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The Growth of Finance, Financial Innovation, and Systemic Risk Lecture 1

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

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The Growth of Finance, Financial Innovation, and Systemic Risk Lecture 1

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

  2. Financial Intermediation in Macroeconomics • Exciting Times! • Intermediaries play virtually no role in early macro models • The crisis stressed the centrality of the process of financial intermediation for the functioning of capitalist economies • Need to go back to basics: institutional detail, specific markets. Large, quantitative, models should wait.

  3. Banks in the Macroeconomy • We will consider three aspects of the link between financial intermediation and economic activity • The growth of finance relative to the “real economy’’ • Financial intermediation: functions and financial crises • Banks as private liquidity creators: creation of safe securities and systemic risk • Banks as buyers of government supplied liquidity: government default risk and systemic risk

  4. Syllabus • The growth of finance: data, causes and consequences • - Philippon, 2012, “Has the U.S. Financial Sector Become less Efficient?”, Mimeo • - Greenwood and Scharfstein, 2012, “The Growth of Modern Finance”, Mimeo. • - Gennaioli, Nicola, Andrei Shleifer and Robert Vishny, 2013, “Money Doctors”, mimeo. • - Gennaioli, Nicola, Andrei Shleifer and Robert Vishny, 2012, “Finance and the Preservation of Wealth”, mimeo. • Shadow Banking, Neglected Risks and the Crisis of 2007-2008: • - Adrian, Tobias, and Hyun Song Shin, 2010, “Liquidity and leverage”, Journal of Financial Intermediation 19, 418-437 • - Brunnermeier, Markus, 2008, “Deciphering the Liquidity and Credit Crunch • of 2007-2008”, Journal of Economic Perspectives • - Gennaioli, Nicola, Andrei Shleifer and Robert Vishny, 2012, “A Model of • Shadow Banking”, Journal of Finance, forthcoming • - Pozsar, Zoltan, Tobias Adrian, Adam Ashcraft, and Hayley Boesky, 2010, • “Shadow banking”, Working paper, NY Federal Reserve Bank

  5. Syllabus How markets plummet: financial innovation, leverage and fire sales - Shleifer, Andrei, and Robert Vishny, 2011, “Fire Sales in Finance and Macroeconomics”, Journal of Economic Perspectives - Geanakoplos, John, 2009, “The leverage cycle”, NBER Macro Annual - Simsek, Alp, 2012, “Risk Sharing and Speculation with new Financial Assets”, mimeo The two-way link between government default risk and bank fragility - Gennaioli, Nicola, Alberto Martin, and Stefano Rossi, 2013, “Sovereign Default, Domestic Banks and Financial Institutions”, Journal of Finance. -Gennaioli, Nicola, Alberto Martin, and Stefano Rossi, 2013, “SovereignDefault, Banks, and Government Bonds: What do the data say?”, mimeo. - Bolton, Patrick, and Olivier Jeanne, 2011, “Sovereign default and bank fragility in financially integrated economies”, NBER working paper. - Acharya, Viral V., ItamarDrechsler, and Philipp Schnabl, 2011, A Pyrrhic victory? Bank bailouts and sovereign credit risk, mimeo, NYU Stern

  6. Why Financial Intermediaries? • Financial Intermediaries (e.g. banks)have a comparative advantage in intermediating savings to real investment. • Ability to monitor and screen real projects • Given their comparative advantage, adverse shocks to the balance sheets of banks, and in particular bank failures, will depress investment and real activity • Hard for firms to raise financing at arm’s length • Compare two financial crises: the dot-com bubble and the recent mortgage crisis

  7. The Dot-Com Bubble (I) • Huge Loss of Stock Market Value • The Real Economy gets off easy

  8. The Dot-Com Bubble (II) • 5 trillions $ marketcaplostbytechcompaniesbetween 2000 and 2002

  9. The Dot-Com Bubble (III) • Pets.com; businessmotto: “becausepetscan’t drive” • Founded in 1998 • Revenues in first fiscal year: 619K $ (not a typo) • IPO on feb. 2000: capitalization of over 1B $ (not a typo) • Folds in Nov. 2000

  10. The Dot-Com Bubble (IV) • Briefrecessionmarchtonovember 2001 (Unemploymentfrom 4.3% to 5.7% • Consumptionnotmuchaffectedrelativetomotgage crisis. Banks had no skin in thegame: hightec stock are notgoodcollateralforborrowing!

  11. The Subprime Crisis (I) • Subprime losses are smaller • Total global write-downs over 2007-2010 of about 3 trillions • Of which, approximately 1 trillion hits financial institutions • Problem: subprime losses are concentrated in highly levered banks!

