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The Growth of Finance, Financial Innovation, and Systemic Risk Lecture 3 BGSE Summer School in Macroeconomics, July 2013 Nicola Gennaioli, Universita’

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Presentation on theme: "The Growth of Finance, Financial Innovation, and Systemic Risk Lecture 3 BGSE Summer School in Macroeconomics, July 2013 Nicola Gennaioli, Universita’"— Presentation transcript:

1 The Growth of Finance, Financial Innovation, and Systemic Risk Lecture 3 BGSE Summer School in Macroeconomics, July 2013 Nicola Gennaioli, Universita’ Bocconi, IGIER and CREI

2 Risk Taking, Leverage and Financial Innovations  We saw previously how macroeconomic developments were linked to the growth in risk taking by certain financial sector players  We now consider the corresponding growth in leverage.  Two key points:  It was inextricably lined to the creation of new financial instruments  These new instruments were critical in the recent crisis 2

3 Shadow banking and the crisis 3  Shadow (/securitized) banking:  Provision of short-term safe debt to intermediaries  Debt is collateralized through securitization: Intermediaries: originate, acquire, and pool loans Tranching of loan pools to create safe pieces  In , as loan pools lost value, the system unraveled:  External financing stopped, intermediaries lost from retained risks

4 The Shadow Banking Sector  Origination: finance companies, financed through commercial paper  Loan warehousing, pooling, and tranching into ABS and their intermediation: broker dealers, structured investment vehicles (SIVs), etc.  Funding of above activities: money market funds, securities lenders 4

5 Shadow Banking and Leverage 5

6 Shadow Banking and Innovation  Traditional banking: banks raise deposits, originate loans, and keep these loans in their balance sheets.  Originate and distribute banking: banks raise deposits, originate loans, but sell these loans to the markets.  Loans are pooled by shadow banks, and used to crated ABS to raise collateralized financing.  The originate and distribute model was taught to bring stability: it would allow banks to reduce the risk in their balance sheets. Not quite what happened. 6

7 Build a “neglected risks” model of Shadow Banking and Securitization 7  Demand for safety: Outside investors only want riskless debt.  Securitization: Intermediaries use funds to originate safe and risky loans. Risky loans are subject to institution-specific idiosyncratic risk (and to aggregate risk). Trading and pooling of risky loans eliminates idiosyncratic risk.  Neglected Risks: investors and intermediaries neglect low probability aggregate risks (GS 2010, GSV 2011).

8 Neglected Risks 8  This assumption captures:  Uncertainty of model-economy: overweighting of historical trends  Difficulty in measuring risk in complex, interconnected financial institutions  These problems exacerbated by financial innovations. New securities are difficult to understand for the price and to price for intermediaries Wrong models (Coval Jurek and Stafford, 2010)  How robust is the financial system to these problems?

9 Main results I 9  Investors’ wealth drives securitization/shadow banking:  As investors’ wealth becomes large, intermediaries make marginal, risky loans. To create safe collateral, they securitize and pool them.  Intermediaries’ assets (loan portfolios) and liabilities (riskless debt) grow together. Aggregate risk yields a carry trade.  Pooling of risks endogenously renders intermediaries interconnected. Under RE, stability and welfare go up.

10 Main results II  With neglected risks, securitization creates a “diversification myth”: each single intermediary now looks safer.  Yet, pooling of idiosyncratic risks also raises the exposure of all intermediaries to any neglected aggregate tail risks.  Ex-ante pooling creates ex-post fragility and illiquidity  Securitization: expand ex-ante financing but creates fragility ex-post by capitalizing on investors’ misperception of risks 10

11 Some Related literature 11  Link shadow banking to growing investor wealth (Caballero et al. 2008). Account for link between risk-taking and low interest rates (Maddaloni and Peydro 2011, Jimenez et al. 2011). Show that with, neglected risks, insurance creates catastrophe bonds (Coval, Jurek, and Stafford 2009b).  Explain comovement of assets and leverage (Adrian and Shin, 2010) and intermediaries’ risk retention (Acharya, Schnabl, and Suarez 2010).  Endogenize bank interconnectedness and systematic risk. Shin (2009a) and Allen and Gale (2000). We focus on neglect of aggregate tail risks.  Explain how banks lose a fortune holding other banks’ risks in a crisis. See Benmelech and Dlugosz on CDO’s.  Ex-post illiquidity. Geanakoplos (2009), SV (2010), Gorton and Metrick (2010), etc. We focus on ex-ante insurance, not on short term debt.  Model pooling and tranching, but not as a result of asymmetric information (De Marzo and Duffie 1999) or ring-fencing.

12 Organization of Presentation 12  The model with rational expectations  The model with local thinking and results  Extensions (briefly)

13 13  Two dates t = 0, 1  There is a measure 1 of infinitely risk averse investors E ω [C 0 + min ω C 1,ω ]  they receive wealth w at t = 0  There is a measure 1 of risk neutral intermediaries E ω [C 0 + C 1,ω ]  they receive wealth w int < 1 at t = 0  Intermediaries invest by using their own wealth w int and by issuing riskless debt to investors:  Issue debt D at t = 0, promise to repay rD at t = 1.

