Neglected Risks, Financial Innovation, and Financial Fragility

49 Pages Posted: 14 Jun 2010 Last revised: 6 Oct 2010

See all articles by Nicola Gennaioli

Nicola Gennaioli

Bocconi University - Department of Finance; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research

Andrei Shleifer

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Robert W. Vishny

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: June 2010

Abstract

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.

Suggested Citation

Gennaioli, Nicola and Shleifer, Andrei and Vishny, Robert W., Neglected Risks, Financial Innovation, and Financial Fragility (June 2010). NBER Working Paper No. w16068. Available at SSRN: https://ssrn.com/abstract=1624109

Nicola Gennaioli (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research ( email )

Via Roentgen 1
Milan, 20136
Italy

Andrei Shleifer

Harvard University - Department of Economics ( email )

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HOME PAGE: http://www.economics.harvard.edu/~ashleife/

National Bureau of Economic Research (NBER)

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European Corporate Governance Institute (ECGI)

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Robert W. Vishny

University of Chicago - Booth School of Business ( email )

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Chicago, IL 60637
United States
312-702-2522 (Phone)
312-702-0118 (Fax)

National Bureau of Economic Research (NBER)

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United States

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