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
2

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.
Banks in the Macroeconomy
3

We will consider three aspects of the link between
financial intermediation and economic activity
 The
growth of finance relative to the “real economy’’
 Financial
 Banks
intermediation: functions and financial crises
as private liquidity creators: creation of safe securities and
systemic risk
 Banks as buyers of government supplied liquidity: government
default risk and systemic risk
Syllabus
4
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
Syllabus
5
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, “Sovereign Default, 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., Itamar Drechsler, and Philipp Schnabl, 2011, A Pyrrhic victory? Bank
bailouts and sovereign credit risk, mimeo, NYU Stern
Why Financial Intermediaries?
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
Financial Intermediaries (e.g. banks) have a comparative
advantage in intermediating savings to real investment.


Given their comparative advantage, adverse shocks to the
balance sheets of banks, and in particular bank failures, will
depress investment and real activity


Ability to monitor and screen real projects
Hard for firms to raise financing at arm’s length
Compare two financial crises: the dot-com bubble and the
recent mortgage crisis
The Dot-Com Bubble (I)
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
Huge Loss of Stock Market Value

The Real Economy gets off easy
The Dot-Com Bubble (II)
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• 5 trillions $ market cap lost by tech companies between 2000 and 2002
The Dot-Com Bubble (III)
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• Pets.com; business motto: “because pets can’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
The Dot-Com Bubble (IV)
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• Brief recession march to november 2001 (Unemployment from 4.3% to 5.7%
• Consumption not much affected relative to motgage crisis. Banks had no skin
in the game: high tec stock are not good collateral for borrowing!
The Subprime Crisis (I)
11

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!
The Subprime Crisis (II)
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



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-term debt = $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.
The Subprime Crisis (III)
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First impressions can be misleading…
The Subprime Crisis (IV)
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
Value of new loans collapsed by 47% in the 4th quarter of 2008!
Some Thoughts
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• Absent aggressive new equity issuance, high leverage of
financial firms means that losses get amplified into large and
prolonged credit contractions.
And new equity issues are impeded by debt overhang.
• The data suggest large loan-supply effects, especially postLehman.
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?
Leverage
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


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
The Simple Economics of Leverage
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

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)
The Negative “Natural” Link Between
Assets Values and Leverage
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

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
Household Sector
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
Data: U.S. Flow of funds, 1963-2006
Non-Financial, Non Farm Corporations
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Data: U.S. Flow of funds, 1963-2006
Commercial Banks
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
Data: U.S. Flow of funds, 1963-2006
Broker Dealer Banks (Inv. Banks)
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
Data: U.S. Flow of funds, 1963-2006
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Important for the Financial Sector
as a Whole
The Leverage Asset Prices Nexus
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
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
An Increase in Asset Prices
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
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
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.
Downward Sloping Supply
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
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.
Some Thoughts
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
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!