The Collateral Link between Volatility and Risk Sharing

Abstract

We show that aggregate volatility affects the extent to which agents can share idiosyncratic risks through the valuation of collateral. Both private and public assets are used in insurance markets as collateral, but their exposure to volatility differs. While aggregate volatility decreases the value of private assets—they are exposed to more variation—it increases the value of public assets—they become more valuable to smooth consumption intertemporally. Hence, a more volatile economy tends to damage risk sharing when the composition of collateral is biased toward private assets. As we show that a stable economy is more propitious to the creation of private collateral, stability makes risk sharing increasingly fragile to volatility shocks. We find empirical evidence that the higher use of private assets in the U.S. has affected the sensitivity of risk sharing to aggregate volatility as predicted by our model.