Neglected Risks, Financial Innovation, and Financial Fragility

Nicola Gennaioli, Andrei Shleifer, Robert W. Vishny

NBER Working Paper No. 16068
Issued in June 2010
NBER Program(s):   AP   CF

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.

Published: Gennaioli, Nicola & Shleifer, Andrei & Vishny, Robert, 2012. "Neglected risks, financial innovation, and financial fragility," Journal of Financial Economics, Elsevier, vol. 104(3), pages 452-468.

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This paper was revised on December 5, 2011

Acknowledgments

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