Risk allocation and financial intermediation

• Published in: Mathematical social sciences 2022-11, Vol.120, p.78-84
• Main Author: Goussebaïle, Arnaud
• Format: Article
• Language: English
• Subjects: Derivatives; Financial intermediation; General equilibrium; Insurance; Market completeness; Pareto optimum; Risk allocation; Risk factors; Securities; Securities markets; Securities trading
• ISSN: 0165-4896; 1879-3118
• DOI: 10.1016/j.mathsocsci.2022.09.004

The classic Arrow–Debreu framework requires a very large number of specific securities to reach Pareto optimality. The present paper shows that financial intermediation can play an important role in maintaining a more parsimonious market framework while still obtaining Pareto optimality. In the framework developed, the aggregate risk components of individual risks are exchanged through a highly reduced set of nonspecific securities, while the idiosyncratic risk components are insured through financial intermediation. Reaching Pareto optimality does not rest on a Law of Large Numbers approximation. The role of financial intermediation is complementary to the role of security derivatives and dynamic trading. •The present paper shows that financial intermediation can play an important role in maintaining a more parsimonious market framework than the classic Arrow–Debreu framework while still obtaining Pareto optimality.•In the framework developed, the aggregate risk components of individual risks are exchanged through a highly reduced set of nonspecific securities, while the idiosyncratic risk components are insured through financial intermediation.•Reaching Pareto optimality does not rest on a Law of Large Numbers approximation.•The role of financial intermediation is complementary to the role of security derivatives and dynamic trading.