Risk-Sharing and the Probability of Crises

In this paper I add heterogeneous agents and risk-sharing opportunities to a coordi-nation game which represents deposit withdrawals from the banking system. I find that heterogeneity in risk aversion within the population amplifies the effect of the business cycle on the probability of a bank run. In particular, risk-sharing enhances the likelihood of bank runs during bad times. The novel insight is that when there is a risk-sharing mo-tive, fundamentals drive not only individual behavior, but also which individuals are more relevant for the likelihood of a crisis. This mechanism has important consequences for the way we think about policy questions. In the paper I discuss three such implications in detail: (1) I show that a policy that facilitates access to banking for previously unbanked individuals generates externalities, and may even decrease welfare of the least risk averse group in the population. (2) I characterize the bias in the estimation of the probability of a banking crisis when heterogeneity is neglected. (3) I show how to correctly calculate the social value of deposit insurance when depositors differ in their risk aversion.