Working Paper: NBER ID: w16068
Authors: Nicola Gennaioli; Andrei Shleifer; Robert W. Vishny
Abstract: We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.
Keywords: financial innovation; financial fragility; neglected risks
JEL Codes: G01; G14; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| neglected risks by investors and intermediaries (G41) | excessive security issuance (G24) |
| realization of risk (D80) | flight to safety (E44) |
| excessive security issuance (G24) | fragility of financial markets (E44) |
| realization of risk (D80) | decline in prices of new securities (G10) |