14 14  Intermediaries have access to projects that pay in t=1:  Safe (H): invest I H,j and obtain RI H,j at t = 1 Limited aggregate supply of 1.  Risky (L). Invest I L,j and obtain:  There are three aggregate states ω = g, d, r, with π g > π d > π r and Pr( π ω ) = φ ω - there is both idiosyncratic and aggregate risk - a pool of projects yields AI L π ω in aggregate state ω

15 Intermediaries’ return to investment 15 Technology features decreasing returns + increasing risk Marginal Return R 1 E(π ω )A Total Investment A 0

16 Timing 16  At t = 0 each intermediary borrows D j, invests I H,j and I L,j, sells S L,j units of risky investment, buys T L,j units of diversified pools of other intermediaries’ investments.  Interest rate r, price of loans p L : competitively set at t=0.  At t = 1 state ω and intermediaries’ returns are revealed.  Investment pays off and debt is repaid.  Investors lend all of their wealth w if r > 1, they are indifferent between lending or not at r = 1.

17 Intermediaries’ expected profits I 17  At t = 0 each intermediary j has expected profits: R∙I H,j + + [E ω (π ω )∙A∙(I L,j –S L,j ) + E ω (π ω )∙A∙T L,j + p L (S L,j –T L,j )] + + D j – I H,j – I L,j + w int – rD j.  Return from idiosyncratic risk kept (I L,j –S L,j ) is 0 or A.  Return from securitized pool T L,j is π ω ∙A in ω.  The pool is only subject to aggregate risk about π ω.

18 Intermediaries’ expected profits II 18  Intermediary j holds two types of risky investments.  Risky investments originated and kept: (I L,j –S L,j ) →  Risky securitized pools purchased in the market: T L,j → A∙(I L,j –S L,j )π g φ g + π d φ d + π r φ r 0otherwise A∙π g ∙T L,j φgφg A∙π d ∙T L,j φdφd A∙π r ∙T L,j φrφr

19 19  The constraints faced by the intermediary are:  Feasibility: at t = 0 cannot invest more than resources raised  Riskless debt constraint: rD j ≤ R∙I H,j + π r ∙A∙T L,j. Pledge safe return and securitized pool in worst state π r. Intermediaries’ “carry trade” is [ E ω (π ω )A – r ]∙T L,j  Feasibility of Securitization: S L,j ≤ I L,j Cannot sell more investments than those undertaken

20 Preliminaries 20  Risky asset is securitized only if debt constraint is binding  Pooling of risks relaxes investors’ demand for safe collateral  Securitization pools are bought by intermediaries: they are the high value buyers. Thus, T L,j = S L,j. Use pools to back debt.  Securitization supports growth in leverage and…  Allows intermediaries to earn a return above safe debt

21 21  low w : no risky investment, no debt, no securitization Interest rate Total wealth Risky investment and securitization R w int

22 22  higher w: no risky investment, some debt, no securitization Interest rate Total wealth Risky investment and securitization R w int 1 R > R(1- w int )

23 23  Intermediate w: some risky investment, debt, no securitization Interest rate Total wealth Risky investment and securitization R w int 1 R > E(π ω )Aw E(π ω )A I L = w + w int – 1 R / E(π ω )A

24 24  high w : risky investment, debt, securitization Interest rate Risky investment and securitization R w int 1 R + π r AS L > E(π ω )Aw E(π ω )A I L = w + w int – 1 S L = [E(π ω )/π r ]w – R/Aπ r R/E(π ω )A w int + w *

25 25  Very high w : risky investment, debt, maximal securitization Interest rate Risky investment and securitization R w int 1 R + π r AI L > r(w)w E(π ω )A R/E(π ω )A w int + w * w int + w ** 1

26 Securitization under RE I 26  Securitization endogenously arises to meet the demand “ w” for riskless debt. Driven by marginal, risky, projects.  By lowering idiosyncratic risk, pooling boosts safe collateral and debt capacity. Growth of assets and leverage  Pools allow intermediaries to earn a yield (“carry trade”)  When at t = 1 returns are revealed, not much happens  Some intermediaries do better than others (if securitization is partial), but all debt is truly safe.  Securitization is welfare improving.

27 Securitization under RE II 27 In worst case scenario π r :  A fraction 1 – π r of intermediaries get 0 on their projects: [R + π r ∙A∙S L + 0∙(I L –S L )] – [R + π r ∙A∙S L ] = 0  A fraction π r of intermediaries get A on their projects: [R + π r ∙A∙S L + A∙(I L –S L )] – [R + π r ∙A∙S L ] = A∙(I L –S L ) > 0

28 Securitization and Local Thinking 28  Local thinking (GS 2010, GSV 2011): neglect unlikely (tail) risk. Here is “recession”, because φ r = min φ ω.  At t = 0, agents think only of “growth” and “downturn”  Two things change with respect to RE at t = 0  Assess higher average return E LT (π ω )A > E(π ω )A  Relax debt constraint: rD j ≤ R + π d ∙A∙T L,j.

