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http://blogs.reuters.com/felix-salmo...causes-crises/
Nicola Gennaioli, Andrei Shleifer, and Robert Vishny have a great new paper out entitled “Financial Innovation and Financial Fragility”.* It doesn’t break a lot of new conceptual ground, but it’s very thought-provoking, and it helps to codify in a formal way the serious problems with financial innovation. Their conclusion is spot-on, I think:
Recent policy proposals, while desirable in terms of their intent to control leverage and fire sales, do not go nearly far enough. It is not just the leverage, but the scale of financial innovation and of creation of new claims itself, that might require regulatory attention.
The idea here is that financial innovation is, by its nature, inherently and predictably dangerous. If something’s innovative, it’s new. And if something’s new, it’s untested. Meanwhile, a very large part of what we consider “financial innovation” consists of “improving” on existing securities, usually by creating a source of new supply for in-demand securities while also providing some kind of pick-up in yield.
Eventually, a test comes along: the world behaves in a way that no one had expected, and the new securities prove to be less attractive than the traditional securities they replaced. When that happens, demand for them plunges, their price falls dramatically, and enormous losses ensue. This narrative has been played out many times — look at CMOs and junk bonds in the 1980s, or CDOs and money-market accounts more recently. Or look back on eight centuries of financial folly, for that matter.
In order to make the model in this paper work, you just need to make a couple of very reasonable assumptions. First of all, there’s the assumption that investors aren’t perfectly rational; instead, they use what’s known as “local thinking”, and don’t consider every possible eventuality when buying securities. Secondly, there’s the assumption (which isn’t even necessary, it just makes the results stronger) that investors prefer safety over risk. The authors dryly note that it would be possible to model such an assumption by considering “investors who have lexicographic preferences with respect to particular characteristics of investments (e.g., AAA ratings)”. Quite.
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Recent policy proposals, while desirable in terms of their intent to control leverage and fire sales, do not go nearly far enough. It is not just the leverage, but the scale of financial innovation and of creation of new claims itself, that might require regulatory attention.
The idea here is that financial innovation is, by its nature, inherently and predictably dangerous. If something’s innovative, it’s new. And if something’s new, it’s untested. Meanwhile, a very large part of what we consider “financial innovation” consists of “improving” on existing securities, usually by creating a source of new supply for in-demand securities while also providing some kind of pick-up in yield.
Eventually, a test comes along: the world behaves in a way that no one had expected, and the new securities prove to be less attractive than the traditional securities they replaced. When that happens, demand for them plunges, their price falls dramatically, and enormous losses ensue. This narrative has been played out many times — look at CMOs and junk bonds in the 1980s, or CDOs and money-market accounts more recently. Or look back on eight centuries of financial folly, for that matter.
In order to make the model in this paper work, you just need to make a couple of very reasonable assumptions. First of all, there’s the assumption that investors aren’t perfectly rational; instead, they use what’s known as “local thinking”, and don’t consider every possible eventuality when buying securities. Secondly, there’s the assumption (which isn’t even necessary, it just makes the results stronger) that investors prefer safety over risk. The authors dryly note that it would be possible to model such an assumption by considering “investors who have lexicographic preferences with respect to particular characteristics of investments (e.g., AAA ratings)”. Quite.
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