Risk sharing with endogenous enforcement: A contract theoretic perspective

Risk sharing involves transfers of resources between people over time. In the absence of enforcement, however, people may not have an incentive to carry out these transfers. When enforcement is not guaranteed a priori, it has to be provided by the parties of the risk sharing agreement. The essays of this thesis assess the relevance of commitment problems for risk sharing, show how risk sharing is possible when enforcement is not guaranteed, and characterize the optimal provision of enforcement through the parties of a risk sharing agreement. All these results represent new insights into the effectiveness of institutional arrangements that are designed for enforcing contracts and other agreements.; The introductory chapter gives a brief, but comprehensive overview of the problem of enforcing agreements and outlines how to analyze the endogenous provision of this enforcement based on Contract Theory. The first essay explains why banks are able to mutually insure themselves through self-enforcing risk sharing agreements when explicit institutions are absent that enforce risk sharing. Banks are exposed to multiple risk factors and the threat of being excluded from insurance against one of these risk factors is sufficient to enforce risk sharing. The extent of insurance between banks depends on how much the risk factors are correlated.; The remaining three essays study optimal enforcement of dynamic risk sharing contracts between people facing income risk. Enforcement is a choice variable for the parties entering a contract. They can either spend resources on a third party to enforce the transfers as specified in their contract or structure these transfers in a self-enforcing manner. While it is optimal to rely on enforcement through a third party whenever commitment problems prevent first-best risk sharing, it is never optimal to do so exclusively. The optimal use of third-party enforcement changes dynamically over time and increases with the severity of the commitment problem or, equivalently, with the parties' wealth inequality. This efficient sharing of income risk is also possible through financial markets when commitment to financial trades is achieved through a competitive, profit-maximizing intermediary providing costly third-party enforcement of trades.