Neglected Risks, Financial Innovation, and Financial Fragility

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Neglected Risks, Financial Innovation, and Financial Fragility

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Title: Neglected Risks, Financial Innovation, and Financial Fragility
Author: Gennaioli, Nicola; Shleifer, Andrei; Vishny, Robert

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Citation: Gennaioli, Nicola, Andrei Shleifer, and Robert W. Vishny. 2012. Neglected risks, financial innovation and financial fragility. Journal of Financial Economics 104(3): 452-468.
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Abstract: We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.
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