The Risk of Risk-Sharing: Diversification and Boom-Bust Cycles
Event details
Date | 01.11.2019 |
Hour | 10:30 › 12:00 |
Speaker | Paymon KHORRAMI, The University of Chicago |
Location | |
Category | Conferences - Seminars |
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.
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