How financial innovation causes crises

By Felix Salmon
April 11, 2010
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:

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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.

(HT: guan)

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.


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Stop calling it “financial innovation” and start calling it “financial complexity”. Needless complexity was re-branded as innovation back in the 80s and that’s been a major source of our problems.

Complexity is easier to condemn, because we all understand that needless complexity is fabricated game to see who can outsmart who. But when it’s called “financial innovation” it makes it sound like some great public service has been done.

Posted by Sprizouse | Report as abusive

Seems like the blog and model fail to distinguish between financial liberalization (in markets and capital accounts) and innovations in products and services, processes, and organizational forms that enable financing. Also, no element in the model considers capital structure, overleverage, and impacts of regulatory arbitrage. This makes the model elegant theoretically, but empirically unable to distinguish between the good, bad and ugly of financial innovation—painting all with a No. 10 brush. For example, CLOs which lost no principal value, had suitable leverage and ability to access underlying collateral (oh yes, no differentiation of collateral is delineated in the model), leveraged loans and junk bonds (which have historically demonstrated their performance based on fundamentals and returns) are lumped with low quality CDOs buried with imprudent leverage, inability to access collateral, and concentration of risk that destroyed bank balance sheets. Not too sure how this helps us understand the incidence of crises derived from asset bubbles in the absence of financial innovation (e.g., Spain, Ireland).

Posted by gyago | Report as abusive

Here’s a question that would get this important discussion you’ve raised beyond financial luddism:

By the end of 2009, 95% of CLO liabilities orginally rated AAA remained rated A or better; 90% of CDOs originally rated AAA were rated BB+ or worse. Why?

Posted by gyago | Report as abusive

I didn’t get this:

“Lemma 3 In the absence of innovation, no risky claim is issued (a = 0) and pA < 1."

Isn't this an empirical question? In other words, couldn't the investors choose the product because it allows for less collateral? Which, in that case, would make them less safe, all things being equal.

The question then becomes did they sell these products on dubious grounds? My impression is that many of these innovations had previously existed, and were sold as tested, and not that investors were told we have theoretically safe investments that have never been tested.

Posted by DonthelibertDem | Report as abusive

“By the end of 2009, 95% of CLO liabilities orginally rated AAA remained rated A or better; 90% of CDOs originally rated AAA were rated BB+ or worse. Why?”

To simplify, correlation assumptions. Even during the peak of the securitisation boom, rating agencies still stuck to relatively strict diversification criteria for the underlying loans in the CLO. By contrast, they assumed that RMBS tranches, even at the BB or BBB level, were inherently diversified – obviously, they weren’t. The cliff risk you saw in CDOs of RMBS wasn’t repeated anything like as widely in CLOs (with some exceptions such as market value CLOs and leveraged super seniors).

Posted by GingerYellow | Report as abusive

These papers very rarely have actual mistakes in the math; Glenn’s points are in fact the reason to read the math rather than just the prose: the math makes the assumptions (more) explicit. In general, you can translate the prose into a fairly decent responsible understanding of the results, and usually the translation takes a form along the lines of “this is an illustration that the phenomenon illustrated can occur, to some extent, in various somewhat plausible circumstances, on top of all the other phenomena that are occurring.” I’m inclined here to recognize this as a potential cost to innovation that should be weighed against potential benefits.

In fact, this sort of phenomenon doesn’t even require “financial innovation”, really. Low-rated bonds weren’t invented in the eighties; it was just realized what a good investment they had been in the past. Canals in England in the 1790′s were very good investments. In both cases, high returns drew in market participants and increased supply, until the rates of return came down to reasonable levels — and then kept going. In both cases, people had started to neglect the ways in which things go wrong, and used recent history to assuage any concerns about risk. What financial innovation adds is that it exacerbates the extent to which relatively well-informed investors can fail to recognizes risks before they get hit. The rest of the boom-bust cycle is more general.

Posted by dWj | Report as abusive

You trust his math? Or do you trust that he uses detail-oriented types to do his math for him? Or was this tongue-in-cheek?

“As a freshman at Harvard, Shleifer took Math 55 with Brad DeLong; he has said that the course made him realize he was not destined to be a mathematician, but the experience gave him a future co-author.”

“During the early 1990s, Andrei Shleifer was an advisor to Anatoly Chubais, the then vice-premier of Russia, and was one of the engineers of the Russian privatization. During that time, Harvard University was under a contract with the United States Agency for International Development, which paid Harvard and its employees to advise the Russian government. The results of privatization in Russia were criticized widely in Russia and western academic circles. Under Anatoly Chubais, privatization led to valuable Russian business assets being acquired at extremely cheap prices amid accusations of rigged auctions.
Shleifer was also tasked with establishing a stock market for Russia that would be a world-class capital market. That effort was also unsuccessful, and became mired in charges of corruption and self-dealing.[6]

Under the False Claims Act, the US government sued Harvard, Shleifer, Shleifer’s wife Nancy Zimmerman, Shleifer’s assistant Jonathan Hay, and Hay’s girlfriend (now his wife) Elizabeth Hebert, because these individuals bought Russian stocks and GKOs while they were working on the country’s privatization, which potentially contravened Harvard’s contract with USAID. In 2001, a federal judge dismissed all charges against Zimmerman and Hebert.[7] In June 2004, a federal judge ruled that Harvard had violated the contract but was not liable for treble damages, but that Shleifer and Hay might be held liable for treble damages (up to $105 million) if found guilty by a jury.[8]
In June 2005, Harvard and Shleifer announced that they had reached a tentative settlement with the US government. On August 3 of the same year, Harvard University, Shleifer and the Justice department reached an agreement under which the university paid $26.5 million to settle the five-year-old lawsuit. Shleifer was also responsible for paying $2 million dollars worth of damages, though he did not admit any wrong doing. A firm owned by his wife previously had paid $1.5 million in an out of court settlement.
Because Harvard University paid most of the damages and allowed Shleifer to retain his faculty position, the settlement provoked allegations of favoritism on the part of Harvard’s outgoing president Lawrence Summers, who is Shleifer’s close friend and mentor. Shleifer’s conduct was reviewed by Harvard’s internal ethics committee. In October 2006, at the close of that review, Shleifer released a statement making it clear that he remains on Harvard’s faculty. However, according to the Boston Globe, he has been stripped of his honorary title of Whipple V. N. Jones Professor of Economics” ifer

Posted by Uncle_Billy | Report as abusive