29 Equilibrium under Local Thinking at t = 0 29  Securitization and leverage expand. At low w this raises interest rates, at higher w this also boosts investment Interest rate R E(π ω )A w int +w * w int + w ** 1 E LT (π ω )A w int + w **,LT higher r higher r, D

30 Securitization and Local Thinking at t=1 30 If at t = 1 the state is g or d, debt is sustainable, as with RE In worst case scenario π r :  Share 1 – π r of unsuccessful intermediaries fail: [R + π r ∙A∙S L + 0∙(I L –S L )] – [R + π d ∙A∙S L ] = – (π d – π r )∙A∙S L < 0  Share π r of successful intermediaries also fail iff: [R + π r ∙A∙S L + A∙(I L –S L )] – [R + π d ∙A∙S L ] = = A∙(I L –S L ) – (π d – π r )∙A∙S L < 0

31 31 Default and repayment in recession  All intermediaries fail if: < 1 + (π d – π r )  A “successful” intermediary is more likely to fail if more investment is securitized!  Pooling creates correlation in intermediaries’ assets  Small mistakes create massive fragility when w is large

32 Securitization and Market Liquidity at t = 1 32  At t = 1, state ω is learned only partially. Observe s in {l, h}  Here h is informative of {g, d}, while l is informative of {d, r}  In s, a share q s of risky projects pays off A at t = 1. q h > q l  Two implications from imperfect learning and “early” projects:  We can study retrading and market liquidity at t = 1  Early intermediaries may have liquidity to buy claims at t = 1.  Due to “early” projects, some debt repayment occurs at t = 1  Still focus on long term debt, but promising two coupons  For simplicity, return R is ring fenced by most senior debt class

33 Event tree nesting the previous setup 33

34 Event tree under local thinking 34  As q l is revealed, the agent realizes to be in the lower branch, which did not come to mind at t = 0.

35 Basic results with partial information 35  Not much changes at t = 0. If at t = 1 neglected state q l realizes, investors learn that debt may default at t = 2 if state is π r.  In q l investors value each securitized asset π r A, intermediaries value the same asset at E(π ω |q l )A > π r A. Can a trade arise?  The total liquidity of “early” intermediaries is equal to: q l ∙[A∙(I L,j –S L,j ) – (π d – π r )A∙S L,j ]  Which increases in the unsecured portion of projects and decreases in the unexpected drop in collateral (π d – π r )A

36 Market Fragility at t = 1 36  In neglected state q l the price of securitized projects drops to investors’ reservation value π r A when: I L,j /S L,j < 1 + (π d – π r ) + π d /q l  High securitization reduces the liquidity of successful intermediaries  Securitization creates fragility also by draining out market liquidity after neglected risks realize. Limited securitization leaves “spare liquidity” ex-post.  Correlation in balance sheet costly when neglect risk occurs This goes beyond idea that intermediaries commit all of their wealth at t = 0 (see SV 2010 and GSV 2011)

37 37 Ex-ante and ex-post liquidity  Due to market liquidity, investors might be willing to lend against risky collateral (and debt) based on resale value.  Or, equivalently, to directly buy securitized assets. Markets do the “pooling,” regardless of who holds the risky assets  If early intermediaries buy back risky assets at t = 1 at p 1 > π d A, investors may lend more than reservation value at t = 0 Market trading at price p 1

38 38 Failure of market insurance at t = 1  Liquidity in good times is consistent with illiquidity in bad times if  “Normal times” market liquidity at t = 1 can coexist with illiquidity when neglected risks materialize.  Investors lend more than reservation value π d A because they expect the t = 1 market to be liquid. If securitization is large, as q l realizes the market becomes illiquid and price drops to π r A  Securitization creates both liquidity in normal times and illiquidity when neglected risks materialize.  This boosts fragility and creates spikes in risk premia

39 Some Facts (I) 39 Mortgage Origination and Subprime Securitization

40 Some Facts (II) Securitization and decline in lending standards 40

41 Some Facts (III) Centrality of the collapse of AAA securities 41

42 Some Facts (IV) Collapse of commercial paper market 42

43 Some Facts (V) Securitization, subprimes and the collapse of ABS 43

44 Some Facts (VI) Unusual securities 44

45 Some Facts (VII) Collapse in the issuance of ABS 45

46 Conclusions I  We offered the following theory for the positive correlation between assets and leverage, and the resulting financial fragility:  Large wealth of risk averse investors creates enormous pressure/opportunities for banks to manufacture safe assets  This induces banks to securitize and expand their balance sheets by holding “safer” pooled risks  Banks make enormous profits out of the resulting carry trade  The system becomes highly interconnected. As some regional housing markets cool off and delinquencies rise, the system collapses 46

47 Conclusions I  Neglected risks are subtle and changing  Cannot expect regulators to stay ahead  Capital requirements are a crude but appropriate instrument for reducing bets  Problems with market-based risk weighting  Extreme concentration of exposures to a given asset class should raise a red flag  Deeper skepticism about innovations that capitalize on neglect of risk, such as prime MMF. 47

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