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Neglected risks, financial innovation and financial fragility

  • Nicola Gennaioli
  • Andrei Shleifer
  • Robert Vishny

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.

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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1251.

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Date of creation: Apr 2010
Date of revision: Sep 2010
Handle: RePEc:upf:upfgen:1251
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