Investor protection, risk sharing and inequality

This paper studies the relationship between investor protection, financial risk sharing and income inequality. In the presence of market frictions, better protection makes investors more willing to take on entrepreneurial risk while lending to firms. This implies lower cost of external finance and better risk sharing between financiers and entrepreneurs. Investor protection, by boosting the market for risk sharing plays the twofold role of encouraging agents to undertake risky enterprises and providing them with insurance. By increasing the number of risky projects, it raises income inequality. By extending insurance to more agents, it reduces it. As a result, the relationship between the size of the market for risk sharing and income inequality is hump-shaped. Empirical evidence from a cross-section of sixty-eight countries, and a panel of fifty countries over the period 1976-2000, supports the predictions of the model.

Investor protection and income inequality: risk sharing vs risk taking

This paper studies the relationship between investor protection, entrepreneurial risk taking and income inequality. In the presence of market frictions, better protection makes investors more willing to take on entrepreneurial risk when lending to firms, thereby improving the degree of risk sharing between financiers and entrepreneurs. On the other hand, by increasing risk sharing, investor protection also induces more firms to undertake risky projects. By increasing entrepreneurial risk taking, it raises income dispersion. By reducing the risk faced by entrepreneurs, it reduces income volatility. As a result, investor protection raises income inequality to the extent that it fosters risk taking, while it reduces it for a given level of risk taking. Empirical evidence from a panel of forty-five countries spanning the period 1976-2000 supports the predictions of the model.

Leverage and beliefs: Personal experience and risk taking in margin lending

What determines risk-bearing capacity and the amount of leverage in financial markets? Thispaper uses unique micro-data on collateralized lending contracts during a period of financialdistress to address this question. An investor syndicate speculating in English stocks wentbankrupt in 1772. Using hand-collected information from Dutch notarial archives, we examinechanges in lenders' behavior following exposure to potential (but not actual) losses. Before thedistress episode, financiers that lent to the ill-fated syndicate were indistinguishable from therest. Afterwards, they behaved differently: they lent with much higher haircuts. Only lendersexposed to the failed syndicate altered their behavior. The differential change is remarkable sincethe distress was public knowledge, and because none of the lenders suffered actual losses ? allfinanciers were repaid in full. Interest rates were also unaffected; the market balanced solelythrough changes in collateral requirements. Our findings are consistent with a heterogeneousbeliefs-interpretation of leverage. They also suggest that individual experience can modify thelevel of leverage in a market quickly.