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Financial Innovation and Financial Fragility

In: Market Institutions and Financial Market Risk

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  • Nicola Gennaioli
  • Andrei Shleifer
  • Robert 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. Financial innovation can make both investors and intermediaries worse off. The model mimics several facts from recent historical experiences, and points to new avenues for financial reform.

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This chapter was published in:

  • Mark Carey & Anil Kashyap & Raghuram Rajan & RenĂ© Stulz, 2012. "Market Institutions and Financial Market Risk," NBER Books, National Bureau of Economic Research, Inc, number care10-1, May.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 13176.

    Handle: RePEc:nbr:nberch:13176

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    1. Douglas W Diamond, 2010. "Fear of fire sales and the credit freeze," BIS Working Papers 305, Bank for International Settlements.
    2. Ricardo J. Caballero & Arvind Krishnamurthy, 2007. "Collective Risk Management in a Flight to Quality Episode," NBER Working Papers 12896, National Bureau of Economic Research, Inc.
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      • Zoltan Pozsar & Tobias Adrian & Adam Ashcraft & Hayley Boesky, 2010. "Shadow banking," Staff Reports 458, Federal Reserve Bank of New York.
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