Risk-Sharing in Financial Markets. In order to discuss the implications of the Banking Union for risk-sharing in Europe, it is useful to start from the benchmark model of risk sharing in open economies. In a complete markets setting, risks can be shared across countries by holding Arrow-Debreu securities. Arrow-Debreu securities provide insurance against fluctuations of income: on the one hand, the evolution of future income streams is uncertain. On the other hand, households are interested in achieving a smooth consumption profile and to decouple their consumption to the best possible degree from fluctuations in income. As state-contingent securities, Arrow- Debreu securities provide households with the opportunity to decouple their consumption from shocks to national income. Consumption will not be entirely flat across all states of nature, but the degree of consumption smoothing will depend on the price of insurance. Risk will be fairly priced. While insurance can be bought against shocks to national income, shocks to world income would still affect consumption plans. Markets are complete because households can insure their future consumption against all possible future contingencies and variations in income. Of course, the complete markets model is a caricature of real world financial markets, and even the most developed and most integrated financial markets worldwide do not achieve the degree of consumption risk sharing that the benchmark model would predict. While a large literature is devoted to an analysis of incomplete markets, most theoretical models do not bear direct implications for the discussion on a banking union: Macroeconomic models typically do not allow for relevant features of banks and of other financial intermediaries; banking models often focus on microeconomic incentive structures and ignore the feedback between banks and the macro-economy. Yet, as with many theoretical constructs, the complete markets model is a useful benchmark which allows assessing causes for departure from the ideal world. In the real world, Arrow Debreu securities cannot be bought or sold on financial markets, and their features can only imperfectly be replicated by existing financial assets. In a strict sense, Arrow Debreu securities are state-contingent securities which guarantee a certain return (or require a certain payment) if a certain state of the world materializes. While there is no direct equivalent to Arrow Debreu securities in the real world, equity ownership in firms comes close i...
