The Growth of Finance, Financial Innovation, and Systemic Risk Lecture 3 BGSE Summer School in...
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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 Bocconi, IGIER and CREI Slide 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 Slide 3 Shadow banking and the 2007-2008 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 2007-8, as loan pools lost value, the system unraveled: External financing stopped, intermediaries lost from retained risks Slide 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 Slide 5 Shadow Banking and Leverage 5 Slide 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 Slide 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). Slide 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? Slide 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. Slide 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 Slide 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 CDOs. 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. Slide 12 Organization of Presentation 12 The model with rational expectations The model with local thinking and results Extensions (briefly) Slide 13 13 Two dates t = 0, 1 There is a measure 1 of infinitely risk averse investors E [C 0 + min C 1, ] they receive wealth w at t = 0 There is a measure 1 of risk neutral intermediaries E [C 0 + C 1, ] 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. Slide 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 = g, d, r, with g > d > r and Pr( ) = - there is both idiosyncratic and aggregate risk - a pool of projects yields AI L in aggregate state Slide 15 Intermediaries return to investment 15 Technology features decreasing returns + increasing risk Marginal Return R 1 E( )A Total Investment A 0 Slide 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 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. Slide 17 Intermediaries expected profits I 17 At t = 0 each intermediary j has expected profits: RI H,j + + [E ( )A(I L,j S L,j ) + E ( )AT 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 A in . The pool is only subject to aggregate risk about . Slide 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 ) g g + d d + r r 0otherwise A g T L,j gg A d T L,j dd A r T L,j rr Slide 19 19 The constraints faced by the intermediary are: Feasibility: at t = 0 cannot invest more than resources raised Riskless debt constraint: rD j RI H,j + r AT L,j. Pledge safe return and securitized pool in worst state r. Intermediaries carry trade is [ E ( )A r ]T L,j Feasibility of Securitization: S L,j I L,j Cannot sell more investments than those undertaken Slide 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 Slide 21 21 low w : no risky investment, no debt, no securitization Interest rate Total wealth Risky investment and securitization R w int Slide 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 ) Slide 23 23 Intermediate w: some risky investment, debt, no securitization Interest rate Total wealth Risky investment and securitization R w int 1 R > E( )Aw E( )A I L = w + w int 1 R / E( )A Slide 24 24 high w : risky investment, debt, securitization Interest rate Risky investment and securitization R w int 1 R + r AS L > E( )Aw E( )A I L = w + w int 1 S L = [E( )/ r ]w R/A r R/E( )A w int + w * Slide 25 25 Very high w : risky investment, debt, maximal securitization Interest rate Risky investment and securitization R w int 1 R + r AI L > r(w)w E( )A R/E( )A w int + w * w int + w ** 1 Slide 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. Slide 27 Securitization under RE II 27 In worst case scenario r : A fraction 1 r of intermediaries get 0 on their projects: [R + r AS L + 0(I L S L )] [R + r AS L ] = 0 A fraction r of intermediaries get A on their projects: [R + r AS L + A(I L S L )] [R + r AS L ] = A(I L S L ) > 0 Slide 28 Securitization and Local Thinking 28 Local thinking (GS 2010, GSV 2011): neglect unlikely (tail) risk. Here is recession, because r = min . 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 ( )A > E( )A Relax debt constraint: rD j R + d AT L,j. Slide 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( )A w int +w * w int + w ** 1 E LT ( )A w int +