Risk Allocation and Financial Intermediation

The classic Arrow-Debreu framework requires a very large number of specific securities to reach Pareto optimality. The present paper shows that financial intermediation can play an important role in maintaining a more parsimonious market framework while still obtaining Pareto optimality. In the framework developed, the aggregate risk components of individual risks are exchanged through a highly reduced set of nonspecific securities, while the idiosyncratic risk components are insured through financial intermediation. The role of financial intermediation is complementary to the role ofsecurity derivatives and dynamic trading