Innovations, Rents and Risk

40 Pages Posted: 9 Nov 2012

See all articles by Bruno Biais

Bruno Biais

University of Toulouse 1 - Toulouse School of Economics (TSE)

Jean-Charles Rochet

Swiss Finance Institute; University of Geneva - Geneva Finance Research Institute (GFRI); University of Zurich - Swiss Banking Institute (ISB)

Paul Woolley

London School of Economics & Political Science (LSE)

Date Written: October 31, 2012

Abstract

We offer a rational expectations model of the dynamics of innovative industries. The fundamental value of innovations is uncertain and one must learn whether they are solid or fragile. Also, when the industry is new, it is difficult to monitor managers and make sure they exert the effort necessary to reduce default risk. This gives rise to moral hazard. In this context, initial successes spur optimism and growth. But increasingly confident managers end up requesting large rents. If these become too high, investors give up on incentives, and default risk rises. Thus, moral hazard gives rise to endogenous crises and fat tails in the distribution of aggregate default risk. Our model fits the stylized facts of the MBS’s industry bust and boom in the first decade of this century.

Suggested Citation

Biais, Bruno and Rochet, Jean-Charles and Woolley, Paul, Innovations, Rents and Risk (October 31, 2012). De Nederlandsche Bank Working Paper No. 356, Available at SSRN: https://ssrn.com/abstract=2171740 or http://dx.doi.org/10.2139/ssrn.2171740

Bruno Biais (Contact Author)

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

Jean-Charles Rochet

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, Geneva 1211
Switzerland

University of Zurich - Swiss Banking Institute (ISB) ( email )

Plattenstrasse 14
CH-8032 Zurich, Zurich 8032
Switzerland

Paul Woolley

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
44-20-7955-7477 (Phone)

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