How financial innovation 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.
The results are predictable. First, you get far too many of the new securities:
When some risks are neglected, securities are over-issued relative to what would be possible under rational expectations. The reason is that neglected risks need not be laid off on intermediaries or other parties when manufacturing new securities. Investors thus end up bearing risk without recognizing that they are doing so.
And second, you get a spike in tail risk:
Markets in new securities are fragile. A small piece of data that brings to investors’ minds the previously unattended risks catches them by surprise, causes them to drastically revise their valuations of new securities, and to sell them in the market. The problem is more severe precisely because new securities have been over-issued.
Finally, if you add leverage to this toxic mix, that only serves to make everything a great deal worse.
More generally, a lot of what’s going on here is that banks are creating “private money”, and that while economists have generally considered that to be a good thing, “security issuance can be excessive and lead to fragility and welfare losses, even in the absence of leverage and fire sales”. Private money, it turns out, is a bit like public money, but not nearly as robust: think of it as a hundred-dollar bill which, unbeknownst to the holder, can occasionally simply self-destruct.
There’s implicit support in this paper for government attempts to intervene in the market during a crisis: under the model, it’s entirely possible that “investors’ valuation of the claim is low not because it is unappealing per se, but because it is not the claim they wanted to hold”. In that situation, intermediaries — banks — can step in to arbitrage the difference, but they often don’t have nearly enough money to do so. If the government steps in with extra liquidity to buy up the now-undervalued securities, that can help to avert a systemic meltdown.
Left to its own devices, a market with financial innovations is very likely to end up harming investors, while still making lots of money for the innovators:
In our model, innovation benefits intermediaries who earn large profits selling securities, but hurts investors, who are lured into an inefficient risk allocation and suffer from ex-post price drops… Investors’ losses from risk misallocation may be so large as to eliminate the social value of innovation altogether.
Realistically, I see very little chance that any financial regulatory reform will do anything to prevent or even slow down the pace of financial innovation. But maybe, if enough investors read and fully grok papers like this, they’ll learn to stay away from securities they don’t fully understand, or which are so new as to be untested in the real world. But I’m not holding my breath.
*Yes, I read this paper the journalistic way, ignoring the mathematics. But dude, it’s Andrei Shleifer. Surely we can trust his math.
Update: The paper also sparks some counterintuitive ideas about the utility of synthetic CDOs.
Update 2: Glenn Yago, author of a new book on the wonders of financial innovation, makes a couple of good points in the comments. The model, he says, is “unable to distinguish between the good, bad and ugly of financial innovation” — which is true. He also suggests that there are fundamental reasons why CLOs haven’t performed nearly as badly as CDOs, which is probably also true, with hindsight, although I’m not sure that the structures are so different that the outperformance would have been particularly predictable ex ante. Not all financial innovations blow up in every crisis, after all, but financial innovations do blow up. Glenn goes on to use credit ratings in support of his argument, which is kinda funny, I think.
Fundamentally, Glenn seems to be saying that if you “consider capital structure, overleverage, and impacts of regulatory arbitrage”, then you’ll somehow be able to weed out the bad financial innovations, and leave yourself with only the good ones. I’d be more willing to believe him if he didn’t go on to laud the wonders of leveraged loans, which are definitely more leveraged than the super-senior tranches of synthetic CDOs.