How financial innovation causes financial crises
In a new paper called "Financial Innovation and Financial Fragility" (pdf), Nicola Gennaioli, Andrei Shleifer, and Robert Vishny offer an uncommonly clear explanation of how "financial innovation" leads to financial crises. While reading this, keep in mind that the subprime securities that crashed the economy were given the AAA seal of approval by the ratings agencies, which is to say, the system treated them as virtually free of risk, like money stuck under your mattress.
Many recent episodes of financial innovation share a common narrative. It begins with a strong demand from investors for a particular, often safe, pattern of cash flows. Some traditional securities available in the market offer this pattern, but investors demand more (so prices are high), or perhaps demand securities with slightly higher returns and no extra risk. In response to demand, financial intermediaries create new securities offering the sought after pattern of cash flows, usually by carving them out from existing projects or other securities that are more risky. By virtue of diversification, tranching, insurance, and other forms of financial engineering, the new securities are believed by the investors, and often by the intermediaries themselves, to offer at least as good a risk return combination as the traditional substitutes, and are consequently issued and bought in great volumes.
At some point, news reveals that new securities are vulnerable to some unattended risks, and in particular are not good substitutes for the traditional securities. Both investors and intermediaries are surprised at the news, and investors sell these “false substitutes,” moving back to the traditional securities with the cash flows they seek. As investors fly for safety, financial institutions are stuck holding the supply of the new securities (or worse yet, having to dump them as well in a fire sale because they are leveraged). The prices of traditional securities rise while those of the new ones fall sharply.
To put this slightly more simply, the game runs like this: Investors want to make more money with less risk. Someone invents a financial product that appears to make investors more money with less risk -- in this case, subprime securities. Demand for this new product explodes. But few understand this new product, and even the people who do understand the new product don't know how it performs under stress (it's a new product, after all). At the beginning, this actually helps the product: because its risks aren't known, they're ignored, and so it looks like a better deal than it is and sells more of itself than it should.
Then something bad happens. The new product shows its flaws. And precisely because no one really understands it, the market cracks. Investors all run away at once, as they don't really have the tools to assess the situation. Where lack of knowledge about the product originally drove demand, now it accelerates flight.
This isn't just an interesting theoretical insight: It goes to heart of financial regulation. Most financial reform proposals accept financial innovation as a good thing and just try to protect against meltdowns, generally by controlling leverage and making it easier to dismantle failed bans. The model in this paper presents a different view: The boom-and-bust cycle of financial innovation is a risk to the economy, and thus "it is not just the leverage, but the scale of financial innovation and of creation of new claims itself, that might require regulatory attention."
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