Neglected Risks, Financial Innovation, and Financial Fragility

Nicola Gennaioli, Andrei Shleifer, Robert W. Vishny

NBER Working Paper No. 16068
Issued in June 2010, Revised in December 2011
NBER Program(s):Asset Pricing, Corporate Finance

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.

Acknowledgments

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Document Object Identifier (DOI): 10.3386/w16068

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. citation courtesy of

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