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Financial Innovation and Financial Fragility

In: Market Institutions and Financial Market Risk

Author

Listed:
  • 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.
(This abstract was borrowed from another version of this item.)

Suggested Citation

  • Nicola Gennaioli & Andrei Shleifer & Robert Vishny, 2010. "Financial Innovation and Financial Fragility," NBER Chapters, in: Market Institutions and Financial Market Risk, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberch:13176
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    More about this item

    JEL classification:

    • G - Financial Economics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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