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Neglected Risks, Financial Innovation, and Financial Fragility

  • Gennaioli, Nicola
  • Shleifer, Andrei
  • Vishny, Robert

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 the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.

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Paper provided by Harvard University Department of Economics in its series Scholarly Articles with number 10886835.

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Date of creation: 2012
Date of revision:
Publication status: Published in Journal of Financial Economics
Handle: RePEc:hrv:faseco:10886835
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