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The Lifecycle of the Financial Sector and Other Speculative Industries

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  • Biais, Bruno
  • Rochet, Jean-Charles
  • Woolley, Paul

Abstract

Speculative industries exploit novel technologies subject to two risks. First, there is uncertainty about the fundamental value of the innovation: is it strong or fragile? Second, it is difficult to monitor managers, which creates moral hazard. Because of moral hazard, managers earn agency rents in equilibrium. As time goes by and profits are observed, beliefs about the industry are rationally updated. If the industry is strong, confidence builds up. Initially this spurs growth. But increasingly confident managers end up requesting very large rents, which curb the growth of the speculative sector. If rents become too high, investors may give up on incentives, and risk and failure rates rise. Furthermore, if the innovation is fragile, eventually there is a crisis, and the industry shrinks. Our model thus captures important stylized facts of the financial innovation wave which took place at the beginning of this century.

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Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 549.

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Date of creation: Apr 2009
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Handle: RePEc:ide:wpaper:20590

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  1. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
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  7. repec:bla:restud:v:75:y:2008:i:3:p:809-833 is not listed on IDEAS
  8. Lubos Pastor & Pietro Veronesi, 2004. "Was There a Nasdaq Bubble in the Late 1990s?," NBER Working Papers 10581, National Bureau of Economic Research, Inc.
  9. Shapiro, Carl & Stiglitz, Joseph E, 1984. "Equilibrium Unemployment as a Worker Discipline Device," American Economic Review, American Economic Association, vol. 74(3), pages 433-44, June.
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Cited by:
  1. Oh, Frederick Dongchuhl, 2013. "Contagion of a liquidity crisis between two firms," Journal of Financial Economics, Elsevier, vol. 107(2), pages 386-400.

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