Financial Innovation April 26, 2010 at 12:39 pm

Nicola Gennaioli, Andrei Shleifer, and Robert Vishny have a new paper on Financial Innovation and Financial Fragility which makes some interesting points.

Their basic claim, to distil an extended argument into too small a space, is that financial innovation often causes instability because the risks of the innovative instruments are misjudged. In particular, securities are often created which are judged as safe, but which have significant tail risk. When the markets visit this tail, a crisis results as investors sell the innovative security: there is a flight to simplicity.

There is much to commend in this model. It seems to capture some salient facts of not just this but previous crises (CDOs in 2008, CMOs in the early 90s, junk bonds in the 80s). However, one area where I do not wholly agree with their account is in why investors buy these innovative securities. The paper says:

We assume that both investors and financial intermediaries do not attend to certain improbable risks when trading the new securities.

That may be true for some investors, but I think that the dynamic is more subtle. Firstly these innovations are a phenomenon of plenty: they happen when there is a lot of money looking for a home. In such conditions, government rates tend to be depressed, and credit spreads collapse. Innovation rightly searches for yield, as there is enormous investor demand for it. One way to create a low probability of default security with a yield above government rates is to take a completely safe security and then take a bit of unlikely-to-happen risk. In options terminology, you sell an out of the money put. Or in ordinary parlance, you insure an unlikely event. The extra premium received juices up the yield of your safe investment.

Now, of course, the problem with this is that if that unlikely event does come to pass, you are creamed. But if everyone is doing it, and everyone thinks the premiums are attractive given the risk, the tempation to join in is considerable. You might very well understand exactly what you are doing (at least in terms of what might happen), and yet still decide to participate. Of course, typically here there is a general misestimate of the probability of these unlikely events, but that isn’t the point. The risk is not ignored: it is simply judged acceptable, given the rewards. Investor greed, in other words, rather than stupidity, drives innovation.

Krugman moreover points out one reason why estimating the probability of these tail events is difficult:

The low-probability event that revealed the falsity of these perceptions [that the innovative security was worth buying] wasn’t exogenous. What has happened instead was that the very growth of the financial sector led to an upward trend in asset prices that masked the real risks — the way the housing bubble masked the true risks of subprime lending is a key example, but not unique.

In other words, by buying these securities, an investor stimulates the creation of more of them, typically with lower standards, less yield and higher risk, and thus increases the probability of a bad crash.

2 Responses to “Financial Innovation”

  1. David, this is a great post (as usual). In fact, I would go a bit further: the problem is not that people in general systematically underestimate the probability of unlikely events, it is that those who happen do do so are the ones who corner the market, determine prices, and generate substantial profits as long as the crisis is averted. Others are then forced to imitate them or face a loss of market share, and fragility increases over time as a result.

  2. Thank you, Rajiv. You’re right of course: those people who call the market right don’t participate at first, and thus lose market share to those who do, and this too intensifies the bubble. Many criticised Prince’s ‘the music is still playing so Citi is still dancing’ remark at the time, but he was only being honest, and it was a good example of the dynamic you describe.