  12. The Subprime Crisis (II) • Approximate Financial Structure of U.S. Banking System: • Assets = $15.0 T • Liabilities = $13.6 T (Deposits = $8.5T, Other short-term borrowing = $3.2T, Long-termdebt = $1.9T, ….) • …Equity capital = $1.4T. • Equity is less than 10% of assets. • Leverage effect: if value of assets falls by only 5% ($750B), over 50% of bank equity is wiped out. • And banks’ ability to lend is constrained by their equity capital. • Due to regulatory capital requirements. • And their own internal risk controls.

  13. The Subprime Crisis (III) First impressions can be misleading…

  14. The Subprime Crisis (IV) • Value of new loans collapsed by 47% in the 4th quarter of 2008!

  15. Some Thoughts • Absent aggressive new equity issuance, high leverage of • financial firms means that losses get amplified into large and prolonged creditcontractions. • And new equity issues are impeded by debt overhang. • The data suggest large loan-supply effects, especially post-Lehman. • You can see why policymakers were so focused on getting more capital into the banks: TARP, stress tests, etc. • To come: how did we get there? Why the financial sector became so large? What are the dynamics of leverage?

  16. Leverage • We will see why intermediaries and the financial sector more generally grew so large. • For now, let us look at one specific way in which it grew, namely by increasing its indebtness • Financial sector leverage: problematic for financial crises

  17. The Simple Economics of Leverage • A household buys a house worth 100 with a mortgage of 10. This is the only asset of the household. The household’s balance sheet is: • Leverage is: value of assets/value of equity, or: value of assets/(value of assets-debt)

  18. The Negative “Natural” Link Between Assets Values and Leverage • As the value of debt is roughly constant, increases in asset values tend to reduce leverage • Example: the value of the house increases to 110. Leverage is now equal to: 110/(110 - 90) = 5,5 < 10 ! • Home equity increases and, for a given value of debt, leverage falls. In principle, this implies that asset price booms should reduce leverage in the economy

  19. Household Sector • Data: U.S. Flow of funds, 1963-2006

  20. Non-Financial, Non Farm Corporations • Data: U.S. Flow of funds, 1963-2006

  21. Commercial Banks • Data: U.S. Flow of funds, 1963-2006

  22. Broker Dealer Banks (Inv. Banks) • Data: U.S. Flow of funds, 1963-2006

  23. Important for the Financial Sector as a Whole

  24. The Leverage Asset Prices Nexus • Where does it come from? • Banks actively, aggressively, manage their balance sheets • Banks seek to maximize their size • We will highlight the role of an important market force: the shadow banking sector demanding safe debt and its interaction with other financial institutions (e.g. banks, broker dealers, etc.) willing to take more (levered) risk. • Profound implications for asset price dynamics • See this through an example

  25. An Increase in Asset Prices 25 • Suppose that a bank initially has the following balance sheets • Leverage is 100/10=10 • The value of asset goes up by 1 (to 101). If the bank is passive, its equity becomes worth 11 and leverage goes to: 101/11 = 9,1 < 10 Debt’ = 90, Equity’= 11 • The bank, just as the previous household, becomes less leveraged during asset price booms

  26. Upward Sloping Demand 26 • Suppose that the bank, rather than being passive, actively manages its balance sheet, i.e. seeks to keep leverage constant • Recall that initial leverage was 100/10=10 • Now that the value of asset has gone up to 101, the bank can borrow D to buy an additional value D of assets: (101 + D)/[(101 + D) – (90 + D)] = 10 → D = 9 Assets’ = 110, Debt’ = 99, Equity’= 11 • The bank buys assets when their price increases. Balance sheets and debt expand together.

  27. Downward Sloping Supply 27 • Suppose now that the value of assets drops again to 100 • Initial leverage now is 110/11 =10 • If, once more, the banks wishes to keep leverage constant, it will have to sell an amount D of assets such that (100 – D)/[(100 – D) – (99 –D)] = 10 → D = 90 Assets’ = 10, Debt’ = 9, Equity’= 1 • Huge contraction in balance sheets. The bank sells assets when their price goes down.

  28. Some Thoughts 28 • The consequences of the previous mechanism can be deadly • In good times banks feed asset price bubbles and build up enormous leverage • In bad time they try to desperately sell their assets to meet their leverage ratios, depleting their net worth • They stop financing real projects and a recession comes about • Questions that need to be addressed: • Why did certain risk-taking institutions become so large? • Why did they take risk by relying on leverage? • How can leverage lead to market failure? We will address this, and more, in the next classes!

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