**Viral V. Acharya 1, Aaditya M. Iyer 2,\* and Rangarajan K. Sundaram <sup>1</sup>**


Received: 24 June 2020; Accepted: 7 August 2020; Published: 17 August 2020

**Abstract:** We address the paradox that financial innovations aimed at risk-sharing appear to have made the world riskier. Financial innovations facilitate hedging idiosyncratic risks among agents; however, aggregate risks can be hedged only with liquid assets. When risk-sharing is primitive, agents self-hedge and hold more liquid assets; this buffers aggregate risks, resulting in few correlated failures compared to when there is greater risk sharing. We apply this insight to build a model of a clearinghouse to show that as risk-sharing improves, aggregate liquidity falls but correlated failures rise. Public liquidity injections, for example, in the form of a lender-of-last-resort can reduce this systemic risk ex post, but induce lower ex-ante levels of private liquidity, which can in turn aggravate welfare costs from such injections.

**Keywords:** banking; clearinghouses; systemic risk

**JEL Classification:** G21; G22; G31
