Banks, Markets, and the Allocation of Risks

Abstract

This paper discusses the role of banks and markets in the allocation of risks in an economy. Starting from a discussion of risk allocations in the Arrow-Debreu model, it criticizes the view that banks and markets are substitutes. Instead it is argued that markets are made by intermediaries and intermediaries in turn rely on - interbank - markets for risk management. The analysis raises the question why traditional contractual arrangements in banking leave banks subject to risks associated with macro shocks, which are in principle contractable in an incentive-compatible way. Several explanations for this phenomenon are discussed.

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