Neglected Risks, Financial Innovation, and Financial Fragility
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.
We are grateful to Pedro Bordalo, Robin Greenwood, Sam Hanson, Anil Kashyap, Brock Mendel, Vladimir Mukharlyamov, Adriano Rampini, Michael Rashes, Joshua Schwartzstein, Jeremy Stein, seminar participants at the Harvard Business School, NBER, Stern School, and ChicagoBooth, as well as the editor and two referees for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
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. citation courtesy of