26 Pages Posted: 9 Jun 2009 Last revised: 17 Jan 2012
Date Written: June 8, 2009
I study the limit of a large random economy, in the ideal case of perfect competition, where full information is available to all market participants, and where a set of consumers invests in financial instruments engineered by banks, in order to optimize their future consumption. This provides a picture of how unregulated financial innovation pushes an economy toward the ideal limit of complete markets.
Hedging new products with existing ones, allows financial institutions to reduce the risk associated with them and hence the risk premium. This has the expected consequence that markets, under such ideal conditions, converge to market completeness as the repertoire of financial instruments expands.
As markets approach completeness, however, two ``unintended consequences" also arise: i) equilibrium portfolios become highly sensitive
to idiosynchratic shocks and/or parameter uncertainty and ii) hedging engenders divergent trading volumes in the interbank market. Combining these, suggests an inverse relation between financial stability and the size of the financial sector, which can be quantified within the present framework.
These results suggest that, even under perfect competition and symmetric information, the pursuit of market efficiency -- in terms of completeness -- may erode financial stability. The proliferation of financial instruments exacerbates the effects of market imperfections and, in order to prevent an escalation of perverse effects, markets may necessitate institutional structures which are more and more substantial as their complexity expands.
Keywords: financial stability, systemic risk
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