cycle
Abstract: In this paper we investigate the effects of risk pooling activity upon the dynamics of a productive economy in general equilibrium. Financial frictions are generated by way of segmented financial markets. Due to exposure to idiosyncratic risk factors, heterogeneous entrepreneurs are willing to mitigate the risk of their portfolio through an aggregate financial sector. While the former has no leverage, the latter leverages its balance-sheet by shorting a risk free bond. Persistent leverage generates a proportional amplification of the business cycle. This structure stems, at the equilibrium, a non-trivial ergodic wealth distribution and a dynamics by which the system may float for long periods far from its steady state. We focus then on welfare effects of limited leverage. When the constraint is binding, the share of pooled idiosyncratic risk is suboptimal although associated to milder business cycle fluctuations. In the long run, tighter limits upon leverage generate persistent low capitalisation of the financial sector due to a sticky transition through the constrained region of the state space. Moreover, we find out leverage constraints to be welfare detrimental.