Sophisticated Intermediation and Aggregate Risk"

Abstract

I consider an economy where investors delegate their investment decisions to financial institutions that choose across multiple investment opportunities featuring different levels of idiosyncratic risk and different degrees of correlation with the aggregate of the economy. Investors solve an optimal contracting problem to induce financial institutions to allocate their investment optimally. I then study how investment decisions are affected when financial securities are introduced that allow agents to trade their risks. Investors do not have the necessary information to understand these securities, but give incentives to financial institutions to hedge certain risks. I show that hedging idiosyncratic risks ameliorates the agency problem between investors and financial institutions and reduces aggregate volatility. On the contrary, when aggregate risk can be hedged the agency problem worsens and aggregate volatility increases. Finally, I study the efficiency properties of the equilibrium and the potential role for financial regulation.