The Risk of Risk-Sharing: Diversification and Boom-Bust Cycles

In this paper, I model a shock whereby financial intermediaries can better diversify borrowers’ idiosyncratic risks. A sector-specific diversification improvement induces intermediaries to reallocate funds toward the shocked sector. As lending spreads fall, intermediaries build up leverage over time. The result is a fragile sectoral boom that can end in an economy-wide bust. This cycle is amplified if the diversification-shocked sector is higher-risk or more external-finance dependent. I apply the model quantitatively to the recent housing cycle. Feeding in a novel mortgage diversification index, the model generates the measured increase in household credit coincident with a 1-2% decline in mortgage spreads. In the subsequent bust, spreads in all sectors spike by 2% as aggregate output drops.